III.

Private Employer-Sponsored Retirement Plans

Many private employers in the United States maintain retirement plans for their full-time employees. About 66 percent of the labor force is covered by some kind of retirement plan. Very few companies offer retirement plans for part-time workers. These plans developed for a number of reasons. One reason was tax incentives. An employer may take an immediate tax deduction for a contribution into a retirement plan even though benefits will not be paid to employees until some future time.

Historically, various other factors contributed to the growth of private retirement plans. During World War II price controls restricted wage increases. However, employers were allowed to offer or improve retirement and other benefits, and many did so to make up for the lack of wage gains. Following the war, trade unions came to believe that the Social Security program did not fully provide for workers’ total retirement needs, and they negotiated with employers for retirement plans. To compete with other companies for workers, some businesses offered retirement plans as a way to attract and retain workers. Finally, to absorb a younger work force, many companies offered retirement plans as incentives for older workers to retire and make way for younger workers who earned lower salaries.

Employer-sponsored retirement plans fall into two categories: qualified plans and nonqualified plans. Qualified plans, in turn, take two major forms: defined benefit plans and defined contribution plans. There are also so-called “hybrid plans” that contain attributes of both forms. Nonqualified plans do not receive the same tax benefits as those provided to qualified plans.

A.

Qualified Plans

A qualified plan is any plan that meets the requirements of Section 401 of the Internal Revenue Code, which Congress passed to encourage retirement savings by providing tax incentives for both employers and employees. Many of these requirements were first enacted in 1974 with passage of the Employee Retirement Income Security Act (ERISA).

This act was one of the most important pieces of legislation affecting private retirement plans. It established employer responsibilities to plan participants. It set compliance standards for employers and gave several government agencies the power to regulate and insure private programs. The Internal Revenue Service (IRS) establishes the rules that qualify the plans for tax breaks. The Department of Labor ensures that employers comply with requirements in order to protect participants in the plans. The Pension Benefit Guaranty Corporation (PBGC) insures defined benefit pension plans.

ERISA’s standards forbid employers from engaging in certain dealings using plan assets. These dealings are called prohibited transactions. For example, employers cannot use plan assets to lend money or extend credit. ERISA requires that a licensed actuary examine some plans on an annual basis. An actuary is an expert on assessing whether a plan can fulfill its obligations to plan participants. For example, the actuary determines whether assets in the plan are sufficient to meet benefit obligations. ERISA also requires employers to disclose information to government agencies and plan participants and their beneficiaries about how the retirement plans are managed.

Qualified retirement plans have vesting requirements. Vesting refers to the amount of retirement benefits guaranteed to a worker after a certain number of years of working for the same employer. To be fully vested means that the worker is entitled to all the contributions or the benefits provided by the employer contributions to the retirement plan, regardless of whether the worker remains employed. There are two types of vesting schedules: graded vesting and cliff vesting. With graded vesting, an employee gradually becomes entitled to the amount of money the employer has contributed to the retirement plan. With cliff vesting, the employee becomes entitled to the employer contribution only after working for the employer for a certain number of years. Before that time, the employee is not vested at all in an employer’s contributions. Employees are fully vested in their own contributions immediately.

The Economic Growth and Tax Relief Reconciliation Act of 2001 impacted schedules for vesting in qualified plans. An employee enrolled in a qualified plan with a cliff-vesting schedule is fully vested in employer contributions after working full-time for the employer for three years. Before that time, the employee is not vested in employer contributions. An employee in a plan with a gradual-vesting schedule is entitled to 20 percent of the employer’s matching contributions after two years of service and is 100 percent vested after six years of participation. If an employer makes a contribution to a plan without requiring employees to contribute as well, the employer can use five-year cliff vesting or seven-year graded vesting.

Qualified employer-sponsored plans must generally conduct nondiscriminatory tests to receive tax-qualified status. They cannot unduly benefit highly compensated employees. The Tax Reform Act of 1986 strengthened the nondiscriminatory nature of qualified plans by instituting a series of precise mathematical tests to determine when highly compensated employees were being unduly benefited.

B.

Nonqualified Retirement Plans

A nonqualified employer-sponsored retirement plan is any plan that does not meet the requirements of Section 401 of the Internal Revenue Code. Other sections of the Internal Revenue Code provide for special types of retirement savings plans, some of which must meet special requirements. Some of the nonqualified programs can be offered on a discriminatory basis to certain employees. Typically, nonqualified plans are offered to key executives in the organization. They are used to provide additional income over the limited amount offered by qualified plans, and they are often an effective device for recruiting executive talent. These programs lack the legislative protections guaranteed by qualified plans. Nor do they enjoy the same tax benefits as qualified plans. These plans generally must be unfunded arrangements. Unfunded means that the assets held in these plans are not protected from general creditors if the firm experiences financial difficulties. Plan participants have no greater claim to these assets than general creditors of the firm.

C.

Defined Benefit and Defined Contribution

The two major types of qualified retirement plans are the defined benefit plan and the defined contribution plan. A defined benefit plan is often referred to as a pension. It establishes a fixed formula for determining the precise benefit amount an employee receives upon retirement. Contributions to the plan are made entirely by the employer. There is no fixed formula for how much the employer must contribute to the plan; instead, the employer is obligated to contribute as much as necessary to meet the defined benefit amount.

The employer faces certain risks and rewards associated with the defined benefit approach. Risks may include the failure of the plan’s assets to earn the expected investment returns required to pay the defined benefit. In that event the employer must make additional contributions into the plan to make up the difference. Rewards include the ability of the employer to take an immediate tax deduction for contributions to the plan and to reduce future contributions if investment returns are better than anticipated.

The employee as well faces certain advantages and disadvantages with the defined benefit approach. The advantages are that the employer typically funds the retirement plan without any contributions from the employee. A certain level of benefits is also guaranteed by the Pension Benefit Guaranty Corporation (PBGC), which was created by ERISA. Even if the company goes out of business, all or a portion of the employee’s pension is protected. A disadvantage of the defined benefit plan is that the employee has no control over the pension fund’s investments. Some employees believe they could earn higher returns if they controlled their retirement benefit investments, although employees often cannot outperform retirement plans investing for the long term.

C.1.

Defined Benefit Formulas

Employers use various types of formulas in determining the defined benefit amount. A flat amount formula establishes the pension benefit as a flat monthly amount—for example, $1,000 per month to any eligible employee upon retirement for the remainder of their life. A flat percentage of earnings formula provides a percentage of either career earnings or earnings averaged over a set number of years, usually the final years of employment. For example, if an employee earned an average of $50,000 per year during the last five years of employment and the employer established a flat formula of 20 percent of those earnings, then the employee would receive a pension benefit of $10,000 per year.

Other common formulas involve providing a flat amount per year of service. Such a formula might be $20 per month for each year of service. Another slightly more complex formula, but one that is fairly common, is the percentage of earnings per year of service. An example of this formula might be 1.25 percent for each year of service multiplied by the average amount of earnings during the last five years of employment.

D.

Defined Contribution Plans

Defined contribution plans require fixed contributions into a plan. Rather than guaranteeing a fixed payout, as the defined benefit plan does, an employer commits to a defined contribution. For example, an employer may contribute 6 percent of each employee’s salary or match a certain percentage of an employee’s contribution to the plan. The resulting pension payout depends on the amount of assets that have accumulated in the plan by the time the participant retires. Many defined contribution plans are participant-directed, meaning the participant determines how the funds in the account are invested. Therefore, the individual participant, rather than the plan sponsor, bears the investment risks, responsibilities, and rewards of investing plan assets.

E.

Types of Defined Contribution Plans

There are many types of defined contribution plans. Among them are 401 (k) plans; corporate profit-sharing plans; stock bonus plans; money purchase pension plans; savings incentive match plans for employees, known as SIMPLE plans; and simplified employee pension (SEP) plans.

E.1.

401(k) Plans

A section of the Internal Revenue Code, Section 401(k), provides the framework for 401(k) plans, which have become increasingly popular with employers and employees. A number of employers have replaced their defined benefit pension plans with 401(k) plans. In 2000 about 42 million Americans participated in about 327,000 401(k) plans with assets totaling $1.8 trillion, increasing from 30,000 plans and 10 million participants in 1985.

The 401(k) plan allows employer and employee contributions and the investment earnings on these contributions to grow tax deferred—that is, as long as assets remain in the plan, they are not taxed. People pay taxes only when they withdraw money from the plan. Consequently, a 401(k) plan is known as a tax-deferred plan. In addition, a 401(k) plan allows an employee to make a pre-tax contribution to the plan. This means that the employee’s contribution is not subject to taxation at the time the contribution is made. For example, if an employee earns $50,000 a year and contributes 10 percent, or $5,000 each year to the plan, then the employee will have a taxable income of only $45,000. As a result, these plans are sometimes referred to as salary reduction plans. The provisions of 401(k) plans give employees an incentive to save for retirement and enable them to see their assets grow on a tax-deferred basis.

The 401(k) plans are available to employees of for-profit corporations, and although once prohibited at not-for-profit organizations they are now available at many such organizations. Also, similar specialized plans exist for employees of certain nonprofit, educational, and governmental organizations. For instance, another section of the Internal Revenue Code, known as Section 403(b) retirement plans, can be offered to certain charitable and educational organizations, including public school systems, community colleges, and state universities. These plans permit contributions by employees to be made on a pre-tax basis, as with a 401(k) plan. Section 457 of the Internal Revenue Code establishes special deferred compensation plans for employees of state and local government and to nonprofit and educational organizations. These special Section 457 plans are commonly used to build tax-deferred assets for retirement purposes, although technically they do not qualify as retirement plans.

E.2.

Corporate Profit-Sharing Plans

A typical corporate profit-sharing plan can be used for retirement but may not be exclusively created for this purpose. Often the purpose of such plans is to provide an incentive for employees to be more productive and thereby boost the company’s profits. Employer contributions to profit-sharing plans are discretionary. The employer does not have to commit to a set contribution, and contributions do not necessarily have to be made each year, although the law requires that contributions must be made on a “substantial and recurring basis.” Under ERISA, profit-sharing plans must be administered so that investments are diversified, thereby protecting participants from the possible failure of an investment in a single security.

E.3.

Stock Bonus Plans

A stock bonus plan is a type of defined contribution plan that does not require diversification. Instead, the stock bonus plan is limited to the securities of the employer, and its purpose is to give employees an incentive to contribute to the success of the company.

The employee stock ownership plan (ESOP) is a type of defined contribution benefit plan that buys and holds company stock. Company contributions to the ESOP are tax deductible within certain limits. In an ESOP, a company sets up a trust fund based on shares of its stock. The company can be private or it can be publicly traded. Shares in the stock are granted on the basis of salary or some other formula to individual employees who become fully vested in their shares within five to seven years. When an employee leaves the company or retires, the company must buy back the shares at its fair market value if the stock is publicly traded or on the basis of an annual outside valuation if the company’s stock is privately held.

E.4.

Money Purchase Pension Plans

A money purchase pension plan is a defined contribution plan in which an employer promises to make a set contribution to the plan each year. The contribution to the money purchase pension plan can be made either as a flat dollar amount or as a percentage of the employee’s pay. Only money purchase plans created prior to the passage of ERISA permit employee contributions on a pre-tax basis. Also, money purchase pension plans do not allow withdrawals while workers are still actively employed, and spouses have certain rights to assets in these plans, as with other tax-favored retirement plans.

Historically, many employers typically offered a money purchase pension plan and a supplementary 401(k) plan. If a 401(k) plan was offered alone, the IRS limited the amount that could be contributed to 15 percent of an employee’s pay. If both a 401(k) and a money purchase plan were offered, the limit on combined deductible contributions was 25 percent. Starting in 2002, the Economic Growth and Tax Relief Reconciliation Act of 2001 increased the allowable contribution percentage to 25 percent of an employee’s pay for the type of plan typically used with 401(k)s. As a result, the use of money purchase pension plans alone may decline in future years.

E.5.

SIMPLE Plans

The Small Business Job Protection Act of 1996 created a way for small businesses to offer retirement plans without having to meet the rigorous government standards required of 401(k) plans. The act created a plan known as savings incentive match plan for employees (SIMPLE). Two types of SIMPLE plans can be offered: SIMPLE individual retirement accounts (IRAs) and SIMPLE 401(k)s. To qualify, a business must have 100 or fewer employees and cannot offer any other retirement plans. Various types of business entities can establish SIMPLE plans.

SIMPLE IRAs enable people to save more annually than they could with a regular, individual IRA, and they require employers to contribute to the IRA. Employers must contribute to a SIMPLE IRA, either by matching 100 percent of the employee’s contributions up to a certain percentage of the employee’s compensation but no greater than a maximum contribution or by contributing a flat percentage of compensation for all eligible employees regardless of whether they participate in the plan. Maximum levels of contributions are adjusted for inflation. All contributions to a SIMPLE IRA, including employer contributions, are fully vested immediately.

A SIMPLE 401(k) provides tax-free advantages like a regular 401(k). For participating employees, employers must match 100 percent of the employee’s contribution up to a certain limit of the employee’s compensation. Alternatively, the employer can make a contribution without requiring an employee contribution, but if the employer chooses this alternative, it must make contributions for eligible employees whether or not they choose to participate. Maximum contributions are adjusted for inflation. Employees are fully vested in all contributions to a SIMPLE plan, and these contributions are nonforfeitable.

E.6.

Simplified Employee Pension (SEP) Plans

Simplified employee pension (SEP) plans are designed for small businesses and the self-employed. They predate SIMPLE plans. SEP plans utilize individual retirement accounts, but allow for higher contribution limits. However, contributions to SEP plans are not mandatory, and if an employer has a bad year, contributions may not be made at all. As with any type of IRA, an employee can specify the type of IRA investment that they want, such as mutual funds, stocks, bonds, or certificates of deposit. Employees are fully vested immediately in these plans.

SEPs require little record-keeping and minimal administration. For this reason, SEP IRAs have appeal. Another retirement plan for the self-employed are known as Keoghs, for the New York legislator who sponsored the Self-Employed Individuals Tax Retirement Act of 1962. Keoghs offer many tax advantages as do SEPs but require more administration to meet government requirements. However, more money can be set aside and sheltered from taxes with a Keogh.