Assignment
Chelsea29440
Ch04_Martocchio_6e.pptxPart Two: Retirement, Health Care and Life Insurance
Chapter Four: Employer-Sponsored Retirement Plans
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Learning Objectives
In this chapter, you will gain an understanding of:
how employer-sponsored retirement plans are defined.
differences between qualified plans and nonqualified plans.
features of defined benefit plans and defined contribution plans.
specific types of defined contribution plans.
features of various hybrid plans.
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Overview
Start by defining retirement plans and then looking at qualified and nonqualified plans.
Next is defined benefit plans including requirements, rules, and limits.
Followed by defined contribution plans including different types of plans.
Last is the different types of hybrid plans.
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Defining and Exploring Retirement Plans
First, two brief definitions.
A defined benefit plan guarantees retirement benefits, usually expressed in an annual sum.
Sometimes referred to as pension plans.
A defined contribution plan is when employees annually contribute to their individual account.
Employers may match contributions.
Participants receive amounts based on the performance of the selected financial plan investments.
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Origins of Employer-Sponsored Retirement Benefits
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Timeline in the United States
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1759 – the first plan was for families of Presbyterian ministers.
1875 – the first private sector plan was at the American Express Company.
Revenue Act of 1921 –growth was due to favorable tax treatment and wage controls.
National Labor Relations Act of 1935 – made retirement plans a bargaining subject.
Trends in Retirement Plan Coverage and Costs
55% of workers participated in a company-sponsored retirement plan in 1992-1993.
Declining to 49% in 2016.
Defined benefit plans have decreased and defined contribution plans have increased.
1992-93 – 32% participated in defined benefit plans and 35% in defined contribution plans.
2016 – 15% participated in defined benefit plans and 44% in defined contribution plans.
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Trends in Retirement Plan Coverage and Costs
Two important factors for these trends are:
Industry characteristics
Goods-producing, capital intensive industries offer higher pay and retirement plans.
Service industries pay lower wages and offer less generous benefits, including retirement plans.
Union status
Unions secured high wages and benefits through the early 1980s and maintain lucrative benefits though costs have resulted in freezes or termination of pension plans.
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Exhibit 4.1
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Characteristics of Qualified Retirement Plans
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Qualified vs. Nonqualified Plans
Participation Requirements.
Age 21 and one year of service (1,000 work hours).
Coverage Requirements.
Qualified plans do not favor highly compensated employees or key employees.
Ratio percentage test, or
Average benefit test.
Defined benefit plans must meet U.S. Department of Treasury participation standards.
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Qualified vs. Nonqualified Plans
Vesting Rules.
Vesting – an employee’s nonforfeitable rights to retirement plan benefits.
Defined benefit plans – employees vest in a specific annual amount, each year after retirement.
Defined contribution plans – employees vest in net employer contributions.
Title I of ERISA requires companies follow an allowed schedule for vesting rights:
Cliff vesting or six-year graduated schedule.
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Qualified vs. Nonqualified Plans
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Vesting Rules
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Cliff vesting
Grants employees 100% vesting after no more than three years from initial participation.
Six-year graduated schedule
Allows workers to become 20% vested after two years and continue vesting at 20% each year until fully vested after six years.
Qualified vs. Nonqualified Plans
Accrual Rules.
Specify the rate at which participants earn benefits.
Nondiscrimination Rules: Testing.
Prohibit favoring highly compensated employees.
Fulfilled using
safe harbors or a
facts-and circumstances testing.
Top-Heavy Provisions.
Non-key employees receive a minimum benefit or a minimum contribution and a special vesting schedule.
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Qualified vs. Nonqualified Plans
Minimum Funding Standards.
Ensures employers contribute the minimum amount necessary to provide promised benefits.
Social Security Integration.
Or permitted disparity rules - employers may consider SS benefits within their defined benefit plan.
Contribution and Benefit Limits.
Benefit limits - maximum annual amount employee may receive from a qualified defined benefit plan.
Contribution limits apply to defined contribution plans.
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Qualified vs. Nonqualified Plans
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Plan Distribution Rules
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Events triggering mandatory distribution
Termination of services
10th anniversary of commencing the plan
Three allowable distribution methods
Lump sum
Annuities – a series of payments for life
Employee reaches retirement age
Payments from a trust fund
Qualified vs. Nonqualified Plans
Qualified Survivor Annuities.
Provides spouses with a qualified joint and survivor annuity (QJSA) or a qualified preretirement survivor annuity (QPSA).
Qualified Domestic Relations Orders.
Qualified domestic relations orders (QDROs) provides benefits in the event of a divorce.
Plan Termination Rules and Procedures.
Plan termination rules – protect employees who participated in a terminated plan.
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Defined Benefit Plans
Defined benefit plans guarantee retirement benefits specified in the plan document.
Benefit is an annual sum equal to a percentage of preretirement pay multiplied by years of service.
Disbursed in equal monthly payments.
Benefit is fixed by a formula.
The level of required employer contributions fluctuates from year to year based on investment performance and life expectancy.
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Defined Benefit Plans
Flat benefit formula
Flat amount formula – each employee receives a flat dollar amount.
Flat percentage formula – the dollar amount is based on an employee’s pay.
May lead to resentment as years of service are not acknowledged.
Unit benefit formula
Recognize length of service.
Annual benefits based on age, years of service, and final average wages/salary.
Specifies annual retirement benefits as a percentage of final average salary.
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Defined Benefit Plans
Nondiscrimination Rules: Testing.
Must meet several uniformity criteria, as well as one additional safe harbor criterion.
Uniform normal retirement benefit.
Uniform post-normal retirement benefit.
Uniform subsides.
Uniform vesting and service crediting.
No employee contributions.
Period of accrual.
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Defined Benefit Plans
Accrual Rules.
Accumulated benefit obligation is the present value of benefits based on a designated date.
To avoid backloading, use one of these three rules
The Three Percent Rule – accrued benefit cannot be less than 3% of the normal retirement benefit.
The 1331/3 Percent Rule – accrual rate cannot exceed 1331/3% of accrual rate of previous year.
The Fractional Rule – apples to early termination and requires benefit be proportional to the normal benefit.
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Defined Benefit Plans
Top-Heavy Provisions.
Non-key employees receive an accrued benefit of a percentage times employee’s average pay.
Minimum Funding Standards.
ERISA imposes strict funding requirements.
Benefits Limits.
The IRC sets a maximum annual benefit equal to the lesser of $215,000, or 100% of the highest average pay for three consecutive years.
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Defined Benefit Plans
The PBGC’s program recognizes three types of plan terminations:
Distress terminations,
Involuntary terminations, and
Standard terminations.
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Defined Contribution Plans
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Overview
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Defined contribution plans
Salary reduction agreements
Forfeitures
Companies set up an account for each participating employee.
Permit an employer to defer a percentage of pay into employee’s account.
Come from accounts of employees who terminated their employment prior to vesting.
Defined Contribution Plans
Individual Accounts.
Three possible contribution sources.
Employee contributions – usually a percent of pay.
Employer contributions – matching contributions.
May make a full or partial match.
Forfeitures from unvested former employees.
Investments of Contributions.
ERISA requires a fiduciary be named with several responsibilities, including prudence.
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Exhibit 4.6
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Conditions Relieving Fiduciary of Responsibility with Employee Participation in Investments
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Defined Contribution Plans
Nondiscrimination Rules: Testing.
Must meet one of two safe harbor conditions:
A uniform allocation formula, or
A uniform points allocation formula for profit-sharing.
Accrual Rules.
Accrued benefit equals individual account balance.
Top-Heavy Provisions.
Companies must contribute to non key-employee accounts equal to either 3% of annual pay or the highest contribution made to key-employee accounts.
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Defined Contribution Plans
Minimum Funding Standard.
Less complex than defined benefit plans.
The standard is met when account contributions meet the minimum amounts specified in the plan.
Contribution Limits.
Annual addition is the annual maximum amount.
Includes additions from all three sources.
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Types of Defined Contribution Plans
401(k) Plans.
Permits employees to defer part of their pay to an individual account.
Only private-sector or tax-exempt employers may sponsor these plans.
Three tax benefits.
Employees do not pay income tax until withdrawn.
Employers deduct contributions from taxable income.
Gains are not taxed until funds are distributed.
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Types of Defined Contribution Plans
Roth 401(k) Plans.
Differ in two ways.
An employee pays income tax on their contributions.
Upon retirement, withdrawals are not taxed.
Profit-Sharing Plans.
Distribute a portion of profits to employees.
Starts with a profit-sharing pool.
Maximum annual contributions are limited.
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Types of Defined Contribution Plans
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Profit-Sharing Plans
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Employer Contributions
Fixed first-dollar-of-profits formula
Graduated first-dollar-of-profits formula
Allocation Formulas
Equal payments
Proportional payments based on annual salary
Profitability threshold formulas
Proportional payments based on contribution to profits
Types of Defined Contribution Plans
Stock Bonus Plans.
A kind of profit-sharing paid in employer stock instead of cash.
Employee Stock Option Plans (ESOPs).
Provides shares of company stock to employees.
Nonleveraged ESOPs
Leveraged ESOPs
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Types of Defined Contribution Plans
Savings Incentive Match Plans for Employees (SIMPLEs).
Small companies meeting certain criteria may establish accounts as IRAs or 401(k) plans.
Section 403(b) Tax-Deferred Annuity Plans.
A TDA is available to nonprofit organizations.
Section 457 Plans.
Nonqualified plans for government employees.
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Hybrid Plans
Combine features of traditional defined benefit and defined contribution plans.
Many employers have replaced traditional defined benefit plans with hybrid plans.
“golden handcuffs”
The traditional approach was not conducive to attracting valuable employees due to younger worker mobility.
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Exhibit 4.8
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Comparison of Features of Pension Equity Plans and Cash Balance Plans
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Hybrid Plans
Cash balance plans differ from 401(k) plans.
Participation – cash balance plans do not require a contribution but 401(k) plans do.
Investment risks – the employer managers a cash balance plan and employees manage 401(k) plans.
Life annuities – unlike 401(k) plans, cash balance plans are required to offer benefits as annuities.
Federal guarantee – the PBGC has authority over defined benefit plans but not defined contribution plans.
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Hybrid Plans
Concerns about Cash Balance Plans.
Possible favorable treatment of younger workers.
Converting tradition defined benefits to cash balance plans.
Target Benefit Plans.
Calculate benefits on a formula that uses income and years of service.
The targeted benefit amount may differ based on the investment performance of the plan’s assets.
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Hybrid Plans
Money Purchase Plans.
Defined as contribution plans because the benefit is based on the account balance.
However, they face funding requirements of defined benefit plans.
Age-Weighted Profit-Sharing Plans.
Defined contribution plans because benefit amounts fluctuate with investment performance.
Consideration of age is a defined benefit plan feature.
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Summary
The chapter started by defining retirement plans and then looking at qualified and nonqualified plans.
Next it defined benefit plans including requirements, rules, and limits.
Followed by defined contribution plans including different types of plans.
Last was the different types of hybrid plans.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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