Benefits and Compensation

Part Two

Retirement, Health, and Life Insurance

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 103

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 104

Chapter Five

Employer-Sponsored Retirement Plans

105

Chapter Outline

Defined Retirement Plans Origins of Employer-Sponsored Retirement Benefits Trends in Retirement Plan Coverage and Costs Minimum Standards for Qualified Plans

Qualified Plans

Defined Benefit Plans Benefit Formulas Nondiscrimination Rules: Testing Accrual Rules Minimum Funding Standards Benefit Limits and Tax Deductions

Defined Contribution Plans Individual Accounts Investments of Contributions Employee Participation in Investments Nondiscrimination Rules: Testing Accrual Rules Minimum Funding Standards Contribution Limits and Tax Deductions

Types of Defined Contribution Plans Section 401(k) Plans Profit-Sharing Plans Stock Bonus Plans Employee Stock Option Plans (ESOPs)

Savings Incentive Match Plans for Employees (SIMPLEs) Section 403(b) Tax-Deferred Annuity Plans Section 457 Plans

Hybrid Plans Cash Balance Plans and Pension Equity Plans Target Benefit Plans Money Purchase Plans Age-Weighted Profit-Sharing Plans

Summary

Learning Objectives

In this chapter, you will gather information about:

1. Differences between qualified plans and nonqualified plans.

2. Features of defined benefit plans and defined contribution plans.

3. Specific types of defined contribution plans.

4. Various hybrid plans, especially the controversy surrounding cash balance plans.

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 105

106 Part Two Retirement, Health, and Life Insurance

Your new employer has informed you that you will automatically be enrolled in the company’s 401(k) defined contribution retire- ment plan and 2 percent of your salary will be deducted from your paycheck each month. You are given the option to have more set aside from your paycheck as long as the amount doesn’t exceed $16,500 (in 2009) or $22,000 if you are 50 or older. Then, you review information showing the allocation of your monthly contribution to various mutual funds, and you are encouraged to consider other mutual funds that will help you achieve having enough money to support retirement. At that moment, you remember that your parents’ retirement plans are a defined benefit pension plan, which does not require any input from them. In fact, they mentioned that they know how much money they will receive from their plans each month for the rest of their lives. And you begin to wonder why your employer does not offer the same plan.

The purpose of this chapter is to review the fundamentals of company-sponsored pension plan design.* It is essential to note that individuals may receive retirement benefits from as many as three sources: First, employer-sponsored retirement plans provide employees with income after they have met a minimum retirement age and have left the company. Second, the Social Security Old-Age, Survivor, and Disability Insurance (OASDI) program, described in Chapter 8, provides government-mandated retirement income to employees who have made sufficient contributions through payroll taxes. Third, individ- uals may use their initiative to take advantage of tax regulations that have created such retirement programs as individual retirement accounts (IRAs) and Roth IRAs.

Companies establish retirement or pension plans following one of three design configurations: a defined benefit plan, a defined contribution plan, or hybrid plans that combine features of traditional defined benefit and defined contribu- tion plans. For example, these configurations determine such outcomes as whether retirement income is fixed by a formula or depends on the performance of investment vehicles such as company stock, company profits, mutual funds, or bonds. With defined benefit plans, retirees receive guaranteed payments for the duration of their lives, but represent a substantial cost burden to companies that must ensure adequate funding to support retirees for longer periods based on rises in life expectancy. In Chapter 4, we described this challenge to companies and the role of the Pension Protection Act of 2006, which is supposed to help shore

*The terms retirement plan and pension plan are typically used interchangeably. Most often, pension programs refer to Social Security old-age benefits (Chapter 8) or company-sponsored defined benefit arrangements. Also, in this chapter, the terms company-sponsored and employer-sponsored are used interchangeably, referencing plans offered to eligible employees.

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 106

Chapter 5 Employer-Sponsored Retirement Plans 107

up the financial solvency of defined benefit plans in private sector companies and to automatically enroll employees in defined contribution plans. From the employee’s perspective, defined contribution plans are much riskier than defined benefit plans because the amount and duration of retirement income depends mainly on the performance of investments. Many companies offer more than one plan based on these design configurations.

In addition, tax incentives encourage companies to offer pension programs. Some of the ERISA Title I and Title II provisions set the minimum standards required to “qualify” pension plans for favorable tax treatment. Failure to meet any of the minimum standard provisions “disqualifies” pension plans for favor- able tax treatment. Pension plans that meet these minimum standards are known as qualified plans. Nonqualified plans refer to pension plans that do not meet at least one of the minimum standard provisions; typically, highly paid employees benefit from participation in nonqualified plans. We find that nonqualified plans often are a part of executive deferred compensation, which is beyond the scope of this book.

From here, we explore the minimum standards that distinguish qualified plans from nonqualified plans. Afterward, we examine the features of alternative company-sponsored pension plans, including defined benefit plans, defined con- tribution plans, and hybrid plans. Then, we discuss Social Security integration, a potentially controversial practice because it can substantially reduce the amount retirees receive from their qualified retirement plans.

DEFINED RETIREMENT PLANS

We learned from Chapter 4 that retirement or pension plans function by provid- ing “retirement income to employees, or [result] in a deferral of income by employees for periods extending to the termination of covered employment or beyond, regardless of the method of calculating the contributions made in the plan, the method of calculating benefits under the plan, or the method of distrib- uting benefits from the plan.”1

Origins of Employer-Sponsored Retirement Benefits According to the Employee Benefit Research Institute,2 the first pension plan in the United States was established in 1759 to benefit widows and children of Presbyterian ministers. In 1875, the American Express Company established a for- mal pension plan. From that point until World War II, pension plans were adopted primarily in the railroad, banking, and public utility industries. The most signifi- cant growth occurred after the favorable tax treatment of pensions was estab- lished through the passage of the Revenue Act of 1921, and government-imposed wage increase controls during World War II in the early 1940s led companies to adopt discretionary employee benefits plans such as pensions that were excluded from those wage increase restrictions.

The current tax treatment of qualified plans continues to provide incentives both for employers to establish plans and for employees to participate in them. In general,

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 107

108 Part Two Retirement, Health, and Life Insurance

a contribution to a qualified plan is deductible in computing the employer’s or employee’s taxes based on who made the contribution. Employees pay taxes only on the amount they withdraw from the plan each year. As we discussed in Chapter 4, this preferential tax treatment is contingent on the employer’s compliance with the Employee Retirement Income Security Act of 1974 (ERISA).

Trends in Retirement Plan Coverage and Costs According to the U.S. Bureau of Labor Statistics, nearly 55 percent of workers employed in the private sector participated in at least one company-sponsored retirement plan in 1992–1993.3 Since then, the participation rate has declined slightly to approximately 50 percent in 2006,4 which represents the latest available data at the time of publication. However, there has been a noticeable decrease in participation rates for defined benefit plans over the last 15 years. In 1992–1993, 32 percent of private sector employees participated in defined contribution plans, and slightly fewer participated in defined benefit plans.5 In 2006, 42 percent par- ticipated in defined contribution plans, but only 20 percent participated in defined benefit plans.6

These trends in retirement plan participation have two important explana- tions.7 First, there has been a shift in the labor force toward different occupations and industries. Specifically, there has been a relative decline in employment among full-time workers, union workers, and workers in goods-producing busi- nesses. The decline in full-time workers and the increase in part-time workers has led to fewer opportunities for participation in company-sponsored retirement plans. Quite simply, employers often employ part-time workers to save benefits costs. The decline in union affiliation (union members or just part of the bargaining unit) also contributes to the overall trends described earlier. In 2006, nearly 90 percent of employees affiliated with unions were eligible to participate in a retirement plan, while only about half of the nonunion workers were eligible. As we discussed in Chapter 4, unions represent workers in negotiations with management over terms of employment. The inclusion of lucrative retirement plans was among the top priorities in negotiations to maintain the support of middle-aged and older work- ers. Finally, among employment trends, the expansion of service industries rela- tive to somewhat stable employment in the goods-producing sector helps to explain retirement plan participation. Fewer service-oriented workers have access to defined benefit plans (19 percent versus 33 percent) though the percentage of workers with access to defined contribution plans is higher and similar in both industries (approximately 50 to 60 percent). However, actual employee participa- tion in defined contribution plans is drastically lower in service employers than in goods-producing companies. Wages in the service-producing companies tend to be lower than in goods-producing companies. It is possible that service employees simply do not have enough money to set aside for retirement.

The second reason for changes away from participation in defined benefit plans to defined contribution plans is because defined benefit plans are quite costly to employers compared to defined contribution plans: Companies struggle to ade- quately fund these plans to ensure that retirees receive entitled benefits for the remainder of their lives. Also, as discussed in Chapter 4, the Pension Benefit

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 108

Guaranty Corporation serves as the insurer by taking over pension obligations for companies that terminate their defined benefit plans because of severe financial stress. Companies with defined benefit plans pay premiums to the PBGC to insure defined benefit plans in the event of severe financial distress. The Pension Protection Act requires that companies at high risk of not meeting their pension obligations pay substantially more to insure defined benefit plans, adding to the substantial cost.

Qualified plans entitle employers and employees to substantial tax benefits. Specifically, employers and employees do not pay tax on their contributions within dollar limits that differ for defined benefit and defined contribution plans. In addition, the investment earnings of the trust in which plan assets are held are generally exempt from tax. Finally, participants or beneficiaries do not pay taxes on the value of retirement benefits until they receive distributions.

Minimum Standards for Qualified Plans Qualified plans possess 13 fundamental characteristics. Exhibit 5.1 lists these char- acteristics.

Participation Requirements Participation requirements include age8 and service requirements9 (ERISA, Title I, see the discussion in Chapter 4) for all plan designs. In general, employees must be allowed to participate in pension plans after they have reached age 21 and have completed one year of service (based on 1,000 work hours).

QUALIFIED PLANS Coverage Requirements Coverage requirements limit the freedom of employers to exclude employees. Qualified plans do not disproportionately favor highly compensated employees,10

as discussed in Chapter 4.

Chapter 5 Employer-Sponsored Retirement Plans 109

• Participation requirements • Coverage requirements • Vesting rules • Accrual rules • Nondiscrimination rules: Testing • Key employee and top-heavy provisions • Minimum funding standards • Social Security integration • Contribution and benefit limits • Plan distribution rules • Qualified survivor annuities • Qualified domestic relations orders • Plan termination rules and procedures

EXHIBIT 5.1 Characteristics of Qualified Pension Plans

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 109

110 Part Two Retirement, Health, and Life Insurance

Companies demonstrate whether plans meet the coverage requirement by maintaining a nondiscriminatory ratio of nonhighly compensated employees to highly compensated employees based on one of the following two tests:

• Ratio percentage test. Qualified plans cover a percentage of nonhighly com- pensated employees that is at least 70 percent of the percentage of highly com- pensated employees covered by the plan.

• Average benefit test. Qualified plans benefit a “nondiscriminatory classifica- tion” of employees and possess an “average benefit percentage” for nonhighly compensated employees that is, at a minimum, 70 percent of the average ben- efit percentage for highly compensated employees.11

Treasury regulations impose an additional participation standard for defined benefit plans. These plans must cover at least 50 employees, or 40 percent of the workforce must benefit from the plan on a day in which a company’s employment is representative of its workforce.12

Vesting Rules As described in Chapter 4, vesting refers to an employee’s nonforfeitable rights to pension benefits.13 These rights apply to defined benefit and defined contribution plans. Title I of ERISA mandates that companies grant full vesting rights to employer contributions on one of the following two schedules, as discussed in Chapter 4: cliff vesting and six-year gradual vesting.

Accrual Rules Qualified plans are subject to minimum accrual rules based on the Internal Revenue Code (IRC) and ERISA.14 Accrual rules specify the rate at which participants accu- mulate (or earn) benefits. Defined benefit and defined contribution plans use dif- ferent accrual rules, which we discuss in subsequent sections of this chapter.

Nondiscrimination Rules: Testing Nondiscrimination rules prohibit employers from discriminating in favor of highly compensated employees in contributions or benefits, availability of benefits, rights, or plan features.15 Also, employers may not amend pension plans so that highly compensated employees are favored.

The nondiscrimination requirement may be fulfilled in one of two ways: safe harbors or nondiscrimination testing. Safe harbors refer to compliance guidelines in a law or regulation. Pension plans that meet safe harbor conditions automati- cally fulfill the nondiscrimination requirement based on particular design fea- tures. Failure to reach safe harbors requires passing at least one of two nondiscrimination tests. Safe harbors and nondiscrimination tests differ between defined benefit and defined contribution plans. We will review the safe harbors and nondiscrimination tests for these plans in subsequent sections of this chapter.

Top-Heavy Provisions Qualified plans must include top-heavy provisions pertaining to minimum bene- fits accrual and vesting rights. Plans are said to be top-heavy if the accrued benefits

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 110

(i.e., the benefit amount that a participant has earned under the plan’s terms at a specified time) or account balances for key employees exceed 60 percent of the accrued benefits or account balances for all employees.16

Top-heavy provisions ensure minimum benefits or contributions for individu- als who are not key employees.17 For defined benefit plans, each nonkey employee must receive an accrued benefit of a designated percentage multiplied by the employee’s average compensation. The percentage is the lesser of 2 percent times the participant’s number of years of service with the employer, or 20 percent. For instance, an employee with four years of service and an average annual com- pensation of $75,000 would be entitled to a minimum benefit of $6,000. That is, $6,000 � (4 years � 0.02% � $75,000 average annual compensation).

For defined contribution plans, employers must make minimum contributions to nonkey employee accounts equal to the lesser of 3 percent of annual compen- sation or the highest contribution credited to key employee accounts.

Minimum Funding Standards Minimum funding standards ensure that employers contribute the minimum amount of money necessary to provide employees and beneficiaries promised benefits. As we will see, the standards differ between defined benefit and defined contribution plans.

Social Security Integration Social Security integration, also known as permitted disparity rules, allows employers to explicitly take into account Social Security retirement benefits when determining company-sponsored pension benefits.18 Subject to established limits, qualified plans may reduce company-sponsored benefits based on the benefits owed under the Social Security program.

Benefit and Contribution Limits Benefit limits refer to the maximum annual amount an employee may receive from a qualified defined benefit plan during retirement. Contribution limits apply to defined contribution plans. Employers are limited in the amount they may con- tribute to an employee’s defined contribution plan each year. The Economic Growth and Tax Relief Reconciliation Act of 2001 amended Section 415, mandating increases in these limits effective after December 31, 2001, and indexing them each year for inflation to keep retirement savings from falling behind increases in the cost of goods and services, thereby making retirees less dependent on Social Security retirement benefits (Chapter 8). The limits were set to expire after the year 2009, but the Pension Protection Act of 2006 made the limits permanent. We review these limits in our respective discussions of defined benefit and defined contribution plans.

Allowable Tax Deductions for Employers Employers may take tax deductions for contributions to employee retirement plans based on three conditions. First, as you have read, retirement plans must be qualified. Second, an employer must make contributions before the due date for

Chapter 5 Employer-Sponsored Retirement Plans 111

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 111

112 Part Two Retirement, Health, and Life Insurance

its federal income tax return for that year. For example, an employer received a tax deduction on contributions for the year 2008 when the contributions were made before April 15, 2009. Third, deductible contributions are based on designated amounts set forth by the Internal Revenue Code (as subsequently amended by the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Pension Protection Act of 2006).

Plan Distribution Rules Distribution refers to the payment of vested benefits to participants or benefici- aries. Three events may initiate a mandatory distribution of benefits:

These three events are the participant’s termination of service with the employer, the 10th anniversary of the year the participant commenced participation in the plan, and the participant’s attainment of the earlier of age 65 or the normal retire- ment age* specified in the plan. Qualified plans must provide that, unless the partic- ipant otherwise elects, the payment of benefits under the plan will commence no later than 60 days after the end of the plan year in which the last of these three events occurs.19

Distributions are payable in one of three forms. Lump sum distributions are sin- gle payments of benefits. In defined contribution plans, lump sum distributions equal the vested amount (the sum of all employee and vested employer contribu- tions, and interest on this sum). In defined benefit plans, lump sum distributions equal the equivalent of the vested accrued benefit.

A second form of distribution is the annuity. Annuities represent a series of pay- ments for the life of the participant and beneficiary. Annuity contracts are usually purchased from insurance companies, which make payments according to the con- tract. The inherent risk of defined contribution plans has given rise to income annu- ities. Income annuities distribute income to retirees based on retirement savings paid to insurance companies in exchange for guaranteed monthly checks for life.

A third form of distribution is a series of periodic payments paid from a trust fund containing the participant’s retirement benefits. In defined contribution plans, the payments are made over a specified period of time, not to exceed the life expectancy of the participant or beneficiary. In defined benefit plans, the pay- ments may come directly from a trust fund.

Qualified Survivor Annuities Qualified plans must provide spouses of covered employees a qualified joint and survivor annuity (QJSA) or a qualified preretirement survivor annuity (QPSA).20

A QJSA is an annuity for the life of the participant with a survivor annuity for the participant’s spouse. A qualified preretirement survivor annuity (QPSA) pro- vides payments for the life of the participant’s surviving spouse if the participant dies before he or she has begun to receive retirement benefits. These benefits may

*The normal retirement age is the lowest age specified in a pension plan. Upon attaining this age, an employee gains the right to retire without the consent of the employer and to receive benefits based on length of service at the full rate specified in the pension plan.

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 112

be waived by written voluntary consent of the participant’s spouse. QPSA amounts must be no less than the QJSA amounts.

Qualified Domestic Relations Orders Qualified plans recognize qualified domestic relations orders (QDROs). State domestic courts may issue QDROs that permit a retirement plan to divide a par- ticipant’s benefits in the event of divorce. Dividing a participant’s benefits without a QDRO is a violation of ERISA and the IRC.21 Without a QDRO, divorced spouses would be ineligible to receive retirement benefits under the participant’s plan.22

QDROs stipulate the extent to which a former spouse is eligible to receive QJSAs (qualified joint and survivor annuities) and QPSAs (qualified preretirement survivor annuities). For example, if a QDRO stipulates that a former spouse will be treated as the current spouse for all of a participant’s benefits, then the former spouse will receive the QJSA or the QPSA unless that former spouse waives the right to the ben- efits. On the other hand, if a QDRO provides that a former spouse will be treated as the current spouse for benefits that accrued prior to divorce, then the former spouse would be treated as the current spouse only for those accrued benefits.23

Plan Termination Rules and Procedures Plan termination rules and procedures apply only to defined benefit plans. As discussed in Chapter 4, three types of plan terminations exist: standard termina- tion, distress termination, and involuntary termination. Qualified plans must fol- low strict guidelines for plan terminations, including sufficient notification to plan participants, notification to the Pension Benefit Guarantee Corporation, and the distribution of vested benefits to participants and beneficiaries in a reasonable amount of time.

DEFINED BENEFIT PLANS

Defined benefit plans guarantee retirement benefits specified in the plan docu- ment. This benefit usually is expressed in terms of a monthly sum equal to a per- centage of a participant’s preretirement pay multiplied by the number of years he or she has worked for the employer. This monthly payment, or annuity, is usually paid to the retiree until death. While the benefit in these plans is fixed by a for- mula, the level of required employer contributions fluctuates from year to year. The level depends on the amount necessary to make certain that benefits prom- ised will be available when participants and beneficiaries are eligible to receive them and on expectations of life expectancy. As life expectancy increases, it has become necessary for defined benefit plan sponsors to increase contributions.

Benefit Formulas Companies usually choose between two types of benefit formulas: flat benefit for- mulas and unit benefit formulas. The key factor distinguishing these two types of formulas is whether employees’ years of service are considered. Years of service are a factor in unit benefit formulas, but not in flat benefit formulas. The Internal

Chapter 5 Employer-Sponsored Retirement Plans 113

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 113

114 Part Two Retirement, Health, and Life Insurance

Revenue Service recognizes both formulas as appropriate calculation methods in employer-sponsored plans.

When companies introduce a defined benefit plan into an established work- force, they must decide whether to reward future performance only, or recognize past service as well. In the former case, all employees, regardless of service, are treated as new employees from the standpoint of benefits allocation.

Flat Benefit Formulas Flat benefit formulas designate either a flat dollar amount per employee (flat amount formula) or a dollar amount based on an employee’s compensation (flat percentage formula). Annual benefits are usually expressed as a percentage of final average wage or salary. The period used to calculate final average wage or salary usually equals the average amount based on the last three or four years of service.

Let’s assume that in 2008 when Robert plans to retire, his final average salary in the three-year period preceding retirement was $100,000 (based on $99,000 in 2008, $100,000 in 2009, and $101,000 in 2010). In this example, $100,000 � ($99,000 � $100,000 � $101,000)/3 years.

Also assume that the plan’s designated percentage is 60 percent. Robert’s annual retirement income equals $60,000 ($100,000 average annual income � 60%).

Flat benefit formulas often lead to resentment among employees because length of service is not a consideration. Longer-service employees expect to receive a higher percentage of final average salary during retirement than employees who retire with substantially less service. There are two possible explanations for this expectation. First, longer-service employees feel they have earned the right to receive a higher percentage. They argue that the combination of more years enabled them to con- tribute more productively to the company than employees with substantially fewer years of service. Second, the company should owe them a larger percentage in recog- nition of their loyalty and commitment to the company over a longer period.

Unit Benefit Formulas Unit benefit formulas recognize length of service. Typically, employers decide to contribute a specified dollar amount for each year worked by an employee. Alternatively, they may choose to contribute a specified percentage amount for years of service.

Annual benefits are usually based on age, years of service, and final average wages or salary. Retirement plans based on unit benefit formulas specify annual retirement benefits as a percentage of final average salary. Exhibit 5.2 illustrates these percentages for one retirement plan based on age and years of service. Looking at this exhibit, let’s assume Mary retires at age 59 with 25 years of service.

Also, let’s assume her final average salary is $52,500. Mary multiplies $52,500 by the annual percentage of 43.43 percent. Her annual benefit is thus $22,800.75 ($52,500 � 43.43%).

Nondiscrimination Rules: Testing Defined benefit plans must meet several uniformity criteria as well as one addi- tional safe harbor criterion based on particular characteristics of the plan. Uniformity refers to consistent treatment based on such factors as a benefits

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 114

Chapter 5 Employer-Sponsored Retirement Plans 115

Age Years of Service 62 60� 59 58 57 56 55

5 8.35 6 10.02 7 11.69 8 — 13.36 12.56 11.76 10.96 10.15 9.35 9 — 15.03 14.13 13.23 12.32 11.42 10.52

10 — 16.70 15.70 14.70 13.69 12.69 11.69 11 — 18.60 17.48 16.37 15.25 14.14 13.02 12 — 20.50 19.27 18.04 16.81 15.58 14.35 13 — 22.40 21.06 19.71 18.37 17.02 15.68 14 — 24.30 22.84 21.38 19.93 18.47 17.01 15 — 26.20 24.63 23.06 21.48 19.91 18.34 16 — 28.10 26.41 24.73 23.04 21.36 19.67 17 — 30.00 28.20 26.40 24.60 22.80 21.00 18 — 31.90 29.99 28.07 26.16 24.24 22.33 19 — 33.80 31.77 29.74 27.72 25.69 23.66 20 — 35.70 33.56 31.42 29.27 27.13 24.99 21 — 37.80 35.53 33.26 31.00 28.73 26.46 22 — 39.90 37.51 35.11 32.72 30.32 27.93 23 — 42.00 39.48 36.96 34.44 31.93 29.40 24 — 44.10 41.45 38.81 36.16 33.52 30.87 25 — 46.20 43.43 40.66 37.88 35.11 32.34 26 — 48.30 45.40 42.50 39.61 36.71 33.81 27 — 50.40 47.38 44.35 41.33 38.30 35.28 28 — 52.50 49.35 46.20 43.05 39.90 36.75 29 — 54.60 51.32 48.05 44.77 41.50 38.22 30 — 56.70 53.30 49.90 46.49 43.09 39.69 31 — 59.00 55.46 51.92 48.38 44.84 41.30 32 — 61.30 57.62 53.94 50.27 46.59 42.91 33 — 63.60 59.78 55.97 52.15 48.34 44.52 34 — 65.90 61.95 57.99 54.04 40.08 46.13 35 — 68.20 68.20 68.20 68.20 68.20 68.20 36 — 70.50 70.50 70.50 70.50 70.50 70.50 37 — 72.80 72.80 72.80 72.80 72.80 72.80 38 — 75.10 75.00 75.00 75.00 75.00 75.00 39 — 77.40 75.00 75.00 75.00 75.00 75.00 40 — 79.70 75.00 75.00 75.00 75.00 75.00 41+ — 80.00 75.00 75.00 75.00 75.00 75.00

EXHIBIT 5.2 Annual Retirement Benefits Based on a Unit Benefit Formula

formula. Exhibit 5.3 describes the uniformity requirements issued by the U.S. Treasury Department. Failure to satisfy safe harbor criteria requires explicit testing for nondiscrimination.

Accrual Rules Accumulated benefit obligation refers to the present value of benefits based on a designated date. Actuaries determine a defined benefit plan’s accumulated benefit

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 115

116 Part Two Retirement, Health, and Life Insurance

A defined benefit plan must be “uniform” to meet the safe harbor requirements:

Uniform Normal Retirement Benefit

The same benefit formula must apply to all employees in the plan. The formula must provide all employees with an annual benefit payable in the same form, commencing at the same uniform normal retirement age. The annual benefit must be the same percentage of average annual compensation or the same dollar amount for all employees in the plan who will have the same number of years of service at normal retirement age. The annual benefit must equal the employee’s accrued benefit at normal retirement age and must be the normal retirement benefit under the plan.

Uniform Postnormal Retirement Benefits

With respect to an employee with a given number of years of service at any age after normal retirement age, the annual benefit commencing at the employee’s age must be the same percentage of average annual compensation or the same dollar amount that would be payable commencing at normal retirement age to an employee who had that same number of years of service at normal retirement age.

Uniform Subsidies

Each subsidized optional form of benefit under the plan must be available to essentially all employees in the plan. In determining whether a subsidized optional form of benefit is available, the same criteria apply that are used for determining whether an optional form of benefit is currently available to a group of employees in the plan. An optional form of benefit is considered subsidized if the normalized optional form of benefit is larger than the normalized normal retirement benefit under the plan.

Uniform Vesting and Service Crediting

All employees in the plan must be subject to the same vesting schedule and the same definition of years of service for all purposes under the plan. For the purposes of crediting service, only service with the employer (or a predecessor employer) may be taken into account.

No Employee Contributions

The plan is not a contributory defined benefit plan. Special rules apply to contributory defined benefit plans.

Period of Accrual

Each employee’s benefit must be accrued over the same years of service that are taken into account in applying the benefit formula under the plan to that employee. Any year in which the employee benefits under the plan is included as a year of service in which a benefit accrues.

EXHIBIT 5.3 Safe Harbors for Defined Benefit Plans

Source: Treas. Regs. §1.401(a)(4)-3(b)(2).

obligation by making assumptions about the return on investment of assets and characteristics of the participants and their beneficiaries, including expected length of service and life expectancies.

The Internal Revenue Service has established criteria to judge whether an employer’s defined benefit plan meets its accumulated benefit obligation. These criteria discourage employers from engaging in a practice known as backloading. Backloading occurs whenever benefits accrue at a substantially higher rate during the years close to an employee’s eligibility to earn retirement benefits. Fulfillment of at least one of these criteria ensures that benefits accrue regularly throughout employee participation in defined benefit plans.

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 116

One of the following three criteria must be met: the three percent rule, the 1331/3 percent rule, or the fractional rule.

The Three Percent Rule Under the three percent rule, a participant’s accrued benefit cannot be less than 3 percent of the normal retirement benefit, assuming the participant began partici- pation at the earliest possible age under the plan, and she or he remained employed without interruption until age 65 or the plan’s designated normal retirement age. For instance, Margaret recently retired at age 62 from Company A. She joined the company 41 years earlier at age 21 and immediately began participation in the employer-sponsored defined benefit plan. Company A’s defined benefit plan awards an annual benefit equal to 70 percent of the four-year average highest salary. Margaret’s four-year average annual salary was $50,000 upon retirement, yielding an annual retirement benefit of $35,000 ($50,000 � 70%). Under the three percent rule, Margaret’s accrued benefit must be no less than $1,050 ($35,000 � 3%).

The 133 1/3 Percent Rule Under the 1331/3 percent rule, the annual accrual rate cannot exceed 133

1/3 percent of the rate of accrual for any prior year. For example, a company’s retirement plan specifies the following annual accrual rates: 1.15 of compensation for the first 10 years, 1.40 for the next 10 years, and 1.88 for the years thereafter. This plan violates the 133 1/3 percent rule because the 1.88 annual accrual rate exceeds 133

1/3 percent of the lowest prior annual accrual rate (1.53—that is, 1.15% of compensation � 1331/3).

Fractional Rule The fractional rule applies to participants who terminate their employment prior to reaching normal retirement age. This rule stipulates that benefit accrual upon ter- mination be proportional to the normal retirement benefits. Said another way, this method compares an employee’s plan participation to the total years she or he would have participated in the plan upon reaching the normal retirement age. For example, let’s assume the annual annuity a person would have earned at the nor- mal retirement age is $20,000. Let’s also assume that her years of service at full retirement age would have been 30 years, but she terminated her employment at 20 years of service. Based on the fractional rule, the annual annuity is $13,333 [$20,000 � (20 years/30 years)]. Paying an annual retirement benefit less than $13,333 would be a violation of the fractional rule.

Minimum Funding Standards As we discussed in Chapter 4, ERISA imposes strict funding requirements on qual- ified plans. Under defined benefit plans, employers make an annual contribution that is sufficiently large to ensure that promised benefits will be available to retirees. As previously noted, actuaries periodically review several kinds of infor- mation to determine a sufficient funding level: life expectancies of employees and their designated beneficiaries, projected compensation levels, and the likelihood of employees terminating their employment before they have earned benefits. ERISA imposes the reporting of actuarial information to the Internal Revenue Service,

Chapter 5 Employer-Sponsored Retirement Plans 117

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 117

118 Part Two Retirement, Health, and Life Insurance

which in turn submits these data to the U.S. Department of Labor. The Department of Labor reviews the data to ensure compliance with ERISA regulations.

Benefit Limits and Tax Deductions The IRC sets a maximum annual benefit for defined benefit plans that is equal to the lesser of $195,000 in 2009, or 100 percent of the highest average compensation for three consecutive years.24 The limit is indexed for inflation in $5,000 incre- ments each year beginning after 2006.25

DEFINED CONTRIBUTION PLANS

Under defined contribution plans, employers and employees make annual con- tributions to separate accounts established for each participating employee, based on a formula contained in the plan document. Typically, formulas call for employ- ers to contribute a given percentage of each participant’s compensation annually. Employers invest these funds on behalf of the employee, choosing from a variety of investment vehicles such as company stocks, diversified stock market funds, or federal government bond funds. Employees may be given a choice of investment vehicles based on the guidelines established by the employer. Defined contribution plans specify rules for the amount of annual contributions. Unlike defined benefit plans, these plans do not guarantee particular benefit amounts. Participants bear the risk of possible investment gain or loss. Benefit amounts depend upon several factors, including the contribution amounts, the performance of investments, and forfeitures transferred to participant accounts. Forfeitures come from the accounts of employees who terminated their employment prior to earning vesting rights.

Companies may choose to offer one or more specific types of defined contribu- tion plans. Common examples of defined contribution plans include profit-sharing plans, stock bonus plans, and employee stock ownership plans. We will review each of these plans later in the chapter.

Individual Accounts Defined contribution plans contain accounts for each employee into which contri- butions are made, losses are debited, or gains are credited. Contributions to each employee’s account come from four possible sources. The first, employer contri- butions, is expressed as a percentage of an employee’s wage or salary. In the case of profit-sharing plans, company profits are usually the basis for employer contri- butions. The second, employee contributions, is usually expressed as a percentage of the employee’s wage or salary. The third, forfeitures, comes from the accounts of employees who terminated their employment prior to earning vesting rights. The fourth contribution source is return on investments. In the case of negative returns (or loss), the corresponding amount is debited from employees’ accounts.

Investments of Contributions ERISA requires that a named fiduciary manage investments in defined contribution plans. Fiduciaries are individuals who manage employee benefit plans and pension

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 118

funds. Also, fiduciaries possess discretion in managing the assets of the plan, offer- ing investment advice to employee participants, and administering the plan. Ultimately, fiduciaries are responsible for minimizing the risk of loss of assets.26

Fiduciaries possess the authority to delegate investment responsibility to an investment manager. Under the supervision of the fiduciary, investment man- agers select investments based on a comparison of the risk and return potential of various investment options. Investment managers may invest assets in a variety of investment vehicles, including equities, government bonds, cash, insurance, and real estate. Usually, investment managers invest assets in more than one type of investment vehicle to balance risk and return potential.

Employee Participation in Investments Some companies may allow plan participants to choose the investment of funds in their individual accounts. Subject to certain conditions described in Exhibit 5.4, employee participation does not constitute fiduciary responsibility. Also, desig- nated fiduciaries cannot be held liable for the investment choices of employees.

Nondiscrimination Rules: Testing Defined contribution plans must meet one of two safe harbor conditions: a uni- form allocation formula, or a uniform points allocation formula in the case of profit-sharing or money purchase plans.27 Defined contribution plans satisfy the nondiscrimination rules when they offer a uniform allocation formula to each employee based on a percentage of compensation, dollar amount of allocation, or the same dollar amount for each uniform unit of service.

Profit-sharing and money purchase plans satisfy the nondiscrimination rules based on a uniform points allocation formula. This formula defines each employee’s allocation for the plan year as the product of the total of all amounts taken into account. Eligible amounts include employer contributions and forfei- tures allocated to an employee’s account. Points for a plan year equal the sum of the employee’s points for age, service, and units of plan-year compensation for the plan year. Under a uniform points allocation formula, each employee must receive the same number of points for each year of age, each year of service, and each unit of plan-year compensation.

Chapter 5 Employer-Sponsored Retirement Plans 119

• Participants have the opportunity to choose from at least three diversified investment alternatives. Each investment has different degrees of risk.

• Participants have the opportunity to change their investment allocations at least once each three months. If market volatility is high, this opportunity must be made available more frequently.

• Participants must be given sufficient information to make informed investment decisions.

EXHIBIT 5.4 Conditions Relieving Fiduciary of Responsibility with Employee Participation in Investments

Source: I.R.C. §404(c).

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 119

120 Part Two Retirement, Health, and Life Insurance

Failure to satisfy safe harbor criteria requires explicit testing for nondiscrimi- nation.

Accrual Rules The accrued benefit equals the balance in an individual’s account.28 Companies must not reduce contribution amounts based on age. Also, they may not set max- imum age limits for discontinuing contributions.

Minimum Funding Standards The minimum funding standard for defined contribution plans is less complex than for defined benefit plans. This standard is met when contributions to the individual accounts of plan participants meet the minimum amounts as specified by the plan.29

Contribution Limits and Tax Deductions Employer contributions to defined contribution plans represent one factor in annual additions. Annual addition refers to the annual maximum allowable con- tribution to a participant’s account in a defined contribution plan. The annual addition includes employer contributions, employee contributions, and forfei- tures allocated to the participant’s account.30 In 2009, annual additions were lim- ited to the lesser of $49,000 or 100 percent of the participant’s compensation.31

The amount of an employer’s annual deductible contribution to a participant’s account depends on the type of defined contribution plan.32 The Economic Growth and Tax Reconciliation Act of 2001 raised the allowable contribution amounts in effect before January 1, 2002. In 2005, the maximum contribution to a profit-sharing, stock bonus, or employee stock ownership plan was 25 percent of the compensation paid or accrued to participants in the plan. Section 401(k), 403(b), and 457 plans have contribution limits of $16,500 in 2009. The limit is indexed for inflation in $500 increments beginning in the year 2007.

TYPES OF DEFINED CONTRIBUTION PLANS

A variety of defined contribution plans are available. These include Section 401(k) plans, profit sharing, stock bonus plans, employee stock ownership plans, savings incentive match plans for employees (SIMPLEs), Section 403(b) tax-deferred annuities, and Section 457 plans. We will review each of these plans in turn.

Section 401(k) Plans Section 401(k) plans are retirement plans named after the section of the Internal Revenue Code that created them. These plans, also known as cash or deferred arrangements (CODAs), permit employees to defer part of their compensation to the trust of a qualified defined contribution plan. Only private sector or tax- exempt employers are eligible to sponsor 401(k) plans.

Section 401(k) plans offer three noteworthy tax benefits. First, employees do not pay income taxes on their contributions to the plan until they withdraw funds. Second, employers deduct their contributions to the plan from taxable income. Third,

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 120

investment gains are not taxed until participants receive payments. Section 401(k) specifies that a 401(k) plan is any arrangement with five specific characteristics:

• Must be a part of a qualified profit-sharing or stock bonus plan, a pre-ERISA money purchase plan, or a rural electric cooperative plan.

• Permits eligible employees to choose to defer part of their compensation (regular wages, salaries, or bonus) to one of the arrangements specified in the previous statement. Deferral of regular salary or wages is known as a salary reduction agreement.

• Limits the amount of annual elective deferrals as described previously. • Restricts distributions. Money may not be distributed to the employee or ben-

eficiary before the earliest of the employee’s death, disability, separation from service, termination of the plan, or sale of the subsidiary or division employing the employee. Profit-sharing or stock bonus plan distributions also are permit- ted upon hardship or after attainment of age 59. Premature withdrawals are subject to a 10 percent penalty.

• Complies with nondiscrimination rules to prevent highly compensated employees from receiving disproportionately higher benefits.

Profit-Sharing Plans Companies set up profit-sharing plans to distribute money to employees. Companies start by establishing a profit-sharing pool—that is, the money ear- marked for distribution to employees. Companies may also choose to fund profit- sharing plans based on gross sales revenue or some basis other than profits. Companies may also take a tax deduction for their contributions, not to exceed 25 percent of the plan participants’ compensation.33 As described in the previous section, a qualified profit-sharing plan may be the basis for a company’s 401(k) plan.

Employer Contributions Companies determine the pool of profit-sharing money by application of a formula every year or based on the discretion of their boards of directors. One of three com- mon formulas establish employer contributions. A fixed first-dollar-of-profits for- mula uses a specific percentage of either pretax or after-tax annual profits (alterna- tively, gross sales or some other basis) contingent upon the successful attainment of a company goal. For instance, a company might establish that the profit-sharing fund will equal 1 percent of corporate profits. Second, other companies use a graduated first-dollar-of-profits formula instead of a fixed percentage. For exam- ple, a company may choose to share 2 percent of the first $10 million of profits and 3 percent of the profits in excess of that level. Third, profitability threshold for- mulas fund profit-sharing pools only if profits exceed a predetermined minimum level but fall below some established maximum level. Companies establish mini- mums to guarantee a return to shareholders before they distribute profits to employees. They establish maximums because they attribute any profits beyond this level to factors other than employee productivity or creativity such as techno- logical innovation.

Chapter 5 Employer-Sponsored Retirement Plans 121

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 121

122 Part Two Retirement, Health, and Life Insurance

Company boards of directors may use their discretion when setting contribu- tions. This approach is somewhat risky: The Internal Revenue Service requires that employer contributions to qualified profit-sharing plans be substantial and made on a recurring basis.34 Failure to meet this criterion may require 100 percent vesting rights to all plan participants, regardless of tenure in the plan.

Allocation Formulas After management selects a funding formula for the profit-sharing pool, they must consider how to distribute pool money among employees. Under a qualified defined contribution plan, the chosen allocation formula must not discriminate in favor of highly compensated employees. Usually, companies make distributions in one of three ways—equal payments to all employees, proportional payments to employees based on annual salary, and proportional payments to employees based on their contribution to profits. Equal payments to all employees reflect a belief that all employees should share equally in the company’s gains to promote cooperation among employees. However, employee contributions to profits prob- ably vary. Accordingly, most employers divide the profit-sharing pool among employees based on a differential basis. Companies may disburse profits based on proportional payments to employees based on their annual salary. Presumably, higher-paying jobs indicate the greatest potential to influence a company’s com- petitive position. Still, another approach is to disburse profits as proportional payments to employees based on their contribution to profits. Some companies measure employee contributions to profits based on job performance. However, this approach is not very feasible because it is difficult to isolate each employee’s contributions to profits.

Stock Bonus Plans As described earlier, a stock bonus plan may be the basis for a company’s 401(k) plan. Qualified stock bonus plans and qualified profit-sharing plans are similar because both plans invest in company securities. These plans are also similar regarding nondiscrimination requirements and the deductibility of employer con- tributions. However, stock bonus plans reward employees with company stock (i.e., equity shares in the company). Benefits are usually paid in shares of company stock. Participants of stock bonus plans possess the right to vote as shareholders. Voting rights differ based on whether company stock is traded in public stock exchanges.35

In the case of publicly traded stock, plan participants may vote on all issues.

Employee Stock Option Plans (ESOPs) Employee stock option plans (ESOPs) may be the basis for a company’s 401(k) plan, and these plans invest in company securities, making them similar to profit- sharing plans and stock bonus plans. ESOPs and profit-sharing plans differ because ESOPs usually make distributions in company stock rather than cash. ESOPs are essentially stock bonus plans that use borrowed funds to purchase stock.

ESOPs are either nonleveraged or leveraged plans.36 In the case of nonleveraged ESOPs, the company contributes stock or cash to buy stock. The stock is then allocated to the accounts of participants. Nonleveraged plans are

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 122

stock bonus plans. In the case of leveraged ESOPs, the plan administrator bor- rows money from a financial institution to purchase company stock. The company may use the borrowed money for different purposes, including financing of exist- ing debt, estate planning, or financing an acquisition or divestiture. Over time, the company makes principal and interest payments to the ESOP to repay the loan. The stock purchased with the loan is placed in a suspense account until amounts equal to the employer’s contributions are allocated to the individual accounts of participants.

Savings Incentive Match Plans for Employees (SIMPLEs) Congress enacted a law in 1996 that established savings incentive match plans for employees (SIMPLEs) working in small companies.37 For the purpose of this plan, small companies employing 100 or fewer employees whose preceding year’s compensation totaled at least $5,000 and who do not maintain another employer- sponsored retirement plan, are eligible.

Companies may establish SIMPLEs as either individual retirement accounts (IRAs) or as 401(k) plans. We will review SIMPLEs as 401(k) plans in this chapter. As a qualified plan, SIMPLEs must meet nondiscrimination and vesting require- ments under ERISA. In addition, employees may contribute up to $11,500 in 2009. The annual limit is indexed for inflation in $500 increments.

Section 403(b) Tax-Deferred Annuity Plans Section 403(b) of the IRC established tax-deferred annuity (TDA) programs. A TDA represents a type of retirement plan for employees of public educational insti- tutions (e.g., state colleges and universities) or private tax-exempt organizations (e.g., charitable organizations, state-supported hospitals).38 Congress enacted Section 403(b) because such organizations may not have sufficient resources to pro- vide a qualified retirement plan. TDAs are not qualified plans under ERISA.

Under TDAs, contributions come mainly from either employers or employees. Employees make contributions through salary reduction agreements with their employers. A less common method is direct employee contributions outside salary reduction agreements. TDAs may be the only retirement program offered in these organizations, or these plans may supplement other employer-sponsored pension programs, usually defined benefit plans. Private tax-exempt organiza- tions may offer both 401(k) and 403(b) plans, but public organizations are prohib- ited from offering 401(k) plans.

Three common methods for funding TDAs include annuity contracts, custodial agreements, and life insurance. Eligible annuity contracts may take different forms. Annuities may be individual or group contracts, and these may be fixed dollar or variable annuities. Also, eligible annuities must be nontransferable. In other words, annuity contracts may not be sold, signed, or pledged as security for collateral. Custodial accounts permit investments in mutual funds.

TDAs possess features similar to 401(k) plans. First, earnings on contributions are also tax-deferred until distributed. Second, the tax code restricts when distri- butions may be taken and under what conditions. These stipulations are the same as those found in 401(k) plans, except participants may not roll over assets into

Chapter 5 Employer-Sponsored Retirement Plans 123

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 123

124 Part Two Retirement, Health, and Life Insurance

Defined Benefit Plan Defined Contribution Plan

EXHIBIT 5.5 Characteristics of Defined Benefit and Defined Contribution Plans

Source: U.S. Department of Labor (2006). What You Should Know About Your Retirement Plan. Online: www.dol.gov/ebsa. Accessed April 26, 2009.

Employer Contributions and/or Matching Contributions

Employer funded. Federal rules set amounts that employers must contribute to plans in an effort to ensure that plans have enough money to pay benefits when due. There are penalties for failing to meet these requirements.

There is no requirement that the employer contribute, except in the SIMPLE 401(k) and Safe Harbor 401(k), money purchase plans, and SIMPLE IRA and SEP plans. The employer may choose to match a portion of the employee’s contributions or to contribute without employee contributions. In some plans, employer contributions may be in the form of employer stock.

Employee Contributions

Generally, employees do not contribute to these plans.

Many plans require the employee to contribute for an account to be established.

Managing the Investment

Plan officials manage the investment, and the employer is responsible for ensuring that the amount it has put in the plan plus investment earnings will be enough to pay the promised benefit.

The employee often is responsible for managing the investment of his or her account, choosing from investment options offered by the plan. In some plans, plan officials are responsible for investing all the plan’s assets.

Amount of Benefits Paid Upon Retirement

A promised benefit is based on a formula in the plan, often using a combination of the employee’s age, years worked for the employer, and/or salary.

The benefit depends on contributions made by the employee and/or the employer, performance of the account’s investments, and fees charged to the account.

Type of Retirement Benefit Payments

Traditionally, these plans pay the retiree monthly annuity payments that continue for life. Plans may offer other payment options.

The retiree may transfer the account balance into an individual retirement account (IRA) from which the retiree withdraws money, or may receive it as a lump sum payment. Some plans also offer monthly payments through an annuity.

Guarantee of Benefits

The federal government, through the Pension Benefit Guaranty Corporation (PBGC), guarantees some amount of benefits.

No federal guarantee of benefits.

Leaving the Company Before Retirement Age

If an employee leaves after vesting in a benefit but before the plan’s retirement age, the benefit generally stays with the plan until the employee files a claim for it at retirement. Some defined benefit plans offer early retirement options.

The employee may transfer the account balance to an individual retirement account (IRA) or, in some cases, another employer plan, where it can continue to grow based on investment earnings. The employee also may take the balance out of the plan, but will owe taxes and possibly penalties, thus reducing retirement income. Plans may cash out small accounts.

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 124

Chapter 5 Employer-Sponsored Retirement Plans 125

any qualified plan. TDA participants may roll over a TDA distribution to another TDA or an Individual Retirement Account (IRA).39

Section 457 Plans Section 457 plans, named after the section of the Internal Revenue Code that cre- ated them, are nonqualified retirement plans for government employees. Until 2002, Section 457 plans were less generous than either 401(k) or 403(b) plans because max- imum annual contributions were substantially lower [$7,000 versus $10,000 for 401(k) or 403(b) plans in 2001]. Now 457 plans have the same limits as 401(k) or 403(b) plans. However, unlike 401(k) and 403(b) plans, only employees may con- tribute to 457 plans.

Exhibit 5.5 summarizes selected differences between defined benefit and defined contribution plans.

HYBRID PLANS

Hybrid plans combine features of traditional defined benefit and defined contri- bution plans. We will discuss four common hybrid plans in turn: (1) cash balance plans and pension equity plans, (2) target benefit plans, (3) money purchase plans, and (4) age-weighted profit-sharing plans.

Many employers have set aside traditional defined benefit pension plans for hybrid plans: Numerous accounts describe defined benefit plans as ”golden handcuffs,” providing generous (golden) retirement income to workers who remain with the same employer (the handcuffs) throughout their work life. Such plans, which often base benefits on earnings in a worker’s last years with the com- pany, may provide lower benefits for those employees who work in multiple jobs throughout their lifetimes.

In January 2007, all employees had worked for their current employer for an average of 3.7 years; those aged 35 to 44 had worked for their current employer an average of 4.9 years and those aged 55 to 64 had worked for their current employer an average of 9.3 years. These data suggest workers may be accumulating retire- ment benefits from several jobs; employers have attempted to deal with these changing needs by seeking alternative approaches to providing retirement income.

The different career plans of the younger generations have led many employ- ers to conclude that their retirement plans were not beneficial to these younger, more mobile workers. This was not conducive to attracting potentially valuable employees that could help increase efficiency.40

Cash Balance Plans and Pension Equity Plans Internal Revenue Service guidelines define cash balance plans as “defined bene- fit plans that define benefits for each employee by reference to the amount of the employee’s hypothetical account balance.”41 Pension equity plans are similar to cash balance plans, except, as described shortly, for how benefits are calculated. Cash balance plans are a relatively new phenomenon compared to traditional defined benefit and defined contribution plans. Many companies have chosen to convert their defined benefit plans to cash balance plans for two key reasons. First,

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 125

126 Part Two Retirement, Health, and Life Insurance

cash balance plans are less costly to employers than defined benefit plans. Second, cash balance plans pay out benefits in a single lump sum payment instead of a series of monthly payments, typically for the remainder of the retiree’s life. Calculating benefits as a lump sum increases the portability of pension benefits from company to company. That is, employees who have achieved full vesting may roll over the lump accumulated in a cash balance plan to their new employer’s qualified retirement plan. Thus, companies are in a better position to recruit more mobile workers. Under a traditional defined benefit plan, an employee who leaves employment prior to qualifying for a retirement annuity (again, monthly payments for the rest of one’s life) will forfeit the annuity.

Benefit Formulas Companies establish individual accounts for employees as in defined contribution plans. They may choose from several methods of crediting contributions to cash balance plans. The most common approaches include a fixed percentage of earn- ings and percentages that vary by age, length of service, or earnings.

Participants receive credits expressed as a percentage of annual pay, and these credits earn interest at a designated rate. The interest rate credit is guaranteed instead of fluctuating with the performance of the investments. In addition, the amounts stated in these individual accounts are strictly hypothetical because the employer contributes money to the plan as a whole, covering all employees.

Complex federal rules require that employers have sufficient assets to cover the amounts expressed in every employee’s hypothetical account. In defined contri- bution plans, on the other hand, the account balance is equal to actual assets held in trust for the participant, and the interest rate fluctuates with the performance of the investments.

Under a cash balance plan, for example, an employer may choose to credit 5 percent of each employee’s annual earnings, and these credited amounts grow based on a preestablished interest rate of 7 percent. Typically, employers establish annual interest credits where the employee receives interest credits on December 31 of each year. Interest is credited on the benefit amount credited on January 1 of the same year, as well as on all benefit and interest credits accumulated during earlier years.

Let’s assume an employee earns $100,000 per year in 2007 and in 2008. Also assume that the value of his cash balance account is $22,000 at the end of 2006. This figure represents the sum of all benefit and interest credits earned through the year 2006. On January 1, 2007, the employer would credit $5,000 ($100,000 annual earnings � 5% annual benefit credit rate) to the employee’s account. That is, on January 1, 2007, the account total would equal $27,000 ($22,000 balance as of December 31, 2006 � $5,000). On December 31, 2006, the employer would credit the account with $1,890, which represents 7 percent (the annual interest rate) on the $27,000 balance on January 1, 2007. That is, on December 31, 2007, the account total would equal $28,890 ($27,000 balance on January 1, 2007 � $1,890 interest credited on December 31, 2007). Continuing with the cycle, the account balance would be $33,890 on January 1, 2008, based on the addition of a benefit credit equaling 5 percent of the employee’s $100,000 annual earnings for 2008.

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 126

Pension equity plans credit employees’ accounts with points based on years of service. The points are often expressed as a percentage of pay. When an employee terminates employment or retires, the benefit is calculated as the product of the employee’s average pay (average of one’s pay over a career) and the total number of points earned. The benefit is expressed as an account balance, much like the benefit of a cash balance plan.

Years of Service Percentage of Pay

Less than 5 2% 5 to 9 4 10 to 14 6 15 to 19 8 20 and above 10

Controversy Surrounding Cash Balance Plans Two controversies have emerged. The first issue centers on favorable treatment of younger workers and unfavorable treatment of older employees. The second issue is based on the practice of converting traditional defined benefit plans to cash bal- ance plans. We will review each of these in turn. Age-Related Treatment Cash balance plans are said to provide favorable treat- ment to younger workers and to workers who switch employers from time to time. These plans do not define benefits as a percentage of final or career average pay or as a flat dollar amount per year of service, which is the case for defined benefit plans. Defined benefit plans provide more favorable treatment to older employees because benefits accrue on an age-related basis, permitting older employees to earn benefits more quickly than younger workers. Cash balance plans, on the other hand, award annual pay-related credits, much as defined con- tribution plans, with the contributions appreciating each year based on a specified interest rate.

The U.S. General Accounting Office (GAO) compared the rates of retirement benefit accrual in defined benefit plans and cash balance plans under a variety of assumptions. It concluded that cash balance plan accrual favors younger employ- ees.42 For example, a 25-year-old employee who is assumed to participate in a cash balance plan until retirement at age 65 accrues an incremental annuity benefit of about $1,660 at age 26 but earns a smaller incremental benefit of about $630 at age 65. Under a defined benefit plan, this same individual earns an incremental annuity benefit of $310 at age 26 but earns a higher incremental annuity benefit of about $2,440 at age 65.

The difference in accrual patterns between these plan types has led some peo- ple to question whether cash balance plans illegally discriminate on the basis of age. According to the GAO:

Cash balance proponents define the accrued benefit as the employee’s hypothetical account balance. Under this definition, cash balance plans generate a level rate of accrual for all employees regardless of age and therefore do not appear to raise

Chapter 5 Employer-Sponsored Retirement Plans 127

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 127

128 Part Two Retirement, Health, and Life Insurance

issues of disparate treatment of employees based on age. Critics state that cash balance plans, as defined benefit plans under the law, must express an employee’s accrued benefit as an annual benefit beginning at normal retirement age or the actuarial equivalent to a deferred annuity.43 When cash balance plans are viewed in this way, the amount of the actuarially determined benefit is a function of the participant’s age and decreases as the participant ages. Therefore, critics argue, cash balance plans violate the prohibition on age discrimination. Federal agencies are considering the issue of whether cash balance plans violate age discrimination statutes. Participants have filed a number of court cases alleg- ing that cash balance plans are age discriminatory but no definitive decision has been reached.44

Converting Defined Benefit Plans to Cash Balance Plans As we discussed ear- lier, retirement benefits accrue at a decreasing rate in cash balance plans in contrast to an increasing rate in defined benefit plans. Converting from defined benefit plans to cash balance plans may result in older workers receiving smaller benefits. The GAO compared lump sum distributions for a traditional defined benefit plan with lump sum distributions for a cash balance plan following conversion at vari- ous ages at separation from employment.45 Exhibit 5.6 shows the increasing dis- parity in lump sum distributions for older workers after a conversion from a defined benefit plan to a cash balance plan.

Further consideration reveals that cash balance plans tend to produce the lowest annuity at retirement for the employee who was oldest at conversion. For example, the GAO study modeled benefits from a basic cash balance

Age at Separation Final Average Pay Formula* Cash Balance Formula†

30 $ 2,476 $ 2,476 35 7,849 13,699 40 18,684 30,358 45 39,618 54,510 50 79,096 88,926 53 117,686 116,000 55 152,611 137,322 60 288,878 204,673 65 544,153 297,625

Notes: Results are based on baseline scenario assumptions for a 30-year-old worker at conversion and show several possible ages when the worker might leave the firm. The 30-year-old worker was assigned a tenure and income value at conversion that corresponds to the worker’s age. Lump sum distributions paid from the traditional formula are calculated on the basis of annuity values that the formula would have produced had no conversion occurred and in accordance with IRC 417(e) regulations. Lump sum values are comparable at given ages but are not comparable across years. * Based on normal retirement age annuity. † Nominal account balance.

EXHIBIT 5.6 Lump Sum Distributions from a Traditional Final Average Pay Formula and a Cash Balance Formula after Conversion

Source: U.S. General Accounting Office, Private Pensions: Implications of Conversions to Cash Balance Plans, GAO/HEHS-00-185 (Washington, DC: General Accounting Office, 2000), pp. 22–23.

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 128

formula for a 35-, 45-, and 55-year-old employee with equal salary and tenure at conversion.46

At retirement the 55-year-old employee would receive an annual annuity of $6,900 from the cash balance plan, the 45-year-old employee would receive $12,600 per year, and the 35-year-old employee about $24,000 a year. These mon- etary values simply represent the expected magnitude of differences.

Another problem with conversion is known as “wearaway.” According to the U.S. Department of Labor, wearaway is said to occur when the formula in a defined benefits plan is changed to a cash balance formula. Oftentimes, when the defined benefit plan formula is changed to a cash balance plan formula, the benefit earned under the defined benefit plan formula may exceed the amount determined to be the benefit under the cash balance plan formula. When this situation arises, an employee may not earn additional benefits until the benefit under the cash balance plan formula exceeds the benefit amount under the defined benefit plan formula. There are legal requirements that have to be sat- isfied with respect to benefit accruals, including prohibition against age dis- crimination. “Wearaway” is one of the issues being closely studied by the Equal Employment Opportunity Commission, the Internal Revenue Service, and the U.S. Department of Labor.

Not all employees experience wearaway following the conversion of their defined benefit plan to a cash balance plan. The GAO study indicated that the wearaway period at conversion is longer for older employees, and in addition, found that the wearaway period is increasingly longer the older the workers are at conversion. Wearaway has two causes. First, companies may create wearaway by setting a participant’s hypothetical balance under the cash balance plan lower than the present value of accrued benefits under the traditional defined benefit plan. Currently, no regulations exist for setting opening hypothetical balances. Second, wearaway may occur because of changes in the federally mandated dis- count rate for determining lump sum distributions from defined benefit plans. The value of lump sum distributions increases when the discount rate falls, while the value of distributions decreases when the discount rate increases.

Indeed, a variety of recent court rulings proved mixed on the issue about whether cash balance plans discriminate on the basis of age. Some courts recently concluded that these plans do not violate the Age Discrimination in Employment Act. In Easton v. Onan Corp., a federal district judge ruled that pension age dis- crimination prohibitions do not apply to employees younger than normal retire- ment age.47 The provisions were set to ensure that employees who chose to work past the normal retirement age continue to accrue pension benefits. In Dan C. Tootle v. ARINC Inc., the judge ruled that a “sensible approach” to determine whether cash balance plans are discriminatory is to use a test from ERISA for defined contribution plans.48

Specifically, plans are not discriminatory as long as employer contributions are not reduced by age.

However, in Cooper v. The IBM Personal Pension Plan,49 a U.S. District Court judge in southern Illinois ruled in 2003 that IBM Corporation’s cash balance

Chapter 5 Employer-Sponsored Retirement Plans 129

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 129

130 Part Two Retirement, Health, and Life Insurance

plan discriminated against IBM’s older employees because the benefit credit provided to older employees purchased a much smaller benefit than the same benefit provided to a younger employee. The judge in the IBM case relied on ERISA-based discrimination tests for defined benefit plans, as described earlier in the chapter.

Since then, language in the Pension Protection Act of 2006 tries to resolve the misunderstanding over wearaway provisions. This act makes it illegal for employ- ers to use wearaway provisions when converting a defined benefit plan to a cash balance plan. As a result, cash balance plan provisions must credit a participant with his or her accrued benefit under the old formula plus full credit for years of service after the adoption of the cash balance formula. The Pension Protection Act also allows employers to create new cash balance plans—or to convert existing defined benefit plans to a cash balance design—with much less fear of litigation.

Shortly after the Pension Protection Act was signed into law in August 2006, judges from the U.S. Seventh Circuit Court revisited the 2003 ruling in Cooper v. The IBM Personal Pension Plan. They reversed the 2003 ruling, concluding that the IBM Personal Pension Plan did not discriminate against employees on the basis of age. Older workers at IBM maintained that “someone who leaves IBM at age 50, after 20 years of service, will have a larger annual benefit at 65 than someone whose 20 years of service conclude with retirement at age 65. The former receives 15 years’ more interest than the latter.” Judges in the 2006 review indicated that nothing in the ERISA language legislates against “the fact that younger workers have (statistically) more time left before retirement, and thus a greater opportu- nity to earn interest on each year’s retirement savings. Treating the time value of money as a form of discrimination is not sensible.”50

Most recently, Cooper made a request to the U.S. Supreme Court to hear this case in the hopes of overturning the Seventh Circuit Court’s ruling. The U.S. Supreme Court declined to review the 2006 court decision in Cooper v. The IBM Personal Pension Plan. In 2007, Cooper appealed the Seventh Circuit Court’s deci- sion. The court refused to rehear the case.

Target Benefit Plans As a hybrid plan, target benefit plans combine features of defined benefit and defined contribution plans. Target benefit plans calculate benefits in a fashion sim- ilar to defined benefit plans based on formulas that use income and years of serv- ice. However, target benefit plans are fundamentally defined contribution plans because the benefit amount at retirement may be more or less than the targeted benefit amount based on the investment performance of the plan assets. “Targeted” benefit is based on the assumption that the actual return on plan assets equals the expected return.

Consistent with defined contribution plans, target benefit plan participants have individual accounts. Employers use actuarial calculations of the annual contribu- tion amount that would be necessary to fully fund the retirement benefit at a par- ticipant’s normal retirement age. These contributions are invested on behalf of the participant. In a defined benefit plan, employers would modify the annual contri- bution amount according to the performance of the investments to ensure benefit

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 130

amounts at retirement. In a target benefit plan, employers do not adjust their con- tributions. As a result, retirement benefits may be more or less than projected.

Target benefit plans at first glance appear to violate ERISA’s nondiscrimination rules because employers contribute greater amounts on behalf of more highly paid employees (usually older employees) than lower-paid employees (usually younger employees). For the moment, let’s assume that older workers are more highly paid than younger workers. The Internal Revenue Service cross-testing rules51 permit age-based contributions in target benefit plans and age-weighted profit-sharing plans under the following conditions: Lower contributions are per- missible for lower-paid (younger) employees because the contributions are pro- jected over a longer period than for higher-paid (older) employees. In the end, plans with age-based contributions are not discriminatory if projected benefits are comparable regardless of age.

Target benefit plans tend to be less expensive than either defined benefit or defined contribution plans. Under a defined benefit plan, employers are required to increase contribution amounts to compensate for shortfalls caused by poor investment performance. Employers do not make adjustments to their annual contributions in target benefit plans. Under a defined contribution plan, the annual contributions of employers are usually based on a fixed percentage of each employee’s income regardless of age. Actuarially determined contributions in tar- get benefit plans mean that larger contributions are made for older workers whose possible length of service is shorter than younger employees. The costs of target benefit plans in companies with predominantly younger workforces may be less than the costs of defined contribution plans.

Money Purchase Plans Money purchase plans are defined contribution plans because the benefit is based on the account balance—that is, the employer contributions plus the returns on investment of employer contributions—at retirement. However, these plans possess the funding requirements of defined benefit plans. Employers must make annual contributions according to the designated formula for the plan. These contributions are not tied to company performance indicators such as profits or stock price. Failure to make these contributions will result in excise tax penalties.52

Age-Weighted Profit-Sharing Plans As a hybrid plan, age-weighted profit-sharing plans combine features of defined benefit and defined contribution plans. Fundamentally, these plans are defined contribution plans because benefit amounts fluctuate according to the performance of investments of plan assets. In this regard, age-weighted profit-sharing plans are like the deferred profit-sharing plans we discussed earlier. Consideration of age makes these plans similar to defined benefit plans. Employers contribute dispro- portionately more to the accounts of older employees based on a projected hypo- thetical benefit at normal retirement age. The idea is to fund all employee accounts sufficiently well so that each employee would likely achieve a similar hypothetical retirement benefit.

Chapter 5 Employer-Sponsored Retirement Plans 131

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 131

132 Part Two Retirement, Health, and Life Insurance

Summary This chapter reviewed the fundamental concepts of company-sponsored retirement plans. Companies must follow a set of strict guidelines in designing and implementing pension plans to qualify for favorable tax treatment. We also reviewed the main features of defined benefit, defined contribution, and hybrid plans.

Key Terms qualified plans, 107 nonqualified plans, 107 coverage requirements, 109 ratio percentage test, 110 average benefit test, 110 vesting, 110 cliff vesting, 110 six-year gradual vesting, 110 accrual rules, 110 nondiscrimination tests, 110 top-heavy provisions, 110 accrued benefits, 110 minimum funding standards, 111 Social Security integration, 111 permitted disparity rules, 111 distribution, 112 lump sum distributions, 112 annuities, 112 income annuities, 112 qualified joint and survivor annuity (QJSA), 112 qualified preretirement survivor annuity (QPSA), 112

qualified domestic relations orders (QDROs), 113 plan termination rules, 113 defined benefit plans, 113 flat benefit formulas, 114 unit benefit formulas, 114 accumulated benefit obligation, 115 backloading, 116 three percent rule, 117 133 1/3 percent rule, 117 fractional rule, 117 defined contribution plans, 118 forfeitures, 118 fiduciary, 118 annual addition, 120 Section 401(k) plans, 120 profit-sharing plans, 121 profit-sharing pool, 121 fixed first-dollar-of-profits formula, 121 graduated first-dollar-of- profits formula, 121 profitability threshold formulas, 121

equal payments, 122 proportional payments to employees based on their annual salary, 122 proportional payments to employees based on their contribution to profits, 122 stock bonus plan, 122 employee stock option plans (ESOPs), 122 nonleveraged ESOPs, 122 leveraged ESOPs, 123 savings incentive match plans for employees (SIMPLEs), 123 tax-deferred annuity (TDA), 123 Section 457 plans, 125 hybrid plans, 125 golden handcuffs, 125 cash balance plans, 125 pension equity plans, 125 wearaway, 129 target benefit plans, 130 money purchase plans, 131 age-weighted profit- sharing plans, 131

1. Describe three criteria used to qualify pension plans for preferential tax treatment. 2. Are employees more likely to favor defined contribution plans over defined benefit

plans? How about employers? Explain your answer. 3. Summarize the controversial issues regarding cash balance plans. 4. Explain why mobile employees might prefer cash balance plans over defined benefit

plans.

Discussion Questions

Endnotes 1. ERISA §3(2)(A), 29 U.S.C. §1002(2)(A). 2. Employee Benefits Research Institute. 1997. Pension Plans (Chapter 4) in Fundamentals

of Employee Benefits Programs. Washington, D.C. Employee Benefits Research Institute.

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 132

3. S. L. Costo. 2006. “Trends in retirement plan coverage over the last decade,” Monthly Labor Review, February, 58–64.

4. Ibid.; U.S. Department of Labor. August 2006. National Compensation Survey: Employee Benefits in Private Industry in the United States, March 2006 (Summary 06-05). Online at www.bls.gov/ecthome.htm. Accessed March 5, 2007.

5. S. L. Costo. “Trends in retirement plan coverage over the last decade.” 6. U.S. Department of Labor. National Compensation Survey. 7. S. L. Costo. “Trends in retirement plan coverage over the last decade”; W. J.

Wiatrowski. 2004. “Medical and retirement plan coverage: Exploring the decline in recent years,” Monthly Labor Review, August, 29–36.

8. Internal Revenue Code (hereafter cited I.R.C.) §§410(a)(1), 410(a)(4); Treas. Reg. §1.410(a)-3T(b); ERISA §202(a).

9. I.R.C. §410(a)(3), Treas. Reg. §1.410(a)-5, 29 C.F.R. §2530.200b-2(a), ERISA §202(a)(3). 10. I.R.C. §414(q). 11. I.R.C. §410(b); Treas. Regs. §§1.410(b)-2, 1.410(b)-4, 1.410(a)(4)–11(g)(2). 12. I.R.C. §401(a)(26), Treas. Reg. §1.401(a)(26)–2(a). 13. I.R.C. §§411(a)(2), 411(a)(5); Treas. Reg. §1.411(a)-3T; ERISA §203(a). 14. I.R.C. §§411(a)(7), 411(b); ERISA §§204, 3(23); Treas. Reg. §1.411(b)-1. 15. I.R.C. §401(a)(4). 16. I.R.C. §416(g)(1). 17. I.R.C. §416; Treas. Reg. §1.416-1. 18. I.R.C. §§401(a)(5)(C), 401(l). 19. ABA Section of Labor and Employment Law. 2000. Employee Benefits Law, 2nd ed.,

Washington, DC: Bureau of National Affairs, pp. 252–53. 20. I.R.C. §§401(a), 417(b), 417(c); ERISA §205; Treas. Regs. §§1.401(a)-11, 1.401(a)-20. 21. ERISA §206(d)(1), I.R.C. §401(a)(13). 22. I.R.C. §§401(a)(13), 414(p); ERISA §206(d). 23. Treas. Regs. §§1.401(a)–13(g)(4)(i). 24. I.R.C. §415(b). 25. I.R.C. §404(a)(1)(A)(i)–(iii). 26. I.R.C. §404(a)(1)(C). 27. Treas. Regs. §1.401(a)(4)-2(b). 28. I.R.C. §411(a)(7)(A)(ii); ERISA §204(b)(2). 29. Prop. Treas. Reg. §§1.412(b)-1(a). 30. I.R.C. §415(c)(2); Treas. Reg. §1.415-6(b)(1). 31. I.R.C. §415(c). 32. I.R.C. §§404(a)(3), 402(g). 33. I.R.C. §404(a)(3). 34. Treas. Reg. §1.401-1(b)(2). 35. I.R.C. §404(a)(3). 36. I.R.C. §§401(a), 4975(e)(7)–(8). 37. I.R.C. §408. 38. I.R.C. §§501(c)(3); 501(a).

Chapter 5 Employer-Sponsored Retirement Plans 133

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 133

134 Part Two Retirement, Health, and Life Insurance

39. I.R.C. §§401(a)(9); 401(a)(31); 403(b)(10). 40. L. B. Green. October 29, 2003. What Is a Pension Equity Plan? Compensation and Working

Conditions Online. Online at http://bls.gov/opub/cwc/cm20031016ar01p1.htm. Accessed July 29, 2004.

41. 26 Code of Federal Regulations §§1.401(a)(4)-8(c)(3)(I). 42. U.S. Department of Labor, Bureau of Labor Statistics. September 23, 2003. “Questions

and answers on cash balance plans,” Compensation and Working Conditions Online. Online at www.bls.gov/opub/cwc/print/cm20030917ar01p.htm. Accessed July 29, 2004.

43. 26 U.S.C. §411(a)(7). 44. U.S. General Accounting Office. September 2000. Private Pensions: Implications of

Conversions to Cash Balance Plans (GAO/HEHS-00-185). Washington, DC: GAO. 45. U.S. General Accounting Office. Private Pensions. 46. Ibid. 47. Eaton v. Onan Corp., 2000 WL 1459801 (S.D. Ind. 2000). 48. Dan C. Tootle v. ARINC Inc., U.S. District Court for the District of Maryland, No. CCB-

03-1086. 49. Cooper v. The IBM Personal Pension Plan, Civil No. 99-829-GPM (S.D. Ill. July 31, 2003). 50. Cooper v. The IBM Personal Pension Plan, Civil No. 05-3588, U.S. District Court of

Appeals for the Seventh Circuit, August 7, 2006. 51. ERISA §401(a)(4); I.R.C. §1.401(a)(4)–(8). 52. I.R.C. §412(h).

mar30522_CH05_103-134.qxd 12/10/09 12:10 PM Page 134