Chapter 04 – Employer-Sponsored Retirement Plans
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Chapter 04 Employer-Sponsored Retirement Plans
I. Learning Objectives (use PP 4.2)
1. Differences between qualified plans and nonqualified plans
3. Specific types of defined contribution plans
4. Various types of hybrid plans, as well as the controversy surrounding cash
II. Retirement Plans
A. Overview (use PP 4.3)
2. Social Security OASDI program provides government-mandated retirement income to
3. Individuals may use initiative to take advantage of tax regulations that have created
such retirement programs as individual retirement accounts (IRAs) and Roth IRAs
4. Three retirement plan designs (use PP 4.4)
6. Defined contribution plans are riskier because the retirement amount is based on the
performance of the investments made with the retirement contributions, like
7. Hybrid plans combine features of traditional defined benefits plans and defined
contribution plans
8. Role of Pension Protection Act of 2006 is to help shore up the financial solvency of
B. Tax Incentives for Retirement Plans
2. ERISA Titles I & II provisions set minimum standards for qualification of tax breaks
4. Nonqualified plans are pension plans that do NOT meet at least one ERISA provision
5. Definition – retirement or pension plans function by providing retirement income to
employees, or resulting in a deferral of income by employees for periods extending to
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III. Defining Retirement Plans (use PP 4.6 & 4.7)
A. Origins of employer-sponsored retirement benefits
2. In 1875 the American Express Company established a formal pension plan
4. Revenue Act of 1921 and government imposed wage increase controls in the 1940s
led companies to adopt discretionary employee benefits such as pension plans
B. Trends in Retirement Plan Coverage and Costs
1. According to the US Bureau of Labor Statistics, 55% of workers employed in
private sector participated in at least one company sponsored plan in 1992-1993.
3. In 2011, 41% participated in defined contribution plans and only 18% participated
in defined benefit plans, indicating a shift in retirement plan participation
4. Two explanations for these trends in retirement plan:
a. Shift in labor force toward different occupation and industries – decline in full-
time, union workers, and workers in goods-producing companies
IV. Qualified Plans
A. Overview
2. Investment earnings of the trust in which the plan assets are held are generally tax
exempt
3. Participants or beneficiaries do NOT pay taxes on the value of the retirement benefits,
until they receive them
B. Fundamental Characteristics (use PP 4.8)
2. Coverage requirements
4. Accrual rules
6. Key employee and top-heavy provisions
8. Social Security integration
10. Plan distribution rules
12. Qualified domestic relations orders
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C. Participation Requirements
1. Include age and service requirements
2. In general, employees are eligible if
D. Coverage Requirements (use PP 4.9)
2. Qualified plans do NOT disproportionately favor highly compensated employees
3. Companies demonstrate whether plans meet the coverage requirement by maintaining
a nondiscriminatory ratio of non-highly compensated employees to highly
compensated employees based on one of the following tests
4. U.S. Treasury regulations require the plans to cover
a. At least 50 employees or
E. Vesting Rules (use PP 4.10)
2. Employees always maintain the right to the contributions they make to employer
sponsored retirement plans
4. Vesting rights entitle employees to receive any employer contributions made to their
retirement accounts
5. Title I of ERISA mandates that companies grant full vesting rights to employer
contributions on one of two schedules
F. Accrual Rules
2. IRC and ERISA set minimum accrual rules
3. Defined benefit and defined contribution plans have different accrual rules (more later
in chapter)
G. Nondiscrimination Rules – Testing (use PP 4.11)
1. Prohibit employers from discriminating in favor of highly compensated employees in
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d. Plan features
3. Can be fulfilled in two ways
4. Safe Harbors (more later in chapter) (use PP 4.11)
a. Refer to compliance guidelines in a law or regulation
5. Two types of nondiscrimination tests (more later in chapter)
6. Safe harbors and nondiscrimination tests differ between defined benefits plans and
defined contribution plans
H. Top-Heavy Provisions (use PP 4.12)
2. Plans are said to be top-heavy if the accrued benefits or account balances for key
3. Ensure minimum benefits or contributions for non-key employees
4. For defined benefit plans
a. Each non-key employee must receive an accrued benefit of a designated
5. For defined contribution plans,
a. Employers must make minimum contributions to non-key employee accounts
I. Minimum Funding Standards
2. Standards differ between defined benefit and defined contribution plans
J. Social Security Integration (use PP 4.13)
2. Allow companies to explicitly take into account Social Security OASDI benefits
when determining pension benefits
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K. Benefit and Contribution Limits (use PP 4.13)
1. Benefit limits refer to the maximum annual amount an employee may receive from a
3. Employers limited in amount they can contribute to an employee’s defined
contribution plan each year
4. The Economic Growth and Tax Relief Reconciliation Act of 2001
5. Limits were set to expire after 2009, but the Pension Protection Act of 2006 made the
limits permanent
L. Allowable Tax Deductions for Employers
2. Condition 1 – retirement plans must be qualified
4. Condition 3 – Deductible contributions should be based on designated amounts set
M. Plan Distribution Rules
1. Refer to the payment of vested benefits to participants or beneficiaries
2. Three events may initiate a mandatory distribution of benefits
a. The participant’s termination of service
3. Distributions are payable three ways
4. Lump-sum distributions
a. Are single payments of benefits
5. Annuities
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6. Series of periodic payments from trusts
a. In defined contribution plans, the payments are made over a specified period of
time NOT to exceed the retiree’s or beneficiary’s life expectancy
b. In defined benefit plans, the payments may come directly from the trust fund
N. Qualified Survivor Annuities
1. Qualified plans must provide spouses of covered employees
3. QJSA is an annuity for the life of the participant with the survivor annuity for the
spouse
5. QPSA amounts must be no less than the QJSA amounts
O. Qualified Domestic Relations Orders (QDROs)
1. Permit a retirement plan to divide a participant’s benefits in the event of a divorce
3. If a QDRO stipulates that a former spouse will be treated as the current spouse for all
4. If a QDRO stipulates that a former spouse will be treated as a current spouse for
benefits that accrued prior to divorce, then the former spouse will be treated as the
current spouse only for those accrued benefits
P. Plan Termination Rules and Procedures
1. Apply only to defined benefit plans
2. Three types (more in chapter 3)
3. Strict guidelines for termination, including
a. Sufficient notification to plan participants
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V. Defined Benefit Plans
A. Overview (use PP 4.14)
2. Benefits are expressed in terms of a monthly sum equal to a percentage of a
participant’s pre-retirement pay multiplied by the number of years of service
4. The employer’s contributions to plan fluctuates yearly
5. Employer’s contributions must insure that the amount needed to pay benefits is
available in the plan
B. Benefit Formulas (use PP 4.15 & 4.16)
1. Two types
2. The difference being whether the employee’s years of service are considered
3. Flat benefit formulas
a. Two types
i. Flat dollar amount per employee (flat amount formula)
ii. Dollar amount based on an employee’s compensation (flat percentage
formula)
b. Benefits usually expressed as a percentage of average wage or salary
d. Example
i. In the 3 years up to 2014, Robert earns an average of $100,000 per year,
($99,000, $100,000, & $101,000/3 = $100,000 average)
e. This plan often leads to employee resentment
i. Because length of service is NOT a consideration
f. Two possible explanations for this exception
i. Longer service employees feel that they have earned the right to receive a
higher percentage
4. Unit benefit formulas
a. Recognize length of service
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iii. Final average income
d. Plans specify annual retirement benefits as a percentage of final average income
e. Example
i. Employee is 59 with 25 years of service
C. Nondiscrimination Rules – Testing
1. Must meet several uniformity criteria as well as one additional safe harbor criterion
based on particular characteristics of the plan
2. Failure to satisfy safe harbor criteria requires explicit testing for nondiscrimination
D. Accrual Rules (use PP 4.17)
1. Accumulated benefit obligation refers to the present value of benefits based on a
designated date
2. Actuaries determine a defined benefit plan’s accumulated benefits obligation by
a. Making assumptions about the return on investment of assets and
4. These criteria discourage employers from engaging in a practice known as
5. Fulfillment of at least one of these criteria ensures that benefits accrue regularly
throughout employees’ participation in defined benefit plans
6. One of three criteria must be met
7. The 3% rule
a. Under this rule, a participant’s accrued benefit CANNOT be less than 3% of the
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b. Example
i. Margaret retires from company at age 62
ii. Hired at age 21, enrolled in retirement plan as soon as eligible
8. The 1331/3 rule
a. Under this rule, the annual accrual rate CANNOT exceed 1331/3% of the rate of
accrual for any prior year.
b. Example: If a company’s retirement plan specifies the following annual accrual
rates
ii. 1.40 for the next 10 years
iii. 1.88 for the years thereafter
9. Fractional rule
a. Applies to participants who terminate their employment prior to reaching normal
retirement age
b. Stipulates that benefit accrual upon termination be proportional to the normal
retirement benefits
c. Example
i. The annual annuity at normal retirement age is $20,000
ii. The years of service at retirement would have been 30
E. Minimum Funding Standards
2. Employers must make an annual contribution that is enough to cover promised
benefits to retirees
3. Actuaries periodically review data to ensure sufficient funding levels
4. Reporting guidelines
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F. Benefit Limits and Tax Deductions
1. The IRC sets a maximum annual benefit that, in 2012
a. Is equal to the lesser of $200,000, or
VI. Defined Contribution Plans (use PP 4.18)
A. Overview
1. Employers and employees make annual contributions to separate accounts
2. Employers invest these funds on behalf of the employee, choosing from a variety of
investments vehicles, such as
4. These plans specify rules for the amount of annual contributions
6. Benefit amounts depend upon several factors, including
7. Forfeitures come from the accounts of employees who terminated their employment
prior to earning vesting rights
8. Examples of common plans include
a. Profit sharing plans
B. Individual Accounts (use PP 4.19)
1. Defined contribution plans contain accounts for each employee into which
2. Contributions may come from 4 possible sources
a. Employer contributions that are expressed as a percentage of an employee’s wage
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C. Investments of Contributions
1. ERISA requires that a named fiduciary manage investments into these plans
a. To possess discretion in managing the assets of the plan,
2. Investment managers, under the supervision of the fiduciary, select investments based
on a comparison of the risk and return potential of various investment options, such as
3. Investment managers invest assets in more than one type of investment vehicle to
balance risk and return potential
D. Employee Participation in Investments
2. Designated fiduciaries CANNOT be held liable for employee’s investment choices
3. Under certain conditions, employee participation does NOT constitute fiduciary
responsibility
a. Participants can choose from 3 diversified investment alternatives, each with
E. Nondiscrimination Rules: Testing
1. Must meet 1 of 2 safe harbors
2. Defined contribution plans satisfy the nondiscrimination rules when
a. They offer a uniform allocation formula to each employee
3. Profit sharing and money purchase plans satisfy the nondiscrimination rules based on
a uniform points allocation formula
Chapter 04 – Employer-Sponsored Retirement Plans
F. Accrual Rules
2. Company’s contribution may NOT be reduced because of an employee’s age
3. Companies may NOT set maximum age limits for discontinuing contributions
G. Minimum Funding Standards
1. NOT as complex as standards for defined benefit plans
H. Contribution Limits and Tax Deductions
1. Annual addition refers to the annual maximum allowable contribution to a plan
2. Includes
3. In 2012, the maximum was limited to the lesser of
4. The amount of employer’s annual tax deductions depends on the type of plan
contributed to
a. The Economic Growth and Tax Reconciliation Act of 2001 raised the allowable
contribution amounts in effect before January 1, 2002
VII. Types of Defined Contribution Plans
A. List of Plans (use PP 4.20)
2. Roth 401(k)
4. Stock bonus
6. Savings incentive match plans for employees (SIMPLE)
8. Section 457
B. 401(k) Plans (use PP 4.21)
2. Also known as cash or deferred arrangements (CODAs)
4. Only private sector or tax-exempt employers are eligible to sponsor these