Human Resources Chapter 4 Employersponsored Retirement Plans Offer Tax Benefits Employees Not Pay Tax Their

Chapter 04 – Employer-Sponsored Retirement Plans

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5. Offer 3 tax benefits

a. Employees do NOT pay tax on their contributions until they withdraw funds

C. Roth 401(k) Plans (use PP 4.22)

2. Similar to 401(k) plans in two ways:

3. Becoming an increasing popular offering to help employees manage the uncertainty of

possible changes in future income tax rates

D. Profit Sharing (use PP 4.23)

1. Overview

a. Comes from money set aside in a profit sharing pool to be distributed to

2. Employer contributions

a. Based on the discretion of the board of directors, or determined by 1 of 3 formulas

i. Fixed first dollar of profits

ii. Graduated first-dollar-of-profits

iii. Profitability threshold formula

b. Fixed first-dollar-of-profits

i. Uses a specific percentage of either pre- or post-tax annual profits upon

reaching a company goal

ii. Might also be based on other things like gross sales

iii. Contingent upon the attainment of a company goal

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e. The IRS requires that employer contributions be substantial and made on a

recurring basis

D. Allocation Formulas

1. Must NOT discriminate in favor of highly compensated employees

2. Distributions are usually made in 1 of 3 ways

4. Proportional payments to employees based on their annual salaries may be used

5. Proportional payments to employees based on their contributions to profits

a. May be based on job performance

b. NOT very feasible because it is difficult to isolate each employee’s contributions

to profits

E. Stock Bonus Plans (use PP 4.24)

1. May be the basis for the company’s 401(k) plans

3. Reward employees with company stock

5. Those voting rights differ based on whether company stock is traded in public stock

exchanges

6. If the stock is publicly traded, employee voting rights are more restricted

F. Employee Stock Ownership Plans (ESOPS) (use PP 4.25)

1. May be the basis for a company’s 401(k) plans

3. They are essentially stock bonus plans that use borrowed funds to purchase stock

4. They are either nonleveraged or leveraged

a. Nonleveraged ESOPs

i. Are stock bonus plans

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

iii. The stock purchased with the loan is placed in a suspense account, until

amounts equal to the employer’s contributions are allocated to participants’

individual accounts

G. Savings Incentive Match Plan for Employees (SIMPLE) (use PP 4.26)

1. Congress enacted law in 1996 for employees working in small companies which

3. Must meet nondiscrimination and vesting requirements under ERISA

4. In 2012, employees may contribute up to $11,500, indexed for inflation in $500

increments

H. Section 403(b) Tax Deferred Annuity Plans (TDA) (use PP 4.27)

1. Was setup for employees of

a. Public educational institutions and

3. They are NOT qualified plans under ERISA

4. Contributions come mainly from either employers or employees

6. Private tax-exempt organizations may offer both 401(k) and 403(b) plans but public

organizations are prohibited from offering 401(k) plans

7. Three common methods of funding TDAs include

8. Annuities

a. May be

10. TDAs are similar to 401(k) plans in that the

11. Participants may NOT rollover assets into any qualified plan

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12. Participants may rollover TDA distributions to another TDA or and IRA

I. Section 457 Plans

2. Nonqualified retirement plans for government employees

4. Now 457 Plans have same limits as 401(k) and 403(b) plans

5. Only employees contribute to 457 plans

VIII. Hybrid Plans

A. Overview (use PP 4.28)

2. Four Common Plans

a. Cash balance and pension equity

3. Many employers are setting aside the traditional defined benefit plans (also described

as “golden handcuffs”) for hybrid plans

4. Different career plans of younger generations have led many employers to conclude

that their retirement plans were not beneficial to younger or more mobile workers

B. Cash Balance Plans and Pension Equity Plans

1. Overview (use PP 4.29)

a. IRS defines cash balance plans as “a defined benefit plan that defines benefits for

each employee by reference to the amount of the employee’s hypothetical account

balance”

2. Benefit formulas

a. Established as individual employee accounts

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interest at a designated rate

d. The interest rate credit is guaranteed instead of fluctuating with the performance

3. Comparing hybrid plan features with defined benefit plan and defined contribution

plan features (use PP 4.31)

a. Hybrid plans contain features of both traditional defined benefit and defined

contribution plans

b. Cash balance plans are defined benefit plans

c. 401(k) plans are a type of defined contribution plan

d. Four major differences between cash balance plans and 401(k) plans:

i. Participation: Participation in typical cash balance plans generally does NOT

depend on the workers contributing part of their compensation to the plan.

Participation in a 401(k) plan does depend on an employee choosing to make a

contribution to the plan

4. Controversies about the plans (use PP 4.32)

a. Age-related treatment

i. Are believed to also favor workers who switch employers periodically

Chapter 04 – Employer-Sponsored Retirement Plans

and cash balance plans and concluded that cash balance plan accrual favors

younger employees

c. Converting defined benefits plans to cash balance plans

i. Retirement benefits accrue at a decreasing rate in cash balance plans in contrast

to an increasing rate in defined benefits plans

ii. Converting from defined benefits plans to cash balance plans may result in

older workers receiving smaller benefits

v. These plans also have a “wearaway” problem, especially for older employees,

that means that some employees do NOT accrue benefits for a period of time

following conversion, while others do NOT experience an interruption in

accruing benefits

vi. Two causes for wearaway

vii. When an employer sets a participant’s hypothetical balance lower than the

4. Cash balance plans do NOT violate the Age Discrimination in Employment Act

i. In Easton v. Onan Corporation, a federal district judge ruled that pension age

discrimination prohibitions do NOT apply to employees younger than normal

retirement age, since the provisions were set to ensure that employees who

chose to work past the normal retirement age continue to accrue pension

benefits

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5. The language of the Pension Protection Act of 2006 tries to resolve the

misunderstanding over wearaway provisions

a. Makes is illegal for employer to use wearaway provisions when converting a

defined benefit plan to a cash balance plan

b. Cash balance plans must credit participant with accrued benefit under the old

formula plus full credit for the years of service after the adoption of cash

balance formula

C. Target Benefit Plans (use PP 4.33)

1. Calculate benefits in a fashion similar to defined benefit plans based on formulas that

2. Are fundamentally defined contribution plans, because the benefit amount at

3. “Targeted” benefit is based on the assumption that the actual return on plan assets

equals the expected return

5. Employers use actuarial calculations of the annual contribution amount that would be

6. The contributions are invested on behalf of the participants

8. These plans appear to violate ERISA’s nondiscrimination rules because employers

contribute greater amounts on behalf of more highly paid employees (older workers)

9. These plans tend to be less expensive for employers because

a. Employers do NOT make adjustments to their annual contributions

Chapter 04 – Employer-Sponsored Retirement Plans

D. Money Purchase Plans (use PP 4.34)

1. These plans are like defined contribution plans because the benefit is based on the

2. Employers make annual contributions according to the designated formula for the

plan

3. Contributions are NOT tied to company performance indicators, such as profits or

stock prices

E. Age-Weighted Profit Sharing Plans

2. Similar to defined contribution plans in that the benefit amounts fluctuate according to

the performance of investments of plan assets

3. These plans are similar to defined benefit plans because employers contribute

4. Idea is to fund all employee accounts sufficiently well so that each employee would

likely achieve a similar hypothetical retirement benefit

Summary

This chapter reviewed fundamental concepts of company-sponsored retirement plans as also the

main features and types of defined benefit, defined contribution, and hybrid retirement plans.

Discussion Questions

1. Describe three criteria used to qualify pension plans for preferential tax treatment.

Main Points

• Qualified plans include 13 fundamental characteristics, which specify the minimum

requirements for employer and employee tax benefits. Three of these are described

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2. Are employees more likely to favor defined contribution plans over defined benefit plans?

What about employers? Explain your answer.

3. Summarize the controversial issues regarding cash balance plans.

Main Points

• There are two controversies:

o age-related treatment,

4. Explain why mobile employees might prefer cash balance plans over defined benefit plans.

Main Points

• Cash balance plans calculate benefits as a single lump sum payment.

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Cases

Understanding Your Benefits

Investing in Your Retirement

1. Do you think you should defer part of your pay to invest in the Section 401(k) plan?

2. If you choose to invest, what percentage of your pay defer to the Section 401(k)? Why?

Instructor Notes

Section 401(k) plans offer features that are attractive to both employers and employees. The

employee, however, must understand that he or she must take ownership in his or her own

Student Responses

1. Should you invest in the Section 401(k) plan?

Chapter 04 – Employer-Sponsored Retirement Plans

2. If you choose to invest, what percentage of your pay defer to the Section 401(k)? Why?

A New Retirement Plan at Grinders Manufacturing

1. Based on the circumstances Grinders Manufacturing is facing, do you feel Shane’s

intention to move to a defined contribution plan is a good idea?

2. Who will the change benefit more, the company or the employees?

Instructor Notes

Student Responses

1. Based on the circumstances Grinders Manufacturing is facing, do you feel Shane’s

intention to move to a defined contribution plan is a good idea?

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2. Who will the change benefit more, the company or the employees?