3/27/2015 Chapter 17 Employee Benefits: Retirement Plans • Fundamentals of Private Retirement Plans • Defined Contribution Plans • Defined Benefit Plans • Section 401(k) Plans • Section 403(b) Plans • Profit-sharing Plans • Retirement Plans for the Self-Employed • Simplified Employee Pension • Simple Retirement Plans • Funding Agency and Funding Instruments 2 • Private retirement plans have an enormous social and economic impact • The Employee Retirement Income Security Act of 1974 (ERISA) established minimum pension standards • The Pension Protection Act of 2006 also has had a significant impact on private pension plans • Private plans that meet certain requirements are called qualified plans and receive favorable income tax treatment • The employer’s contributions are deductible, to certain limits • Investment earnings on the plan assets accumulate on a tax-deferred basis 3 1
3/27/2015 • A qualified plan must benefit workers in general and not only highly compensated employees, so certain minimum coverage requirements must be satisfied • Under the percentage test, the plan must cover at least 70% of all non-highly compensated employees • Under the ratio test, the percentage of non-highly compensated employees covered under the plan must be at least 70% of the percentage of highly compensated employees who are covered • Under the average benefits test: • The plan must benefit a reasonable classification of employees and not discriminate in favor of highly compensated employees • The average benefit for the non-highly compensated employees must be at least 70% of the average benefit provided to all highly compensated employees 4 • Most plans have a minimum age and service requirement that must be met • Under current law, all eligible employees who have attained age 21 and have completed one year of service must be allowed to participate in the plan • Normal retirement age is the age that a worker can retire and receive a full, unreduced pension benefit • Age 65 in most plans • An early retirement age is the earliest age that workers can retire and receive a retirement benefit • The deferred retirement age is any age beyond the normal retirement age • Employees working beyond age 65 continue to accrue benefits under the plan 5 6 2
3/27/2015 • A benefit formula is used to determine contributions or benefits • In a defined-contribution formula, the contribution rate is fixed, but the retirement benefit is variable • In a defined-benefit plan, the retirement benefit is known, but the contributions will vary depending on the amount needed to fund the desired benefit 7 • Defined-benefit plans: • The amount can be based on career-average earnings or on a final average pay, which generally is an average of the last 3-5 years earnings • Under a unit-benefit formula, both earnings and years of service are considered • Some plans pay a flat percentage of annual earnings, while some pay a flat amount for each year of service • Some plans pay a flat amount for each employee, regardless of earnings or years of service 8 • Vesting refers to the employee’s right to the employer’s contributions or benefits attributable to the contributions if employment terminates prior to retirement • A qualified defined-benefit plan must meet a minimum vesting standard: • Under cliff vesting, the worker must be 100% vested after 5 years of service • Under graded vesting, the worker must be 20% vested by the 3 rd year of service, and the minimum vesting increases another 20% for each year until the worker is 100% vested at year 7 9 3
3/27/2015 • Faster vesting is required for qualified defined-contribution plans to encourage greater employee participation • Employer contributions must be 100% vested after 3 years • The worker must be 20% vested by the 2 rd year of service, and the minimum vesting increases another 20% for each year until the worker is 100% vested at year 6 10 • Contributions to defined benefit plans are limited: • For 2013 and 2014: • The maximum annual benefit is limited to 100% of the worker’s average compensation for the three highest consecutive years or $205,000 , whichever is lower • Increase $5,000 per year • The maximum annual compensation that can be counted in the contribution of benefits formula for all plans is 2013: $255,000 2014: $260,000 Increase $5,000 per year 11 • The Pension Benefit Guaranty Corporation (PBGC) is a federal corporation that guarantees the payment of vested benefits to certain limits if a private pension plan is terminated • The maximum guaranteed pension at age 65 is • $3,699 for plan terminated in 2004 • $4,500 for plans terminated in 2009 • $4,943 for plans terminated in 2014 12 4
3/27/2015 • Funds withdrawn from a qualified plan before age 59½ are subject to a 10% tax penalty, except under certain circumstances, e.g., for certain medical expenses • Pension contributions cannot remain in the plan indefinitely • Distributions must start no later than April 1 st of the calendar year following the year in which the individual attains age 70½ • If the participant is still working, the distributions can be delayed • Qualified plans use advance funding to finance the benefits • The employer systematically and periodically sets aside funds prior to the employee’s retirement 13 • Many qualified private pension plans are integrated with Social Security • Integration provides a method for increasing pension benefits for highly compensated employees without increasing the cost of providing benefits to lower-paid employees • A top-heavy plan is a retirement plan in which more than 60% of the plan assets are in accounts attributed to key employees • To retain its qualified status, a rapid vesting schedule must be used for nonkey employees • Certain minimum benefits or contributions must be provided for nonkey employees 14 • Recall: in a defined contribution plan, the contribution rate is fixed, but the actual retirement benefit varies • For example, a money purchase plan is an arrangement in which each participant has an individual account, and the employer’s contribution is a fixed percentage of the participant’s compensation • The employer’s cost is reduced because past-service credits are typically not granted for service prior to the plan’s inception date 15 5
3/27/2015 • Disadvantages include: • Employees can only estimate their retirement benefits • Some employees invest a large proportion of their contributions in a stable value fund 16 • Recall: in a defined benefit plan, the retirement benefit is known in advance, but the contributions vary depending on the amount needed to fund the desired benefit • Plans typically pay benefits based on a unit-benefit formula • A worker’s retirement benefit is guaranteed • The investment risk falls on the employer • These types of plans have declined in relative importance because they are more complex and expensive to administer than defined contribution plans 17 • A cash-balance plan is a defined-benefit plan in which the benefits are defined in terms of a hypothetical account balance • Actual retirement benefits will depend on the value of the participant’s account at retirement • Each year, a participant’s “hypothetical” account is credited with a pay credit, which is related to compensation, and an interest credit • The employer bears the investment risks and realizes any investment gains • Many employers have converted traditional defined-benefit plans into cash-balance plans to hold down pension costs 18 6
3/27/2015 19 • A Section 401(k) plan is a qualified cash or deferred arrangement (CODA) • Typically, both the employer and the employees contribute, and the employer matches part or all of the employee’s contributions • Most plans allow employees to determine how the funds are invested • Some plans allow the contributions to be invested in company stock • Employees can voluntarily elect to have part of their salaries invested in the Section 401(k) plan through an elective deferral • Contributions accumulate tax-free, and funds are taxed as ordinary income when withdrawals are made • For 2014, the maximum limit on elective deferrals is $17,500 for workers under age 50 20 • A Section 401(k) plan is a qualified cash or deferred arrangement (CODA) • For 2014, the maximum annual contribution to a defined-contribution plan is 100% of earnings or $52,000, whichever is lower • Workers age 50 or older can make an additional catch-up contribution of $5000 per year 21 7
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