RETIREMENT
PLAN BASICS
Types
of Retirement Plans
Employers can
choose between two basic types of retirement plans: defined
contribution or defined benefit.
In a defined
contribution plan, an annual contribution is made for each
participant. The benefit that the participant ultimately receives is
based upon the "vested" portion of the accumulated value
of these contributions with investment earnings.
In a defined
benefit plan, a projected benefit is calculated for each
participant. The annual contribution that the employer must make to
provide these benefits is actuarially determined. Participants are
always entitled to their "vested accrued benefit", i.e.,
and the vested portion of the benefit they have earned to date.
These plans usually favor older employees and are designed to
provide more retirement security than do defined contribution plans.
In one defined
contribution plan, a profit sharing plan, the employer can
contribute, annually, up to 15% of the total eligible compensation
of the participants. This plan offers the flexibility needed by some
employers. A 401(k) plan is a popular type of profit sharing plan;
it encourages employees to make their own plan contributions, thus
enabling the employer to lower plan cost. In another type of defined
contribution plan, a money purchase pension plan, the employer MUST
contribute annually a fixed percentage (between 0 and 25% but not
exceeding $30,000) of each eligible participant`s compensation. An
advantage of this type of plan is that it allows greater
contributions than does a profit sharing plan.
Other retirement
plans include:
1. Employee
Stock Ownership Plans. These are defined contribution plans that
invest in the employer`s stock. They enable employees to obtain
company stock and the employer can realize tax advantages from the
sale of these securities.
2. Hybrid Plans.
These sophisticated plans have features of both defined contribution
and defined benefit plans. Target benefit plans and age-weighted
profit sharing plans are classified as defined contribution plans,
but have design features similar to those of defined benefit plans
and favor older employees.
3. SEPS, SARSEPS,
Simple Plans. These plans allow employers to have retirement plans
without fulfilling all the compliance requirements of
"regular" plans. Despite being easier to administer, the
limitations imposed upon them may make regular plans more
advantageous.
Retirement Plan
Features
All defined
contribution and defined benefit retirement plans have certain
features in common. In both, employees must meet certain eligibility
requirements to become plan participants, accrue contributions or
benefits and receive the "vested" portion of these
benefits upon attainment of normal retirement age (they may receive
them earlier). The amount that is not vested is reallocated to other
participants or used to lower employer contributions.
Generally, plans
may not require otherwise eligible employees to wait more than one
year and the attainment of age 21 to be eligible for plan
participation. Plans that provide 100% vesting may require two years
for eligibility purposes: 401 (k) plans however, cannot require more
than one year of service for employees to be eligible to make their
own contributions (elective deferrals) to the plan.
Employer
contributions must be allocated to all participants on a
"non-discriminatory" basis. They must not favor
"highly-compensated" participants over "nonhighly-compensated"
ones. It may be possible; however, to weigh contributions towards
the highly compensated participants, providing they are
non-discriminatory. It should be noted that there are various
statutory limitations regarding contributions and benefits under
retirement plans.
In a defined
contribution plan, contributions accumulate with investment earnings
to produce an account balance for each participant. Participants are
entitled to the "vested" portion of such balances when
they reach their normal retirement age; most defined contribution
plans, however, provide for the payment of these amounts on dates
prior to attainment of normal retirement age, such as termination of
employment. In a defined benefit pension plan a participant accrues
a benefit for each year of service. Employees are always entitled to
the vested accrued benefit earned to date. These benefits are
payable at normal retirement age but also may be available prior to
that date; small defined benefit pension plans usually provide for
their payment as a lump sum at termination of employment.
In addition to
retirement benefits, retirement plans can include benefits for
death, disability and other occurrences. Retirement plans can also
contain other features, such as loans to employees or self-directed
accounts, which allow defined contribution plan participants to
select their own investments and many other options.
Retirement
Plan Functions
To receive tax
advantages, retirement plans must meet certain reporting and
disclosure requirements as well as
Primarily
concerned with the tax status of the plan; if the plan does not meet
IRS regulations, it can lose its tax advantages and be subject to
substantial penalties. The DOL is primarily concerned with the
protection of plan participants. It requires that participants have
access to information about the plan; they must receive a Summary
Plan Description, a Summary Annual Report detailing the plans
financial condition and annual benefit statement, as well as other
material. The PBGC insures participants of most defined benefit
pension plans and charges annual premiums to ongoing defined benefit
plans to assist in meeting its obligations.
B. Investment and Fiduciary Requirements
ERISA imposes
requirements for plan investments to protect plan participants.
Investments must be diversified and follow the prudent man rule.
Plan assets must be protected by a trust and be distinct from the
assets of the employer. There must be no self-dealing of any kind
between the employer and the trust; these actions are called
"prohibited transactions" and are subject to significant
penalties. If possible, employers should remove themselves from
selecting plan investments by either delegating this function to an
investment committee or using investment managers or advisers.
Establishment
of a Retirement Plan
Retirement plans
contain benefits that provide tax advantages for both the employer
and the employees. They also help attract and retain desirable
employees.
Retirement
benefits offered by competing organizations help determine if a
retirement plan should be adopted. After employers have decided to
establish a retirement plan, they must select the type of plan (see
our basic article on Types of Retirement Plans), decide how
contribution and benefits for each employee are to be determined and
choose appropriate plan features. Installation of the plan can then
proceed as follows:
1. A written
plan document must be prepared that reflects the options discussed
above. It must be adopted by the end of the tax year for which the
first contribution is made. Depending upon various factors, the plan
may be submitted to the Internal Revenue Service to obtain its
approval as to whether it satisfies the requirements for favorable
tax treatment.
2. The plan must
be for the exclusive benefit of plan participants. They must receive
written material pertaining to the plan, including a Summary Plan
Description, which describes the plan in detail. The employer has
fiduciary exposure with respect to the plan and must not engage in
any actions in which there is self-dealing or a conflict of
interest.
Employers should
exercise care in the adoption of a retirement plan. They should be
aware of their obligations before a plan is adopted. These include
the responsibility to make the required plan contributions, monitor
and oversee the plan`s investments, meet all governmental reporting
requirements and communicate with and periodically report to
employees regarding the plan`s operation.
There are many organizations
that can provide employers with a retirement plan. Essentially, they
can be divided into two groups: those that are compensated strictly
on a fee basis and those that sell a product, such as life insurance
or mutual funds, that are used as plan investments. Employers should
exercise care when dealing with the latter, since their agents often
receive substantial commissions for the sale of the product but do
not have the expertise needed to design or administer the best plan.
It is advisable for employers to use fee-based retirement plan
specialists in establishing and maintaining plans.
Termination of a
Retirement Plan
To maintain its
favorable tax status, a plan must be considered by the IRS to be a
permanent arrangement for the exclusive benefit of employees. If it
is abandoned within a few years without compelling business
necessity, it may encounter difficulties. Retirement plans are
terminated for various reasons. If employers are experiencing
financial difficulties, they should consider reducing or suspending
contributions, before a plan is terminated. If the plan has not
worked as expected, possible negative repercussions from employees
should be considered before termination. If the paperwork has become
too burdensome, employers should consider redesigning the plan to
make it easier to administer, using additional help or outsourcing
the retirement plan function. Certain administrative tasks must be
performed when terminating a retirement plan. These include the
adoption of a resolution terminating the plan, the amendment of the
plan document to comply with the laws in effect at the time of plan
termination, the submission to the IRS for approval of the plan`s
termination (optional) and the calculation of the benefits payable
to the plan`s participants. It should be noted that all plan
benefits become fully vested at plan termination.
Defined benefit
plans often pose special problems with plan termination. The Pension
Benefit Guaranty Corporation must approve terminations for most of
these plans. The extent of the involvement of the PBGC depends upon
how well the plan is funded. Although the PBGC insures underfunded
defined benefit plans (within certain limits), it will first look to
the employer to satisfy the payment of benefits guaranteed them.
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