Benefits Ch 4
2 important factors for the trends
1. Industry characteristics - Goods-producing, capital intensive industries offer higher pay and retirement plans. Service industries pay lower wages and offer less generous benefits, including retirement plans. 2. Union status - Unions secured high wages and benefits through the early 1980s and maintain lucrative benefits through costs have resulted in freezes or termination of pension plans.
Origins of employer-sponsored retirement benefits
1759 - First plan for families of Presbyterian ministers. 1875 - First private sector plan was at the American Express Company. Revenue act of 1921 - Growth was due to favorable tax treatment and wage controls. National Labor Relations Act of 1935 - Made retirement plans a bargaining subject.
DC plans: Individual accounts
3 possible contribution sources - (1) Employee contributions: usually a percent of pay (2) Matching contributions: Most often expressed as a percentage of the employee's annual compensation, and they may choose to make a full or partial match. (3) Forfeitures from unvested former employees.
Trends in retirement plan coverage and costs
55% of workers participated in a company-sponsored retirement plan in 1992-1993. Declining to 46% in 2016. DB plans have decreased and DC plans have increased. 1992-1993 - 32% participated in DB plans and 35% in DC plans. 2016 - 15% participated in DB plans and 44% in DC plans.
Brief definitions of defined benefit plans and defined contribution plans
A defined benefit plan guarantees retirement benefits, usually expressed in an annual sum. Sometimes referred to as pension plans. A defined contribution plan is when employees annually contribute to their individual account. Employer may match contributions. Participants receive amount based on the performance of the selected financial plan investments.
Qualified vs Nonqualified plans: Accrual and nondiscrimination rules
Accrual rules: Specify the rate at which participants accumulate (or earn) benefits. IRC and ERISA set minimum accrual rules. Nondiscrimination rules - Prohibit employers from favoring highly compensated employees in making contributions or benefits, availability of benefits, rights, or plan features. Can be fulfilled in two ways - Safe harbors (based on a particular plan design features) or a facts-and-circumstances testing. Safe harbors and nondiscrimination tests differ between defined benefits plans and defined contribution plans.
DC plans: Accrual rules
Accrued benefit equals individual account balance. Company's contribution may not be reduced because of an employee's age.
DB plans: Accumulated benefit obligation
Accumulated benefit obligation: Refers to the present value of benefits based on a designated date. Actuaries determine a DB plan's accumulated benefits obligation by - Making assumptions about the ROI of assets, and characteristics of the participants and their beneficiaries including expected length of service and life expectancies. The IRS established criteria to judge whether an employer's DB plan meets its accumulated benefit obligation. These criteria discourage employers from engaging in backloading.
DC plans: ERISA fiduciary duties
Acting solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them. Carrying out their duties prudently. Following the plan documents. Diversifying plan investments. Paying only reasonable plan expenses.
DC plans: Contribution limits
Annual addition: The annual maximum allowable contribution to a participant's account in a defined contribution plan. Includes additions from all three sources (employer, employee, forfeitures). In 2019 annual additions are limited to the lesser of $56,000 of 100% of the participant's compensation (includes employee + employer contributions).
DC plans: 403(b) tax-deferred annuity (TDA)
Available to a broad range of nonprofit organizations such as churches, private and public schools and colleges, hospitals, and charitable organizations. Subject to the same contribution limits as 401(k) plans. Private tax-exempt organizations may offer both 401(k) and 403(b) but public organizations are prohibited from offering 401(k) plans. Not every 403(b) plan is subject to ERISA minimum standards...only private sector.
DB plans: Backloading
Backloading: Occurs whenever benefits accrue at a substantially higher rate closer to an employee's eligibility to earn retirement benefits. To avoid backloading, companies can use one of three rules - (1) Three percent rule: A participant's accrued benefit cannot be less than 3% of the normal retirement benefit, assuming the participant began participation at the earliest possible age and remained employed without interruption until age 65 or until the plan's designated normal retirement age. (2) 133 1/3 percent rule: The annual accrual rate cannot exceed 133 1/3 percent of the accrual rate for any prior year. (3) Fractional rule: Applies to participants who terminate their employment prior to reaching normal retirement age.
Qualified vs Nonqualified plans: Contribution and benefit limits
Benefit limits - Maximum annual amount employee may receive from a qualified defined benefit plan. Contribution limits apply to defined contribution plans.
DB vs DC: Plan administration
Both can be complex to administer. DB - Require use of actuarial projections; must meet both minimum and maximum funding requirements; must pay premiums to PBGC. DC - ERISA and tax code have less impact on DC plans; DC plans do not have to meet min/max funding standards; no PBGC premiums because DC plans are by nature fully funded.
Hybrid plans: Cash balance plans
Cash balance plans: Defined benefit plans that define benefits for each employee by reference to the amount of the employee's hypothetical account balance (hypothetical because they do not reflect actual contributions or actual gains and losses allocable to the accounts). Each year the account is credited with a deposit usually equal to a percentage of the employee's wage. The account grows with annual pay-related credits and fixed interest credits. Employees receive lump sum or annuity at retirement/termination. Terminated employees may roll over the vested sum to another employer's qualified retirement plan. Employers manage the trust fund of a cash balance plan similarity to a DB plan. Many employers convert their traditional DB plan to a cash balance plan because they are usually less costly.
DC plans: Top heavy provisions
Companies must contribute to non-key employee accounts equal to the lesser of 3% of annual comp or the highest contribution credited to key-employee accounts.
DC plans: Savings incentive match plans for employees (SIMPLEs)
Company that employs 100 or fewer people meeting certain criteria may establish accounts as IRAs or 401(k) plans. Each employee's pervious year earnings was at least $5000. Company does not maintain another retirement plan. In 2017, employees could contribute the lesser of 100% of compensation or $12,500. Employers may make a regular contribution of 2% of compensation or a matching contribution not to exceed 3% of compensation.
DB vs DC: Pension benefits and length of service
DB - Cliff vesting with no vesting before designated years of service; and no payout at termination, only at retirement age. DC - Partial vesting after 2-3 years, full vesting at 4-6. Payout at termination or retirement.
DB vs DC: Ownership of assets and investment risk
DB - Company owns the assets and assumes the investment risk. DC - Employee owns the assets and assumes the investment risk.
DB vs DC: Plan cost
DB - Employer costs unknown based on actuarial assumptions recalculated annually, with contributions adjusted up or down accordingly. DC - Employers know the plan's cost on a yearly basis (exception true profit sharing plans).
DB vs DC: Taxes
DB - Employer may deduct annual contribution but cannot exceed maximum amount without penalty. DC - Employer may deduct annual contribution subject to certain statutory limits (higher than for DB).
DB vs DC: Employee acceptance
DB - Formulas are complicated for employees to understand and promised future benefits may seem remote. DC - Complexity is less apparent to employees and individual accounts have a known value. Also have opportunity to take a lump sum upon termination.
DB vs DC: Ancillary benefit provisions
DB - In the event of death normally pays a survivor annuity. DC - In the event of death normally pays vested account balance as a lump sum to beneficiary.
DB vs DC: Achievement of retirement income objectives
DB - Rewards long-term employees. DC - Better for employees who change jobs frequently.
How cash balance plans differ from DB plans
DB plans define an employee's benefits as a series of monthly payments; cash balance plans as a designated hypothetical account balance.
Defined benefit plans
Defined benefit plans: Guarantee retirement benefits specified in the plan document. Benefit is an annual sum equal to a percentage of preretirement pay multiplied by years of service. Disbursed in equal monthly payments. Benefit is fixed by a formula. The level of required employer contributions fluctuates from year to year based on investment performance and life expectancy.
DC plans: Age-weighted profit sharing plans
Defined contribution plans because benefit amounts fluctuate with investment performance of plan assets. Consideration of age is a defined benefit plan feature.
DC plans: Money purchase plans
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 the time of retirement. However, they face funding requirements of defined benefit plans. Employers make annual contributions according to a designated formula.
Defined contribution plans
Defined contribution plans: Companies set up an account for each employee who chooses to participate. The retirement benefit consists solely of the accumulated lump sum at the time of retirement - May take as a lump sum, roll over to an IRA, or make periodic withdrawals from the plan. Must take minimum distribution withdrawals by age 70.5. In case of termination, lump sum payout should go directly to another qualified plan or IRA...or 10% penalty and taxation. Plan may permit "hardship" withdrawals or plan loans (up to 50% of vested balance). Employee contributions vest immediately; employer contributions vest either gradually (max 6 years) or "cliff" up to 3 years. Employers typically require a minimum number of hours annually to participate and receive match (ex. 1000 hours).
DC plans: Roth 401(k)
Differ from 401(k)'s in two ways - (1) An employee pays income tax on their contributions. (2) Upon retirement, withdrawals are not taxed. Becoming increasingly popular by offering employees retirement income that is not subject to taxation.
DC plans: Profit sharing plans
Distribute a portion of profits to employees (although the employer does not have to base contribution on profits). Profit-sharing pool: Money earmarked for distribution. Determined by application of a formula every year based on the discretion of their Board of Directors.
Qualified vs Nonqualified plans: Pay distribution rules
Distribution: The payment of vested benefits to participants or beneficiaries. 1 of the 3 events triggers a distribution - (1) Participant's termination of service with the employer. (2) 10th anniversary of the year the participant commenced participation in the plan. (3) Participant's attainment of the earlier of age 65 or the normal retirement age. 3 allowable distribution methods - (1) Lump sum distributions: Single payments of benefits. (2) Annuities: Represent a series of payments for the life of the participant and beneficiary. (3) Series of payments paid from a trust fund.
Roth IRAs
Do not receive up front tax deduction. Money grows tax free. Usually no taxes at withdrawal. Unlike IRAs, the eligibility of Roth IRAs only depends on individuals' income, no matter if they are active participants in a qualified plan or not. Contribution limits are similar to traditional IRAs.
DB plans: Minimum funding standards
ERISA imposes strict funding requirements on qualified plans. Actuaries periodically review to ensure sufficient funding levels reported to IRS then submitted to DOL who ensures compliance with ERISA.
DC plans: Employee stock option plans (ESOPs)
Employee stock option plans (ESOPs): Provides shares of company stock to employees. Essentially stock bonus plans that use borrowed funds to purchase stock. Nonleveraged ESOPs: Company contributes stock or cash to buy stock. The stock is then allocated to the accounts of participants. Leveraged ESOPs: The plan administrator borrows money from a financial institution to purchase company stock. Over time, the company makes principal and interest payments to the ESOP repay the loan.
Reasons for movement from DB plans to DC plans
Employers are facing increasing competition and cost pressures to minimize wage and benefits costs. Increasingly businesses are undergoing frequent acquisitions, dissolutions, and reorganizations that discourages employer long term commitment to employees. Labor unions are in decline and they have generally favored DB plans. Employers are using more part-time and leased employees, and independent contractors. DC's plans with their individual accounts, periodically reported are easier for employees to understand. DC plans with their portability fit the nature of today's workforce, which experience frequent job changing.
Qualified vs Nonqualified plans
Employers establish qualified plans when all of the ERISA minimum standards are met. Failure to meet at least one (of 13) minimum standard results in a plan becoming disqualified.
Profit sharing plans: Allocation formulas
Equal payments: Reflects a belief that all employees should share equally in the company's gains to promote cooperation among employees. Proportional payments to employees based on their annual salary - Higher-paying jobs indicate the greatest potential to influence a company's competitive position. Proportional payments to employees based on their contribution to profits - Measure contributions based on job performance.
Individual retirement accounts (IRA)
Established by individuals, unions, or employers through wage deductions. No nondiscriminatory rules. Deduction limit for 2019 - $6,000 Catch-up limit for 50 and over - $1,000 Same rules as 401(k) - upfront tax deduction, money grows tax-free, pay ordinary income taxes upon withdrawal, 10% penalty before 59.5, must begin withdrawal by 70.5. Can accept "rollovers" from 401(k)s. Like 401(k)s contributions to IRAs are subject to Social Security and Medicare Tax.
IRA distributions
Exceptions to the 59.5 early withdrawal 10% penalty (IRAs and 401(k)s) - The potions or reimbursed medical expenses that are more than 7.5% (10% for IRAs) of adjusted gross income. Distributions for the cost of medical insurance while unemployed (IRAs only). Disability. Distributions made to beneficiaries of plans inherited after death. Distributions in the form of an annuity, also called substantially equal periodic payments (SEP). Distributions for qualified higher education expenses of the owner or their children or grandchildren (IRAs only). Distributions to buy, build, or rebuild a first home ($10,000 lifetime maximum) (IRAs only).
DC plans: Fiduciary
Fiduciary: Have important responsibilities and are subject to standards of conduct because they act on behalf of participants in a retirement plan and their beneficiaries.
Profit sharing plans: Employer contributions
Fixed first-dollar-of-profits formula: Uses a specific percentage of either pretax or after-tax annual profits, contingent upon the successful attainment of a company goal. Graduated first-dollar-of-profits formula: Uses a different percentage based on level of attained profits. Profitability threshold formulas: Fund profit-sharing pools only if profits exceed a predetermined minimum level but have a maximum payout level.
DB plans: Flat benefit formulas
Flat amount formula - Each employee receives a flat dollar amount for every year of service. Flat percentage formula - Dollar amount is based on an employee's pay (average over final 3-5 years). May lead to resentment as years of service are not acknowledged.
DB plans: Benefit formulas
Flat benefit formulas and unit benefit formulas.
DC plans: Hybrid plans
Hybrid plans: Combine features of traditional defined benefit and defined contribution plans. Many employers have replaced traditional defined benefit plans "golden handcuffs" with hybrid plans - "Golden handcuffs": What is used to describe defined benefit plans because they provide generous (golden) retirement income to workers who remain with the same employer (the handcuffs) throughout their work lives.
IRA eligibility
Individuals who are not active participants in an employer-maintained retirement plan. Any other individuals whose adjusted gross income is below a specific limit - in 2018, $63,000 for singles, and $101,000 for couples. There is a phase-out range for active participants.
DC plans: Stock bonus plan
Kind of profit-sharing plan paid in employer stock instead of cash. Participants possess the right to vote as shareholders.
DC plans: Minimum funding standard
Less complex than defined benefit plans. The standard is met when account contributions meet the minimum amounts specified in the plan.
Qualified vs nonqualified plans: Minimum funding standards
Minimum funding standards: Ensure that employers contribute the minimum amount of money necessary to provide promised benefits.
DC plans: Nondiscrimination rules - testing
Must meet 1 or 2 safe harbor conditions: (1) A uniform allocation formula on a percentage basis of your salary. (2) A uniform points allocation formula for profit sharing. Ex. If the profit sharing is 7%, employees will get 7% of their salary. DC plans satisfy the nondiscrimination rules when - (1) They offer a uniform allocation formula to each employee. (2) Based on a percentage of compensation, or dollar amount of allocation or the same dollar amount for each uniform unit of service.
DB plans: Nondiscrimination rules - testing
Must meet several uniformity criteria, as well as one additional safe harbor criterion. Uniform normal retirement benefit - The same benefit formula must apply to all employees in the plan in the same form and commencing at the same age. Uniform post-normal retirement benefit - Annual benefits must be the same for those retiring past normal retirement age as those retiring at normal age, assuming equal years of service. Uniform subsidies - Each subsidized optional form of benefit under the plan must be available to all employees in the plan. Uniform vesting and service crediting - All employees must be subject to the same vesting schedule and the same definition of service for all purposes of the plan. No employees contributions - The plan is not a contributory defined benefit plans, special rules apply to contributory 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.
DC plans: Section 457 plans
Nonqualified retirement plans typically for local or state government employees. Same limits as 401(k) and 403(b) plans. Only employees contribute to 457 plans.
Qualified vs Nonqualified plans: Social security integration
Or permitted disparity rules - employers may consider social security benefits based on the benefits within their defined benefit plan. Subject to established limits, qualified plans may reduce benefits based on the benefits owed under the Social Security program.
DC plans: Conditions relieving fiduciary of responsibility with employee participation in investments
Participants have the opportunity to choose from at least 3 diversified investment alternatives. Each investment has different degrees of risk. Participants have the opportunity to change their investment allocations at least once each 3 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.
How cash balance plans differ from 401(k) plans
Participation - Cash balance plans do not require a contribution but 401(k) plans do. Investment risks - Employer manages a cash balance plan and employees manage 401(k) plans. Life annuities - Unlike 401(k) plans, cash balance plans are required to offer benefits as annuities. Federal guarantee - The PBGC has authority over defined benefit plans but not defined contribution plans.
Qualified vs Nonqualified plans: Participation and coverage requirements
Participation requirements - age 21 and one year of service (1,000 work hours). Coverage requirements - Qualified plans do not favor highly compensated employees or key employees (ratio percentage test and average benefit test - 70%). Defined benefit plans must meet U.S. Dept. of Treasury participation standards - At least 50 employees or 40% of an employer's workforce must benefit from the plan.
Hybrid plans: Pension equity plans
Pension equity plans: Similar to cash balance plans except for how benefits are calculated. Credit employees' accounts with points based on years of service. Similar to cash balance plans, pension equity benefits are expressed as an account balance. An alternative formula in pension equity plans is employee age plus years of service, the percentage of pay is based on the sum of the age plus service.
DC plans: 401(k)
Permits employees to defer part of their pay to an individual account. Only private-sector or tax-exempt employers may sponsor these plans. Employers usually "match" employee contributions to a designated maximum percentage (ex. 50% match up to 6% employee contribution, or 100% match on first 4%). Employers can auto-enroll employees (PPA 2006). 3 tax benefits - (1) Employees do not pay income tax until withdrawn. (2) Employers deduct contributions from taxable income. (3) Gains are not taxed until funds are distributed. Contribution limits (401(k), 403(b), 457 plans) - Employees 2019 - $19,000; $25,000 for 50 and over.
Concerns about cash balance plans
Possible favorable treatment of younger workers (possibly event to the extent of illegal age discrimination). DB plans are not age neutral because the value of benefit grows substantially with age and participation, thus favoring older workers ("backloading")
DB plans: Top-heavy provisions
Present value of the accrued benefits for key employees exceeds 60% of the present value of the accrued benefits of all employees; rule applies to both DB and DC plans. Non-key employees receive an accrued benefit of a percentage times employee's average pay. The percentage is the lesser of 2% times the participant's number of years of service (x average comp), or 20%.
Plan termination rules
Protect employees who participated in either a defined benefit or defined contribution plan that was terminated.
Qualified domestic relations orders (QDROs)
Provides benefits in the event of a divorce. Plan termination rules: Protect employees who participated in either a defined benefit or defined contribution plan that was terminated.
Qualified survivor annuities
Qualified joint and survivor annuity (QJSA). Qualified retirement survivor annuity (QPSA).
Why do we care if our plan is "qualified?"
Qualified plans provide both employees and employers with immediate tax benefits. Monetary contributions to qualified plans reduce the amount of an employee's or company's annual earnings that are subject to taxation. Companies often carve out highly compensated executive employees because they can't meet discrimination testing requirements and create nonqualified deferred compensation plans (NQDC).
DB plans: Unit benefit formulas
Recognize length of service. Annual benefits based on age, years of service, and career or final average wages/salary (usually 5 years). Specific annual retirement benefits as a percentage of average salary.
Converting DB plans to cash balance plans
Retirement benefits accrue at a decreasing rate in cash balance plans in contract to an increasing rate in DB plans. Converting from a DB plan to a cash balance plan may result in older workers receiving smaller benefits. A potential problem with conversion is called "wearaway" where a participant's hypothetical balance may be set lower than the present value of accrued balance under the DB plan.
DC plans: Salary reduction agreements and forfeitures
Salary reduction agreements: Permit an employer to defer a percentage of pay into employee's account. Forfeitures: Come from the accounts of employees who terminated their employment prior to earning vesting rights.
DC plans: Target benefit plans
Similar to DB plans, calculate benefits on a formula that uses income and years of service. Fundamentally DC plans because the benefit amount at retirement may be more or less than the targeted amount based on investment performance of plan assets (employers do not adjust their contributions based on performance). "Targeted" benefit is based on the assumption that the actual return on plan assets equals the expected return. They do not use individual accounts and contributions are invested on behalf of the participants. Employers use actuarial calculations to estimate annual contribution amount required to fund the retirement benefit at normal retirement age. These plans tend to be less expensive for employers than traditional DB or DC plans.
SEP IRAs and SIMPLE IRAs
Simplified employee pension (SEP) IRA - Allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a traditional IRA established in the employee's name, instead of to a pension fund account in the company's name. SIMPLE IRA - A simplified employee pension plan that allows both employer and employee contributions similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately (contribution limit was $12,500 in 2018).
DB plans: Benefit limits
The IRC sets a maximum annual benefit equal to the lesser of $215,000 or 100% of the highest average pay for three consecutive years.
DB plans: Plan termination rules and procedures
The PBGC (pension benefit guaranteed corporation)'s program recognizes three types of plan terminations - (1) Distress terminations: A company in financial distress may voluntary terminate a pension if it meets certain requirements. (2)Involuntary terminations: Law provides that the PBGC may terminate a pension plan, even if a company has not filed to terminate their plan(3) Standard terminations: A plan may terminate only if plan assets are sufficient to satisfy all plan benefits and if the plan administrator has taken certain steps.
Wearaway provision - Pension Protection Act of 2006
The language of the Pension Protection Act of 2006 tries to resolve the misunderstanding over wearaway provisions - Makes it illegal for employers to use wearaway provisions when converting from DB to cash balance. Cash balance plans must credit participants with accrued benefits under the old formula plus full credit for the years of service after the adoption of the cash balance formula. Allows employers to create new cash balance plans or convert existing DB plans with much less fear of litigation.
Qualified vs Nonqualified plans: Top-heavy
Top-heavy: Non-key employees receive a minimum benefit (DB plan) or a minimum contribution (DC plan) and a special vesting schedule. A defined benefit plan is top-heavy if the present value of the accrued benefits (PVAB) under the plan for the key employees exceeds 60% of the PVAB under the plan for all employees. A defined contribution plan is top-heavy if the total of the accounts of the key employees under the plan exceeds 60% of the total of the accounts of all employees under the plan. A top-heavy plan must also provide a special vesting schedule - 3 year 100% vesting schedule or 6 year graduated vesting schedule.
Millennials and retirement
Two-thirds of working Millennials have nothing saved for retirement. Based on recommendations of financial experts only five percent of working Millennials are saving adequately for retirement. Even though two-thirds work for an employer that offers a retirement plan, only slightly over one-third participate. Millennials on average are expected to live to 89. Social Security will replace less income and they have a very low likelihood of having a DB plan Millennials will have to put aside double (15-22%) previous generations to safely retire.
Qualified vs. Nonqualified plans: Vesting rules
Vesting: Refers to an employee's nonforfeitable rights to retirement benefits. DB plans - Employees vest in a specific annual amount each year after retirement. DC plans - Employees vest in net employer contributions (employer contributions +/- investment gains/losses). Title I of ERISA requires companies follow an allowed schedule for vesting rights - (1) Cliff vesting: Must grant employees 100 percent vesting after no more than three years from beginning participation in the retirement plan. (2) Graduated schedule: Allows workers to become 20 percent vesting after two years and to vest at a rate of 20 percent each year thereafter until they are 100 percent vested after six years from beginning participation in the retirement plan.
Roth IRA distributions
Withdrawing the principal is tax free and no penalty at any time for contributions to Roth IRA. Withdrawing the principal tax is free and no penalty for converted balance from traditional IRA after 5 years of conversion (10% penalty if less than 5 years). Withdrawing the earning portion is tax free at 59.5 years...earlier is 10% penalty. There are also some exceptions for earlier withdrawals, similar to traditional IRAs.