Module 2 Defined Contribution and Defined Benefit Structures
Describe the factors that will determine an employee's retirement benefit under the defined contribution approach.
Under the defined contribution approach, the employee's retirement benefit will depend upon factors such as: (a) The level of the employer's (and, if applicable, employee's) contribution (b) Age at entry (c) Retirement age (d) Investment earnings (or losses).
Are the ERISA mandated disclosures generally dependent on the number of plan participants covered by the plan?
A major aspect of Title I of ERISA concerns the disclosure of information—to participants and their beneficiaries and to the government. These requirements generally apply to most tax-qualified plans, regardless of the number of participants involved.
ummarize the nondiscriminatory requirements that a qualified plan must adhere to.
A qualified plan must meet specific nondiscriminatory requirements as to employees covered under the plan. This requirement is set forth in section 410(b) of IRC, and the tests required by this section often are called the "410(b)" or coverage tests. A plan will be considered nondiscriminatory as to coverage if it meets one of the following two tests: (1) the ratio percentage test or (2) the average benefit test.
Describe the minimum distribution requirements. (
Minimum distribution rules are found in Section 401(a)(9) of IRC. There are two distinct elements to these rules. The first is that distributions, either to an employee or a beneficiary, must commence within stated periods of time. The second is that distributions must be made in minimum amounts. The basic requirement is that distributions to a participant must commence by April 1 of the year following the later of: (1) The year in which the participant retires (2) The year in which he or she attains the age of 70½, and distributions must be made by December 31 of each year thereafter. For years prior to 1996, the rule was different—Distribution had to commence by April 1 of the year following the year in which the participant attained the age of 70½, even though the participant was still working. While this old rule no longer applies to most employees, it still applies to 5% owners who must commence distribution when they reach the age of 70½, regardless of their employment status. The payments must be made over a period not exceeding the employee's life (or life expectancy) or the joint lifetimes (or joint life expectancy) of the employee and his or her beneficiary.
Identify and describe the items that ERISA disclosure and reporting provisions require to be(b) made reasonably available to employees on request.
The items which must be given to employees on request and/or made available for examination at the principal office of the plan administrator and at other locations convenient for participants include: (1) Supporting plan documents (2) The complete application made to IRS for determination of the plan's tax-qualified status (3) A complete copy of the plan's annual financial report (4) A personal benefits statement. While still retaining the right to request a benefit statement within any 12-month period, PPA expanded issuance requirements as described above. (5) A plan termination report (IRS Form 5310) should the plan be terminated.
Explain how the use of controlled groups in nondiscrimination testing limits the possibility of employers circumventing these requirements
The nondiscrimination requirements of IRC could be easily circumvented if employers were given complete flexibility in splitting employees among a number of subsidiaries. To eliminate this potential for abuse, employees of all corporations who are members of a controlled group of corporations are to be treated as if they were employees of a single employer.
Describe (a) when distributions must commence from a retirement plan unless otherwise requested by the participant
Unless otherwise requested by the participant, benefit payments must commence within 60 days of the latest of the following three events: (1) The plan year in which the participant terminates employment (2) The completion of ten years of participation (3) Attainment of the age of 65 or the normal retirement age specified in the plan.
What are meant by (a) nondiversion/exclusive benefit requirement
a) The nondiversion/exclusive benefit requirements mandate that a plan must specifically provide that it is impossible for the employer to divert or recapture contributions before the satisfaction of all plan liabilities. With certain exceptions, funds contributed must be used for the exclusive benefit of employees or their beneficiaries. Some of the limited exceptions would include the following: (1) At termination of a pension plan when, after all fixed and contingent obligations of the plan have been satisfied, funds remain because of "actuarial error." Such excess funds may be returned to the employer. (2) It is possible to establish or amend a plan on a conditional basis so that employer contributions are returnable within one year from the denial of qualification if the plan is not approved by the IRS. (3) An employer can make a contribution on the basis that it will be allowed as a deduction. If this is done, the contribution, to the extent disallowed, may be returned within one year from the disallowance. (4) Contributions made on the basis of a mistake in fact can be returned to the employer within one year from the time they were made.
Explain how top-heaviness is determined for a defined benefit plan
A defined benefit plan is top-heavy in a plan year if, as of the determination date, either: (1) The present value of the accumulated accrued benefits of all key employees participating in the plan is more than 60% of the present value of the accumulated accrued benefits of all covered employees. (2) The plan is part of a top-heavy group. The implication of a plan becoming top-heavy is that such a plan must meet certain additional requirements under IRC in order to maintain its status as a qualified plan. Becoming top-heavy potentially triggers (1) faster vesting for non-key employees and (2) minimum benefits for non-key employees.
Describe the vesting requirements for a qualified plan
A qualified plan must provide that employees will have a vested right to their benefits under specific rules. The value of after-tax and elective (before-tax) employee contributions must be fully vested at all times. The value of employer contributions must be vested when the employee reaches the plan's normal retirement age, regardless of the employee's service at that time. Otherwise, the value of employer contributions must be vested at least as rapidly as provided under the following minimum-vesting schedules.
Discuss how the qualified separate line of business (QSLOB) rules somewhat modify the application of the controlled group rules.
The controlled group rules can result in the aggregation of employee groups for qualification testing purposes that would otherwise be considered separate. However, an employer may be able to test a plan in a controlled group separately if it can show that the employees covered by the plan are in a QSLOB. These rules are designed to allow employers to structure benefit programs to meet the competitive needs of separate business operations or operating units in separate geographic locations.
HEC
These provisions were greatly simplified by the Small Business Job Protection Act of 1996. In 2017, an employee is deemed an HCE if he or she: (a) Was a 5% owner of the employer during the current or preceding year (b) Had compensation in the preceding year of $120,000 (as of 2017 and indexed for inflation in later years) and (at the election of the employer) was in the top 20% of employees in terms of compensation for that year. If the employer makes this election, the determination of who falls into the top 20% of the employees is a two-step process: (1) The employer must determine how many employees constitute 20%. Employers may exclude: Employees who have not completed six months of service or who have not attained the age of 21 by year-end Employees who normally work less than 17½ hours per week or less than six months during any year Nonresident aliens who have no U.S.-source income Employees included in a collective bargaining agreement that does not provide participation in the plan if 90% or more of all employees of the company are covered under such an agreement. (2) The employer having subtracted excludable employees (except for union employees) then multiplies the remaining number by 20%. Once the number is ascertained, the excluded employees are added back in to determine which specific employees are in the top-paid group.
In order to achieve a tax-qualified status, does a plan have to observe any statutory limits on contributions and/or benefits?
To achieve a tax-qualified status, a plan must observe two statutory limits on contributions and/or benefits. The first is a limit on the amount of an employee's compensation that may be taken into account when determining the contributions or benefits made on his or her behalf. The second is a limit on the annual additions that may be made to an employee's account in the case of a defined contribution plan or on the benefits payable to an employee in the case of a defined benefit plan.
What are meant by and (b) the plan permanency requirements?
While the employer may reserve the right to amend or terminate the plan at any time, it is expected that the plan will be established on a permanent basis. If a plan is terminated for any reason other than business necessity within a few years after it is established, this will be considered as evidence that the plan, from its inception, was not a bona fide plan designed for the benefit of employees. This could result in adverse tax consequences.
Identify and describe the items that ERISA disclosure and reporting provisions require to be (a) automatically given to employees
a) Items that must be automatically distributed to employees include: (1) The plan's summary plan description (SPD) (2) Any summary of material modification (SMM) (3) A summary annual report (SAR)—a summary of the plan's annual financial report. The Pension Protection Act (PPA) of 2006 substituted the Notice of Funding Status in lieu of the SAR for defined benefit plans beginning in 2008. (4) A statement of benefits for all employees who terminate employment (5) A written explanation to any employee or beneficiary whose claim for benefits is denied (6) As noted in the section below, a plan sponsor must supply a benefit statement to a participant or beneficiary upon request, although the employer need not provide more than one statement in every 12-month period. PPA modified the requirements for benefit statements, expanding the need for issuance beyond the need to fulfill a plan member's request in any 12-month period beginning after December 31, 2006. Under PPA rules: If a participant in a defined contribution plan is entitled to direct plan investments, he or she must receive a benefit statement once per quarter. If a participant in a defined contribution plan is not entitled to direct plan investments, he or she must receive a benefit statement once per year. For an active, vested participant in a defined benefit plan, the plan sponsor must provide either (1) a benefit statement once every three years or (2) an annual notice describing the availability of a benefit statement and the manner in which the participant can obtain a benefit statement.
Explain how top-heaviness is determined for (a) a defined contribution retirement plan
A defined contribution plan is top-heavy in a plan year if, as of the determination date, either: (1) The sum of the account balances of all key employees participating in the plan is more than 60% of the account balances for all covered employees. (2) The plan is part of a top-heavy group
Summarize the major tax law requirements in order for a plan to be qualified under IRC.
Summarize the major tax law requirements in order for a plan to be qualified under IRC.
Describe the purpose of Section 415 compensation.
IRC Section 415 limits the amount of benefits that can be paid to an individual employee under a defined benefit plan and the annual additions that can be made to an employee's account under a defined contribution plan. Limits for both types of plans are restricted to the lesser of a dollar amount or a percentage of compensation. Section 415 compensation is used in determining compliance in applying the Section 415 limits and for determining which employees are HCEs for plan nondiscrimination testing purposes.
Define what is meant by a qualified joint and survivor annuity (QJSA) in the case of a defined contribution plan.
In the case of a defined contribution plan, a QJSA means an annuity for the life of the surviving spouse, the actuarial equivalent of which is not less than 50% of the account balance of the participant on the date of death.
Explain the Section 415 limits in connection with () the annual benefit limit.
The Section 415 limit for the maximum annual benefit that can be paid to a participant under a defined benefit plan is the lesser of: (1) 100% of the participant's high three-year average compensation (2) $215,000 (as of 2017 and subsequently adjusted for inflation).
For a DB plan since the passage of the Tax Reform Action of 1986
100% vesting after 3 years of services Graded vesting with 20% vesting after 2 years of service, increasing by 20% multiples for each year until 100% vesting is achieved after 6 years
For a DC plan since the passage of PPA after December 31, 2006
100% vesting after 3 years of services Graded vesting with 20% vesting after 2 years of service, increasing by 20% multiples for each year until 100% vesting is achieved after 6 years
1.1 Describe the two broad choices an employer has in selecting a plan to provide retirement benefits to its employees.
An employer has two broad choices in selecting a plan to provide its retirement benefits. One of these is the defined benefit plan, under which the employer provides a determinable benefit, usually related to an employee's service and/or pay. Under this approach, the employer's cost is whatever is necessary to provide the benefit specified. The second approach is the defined contribution plan, in which the employer's contribution is fixed and accumulates to provide whatever amount of benefit it can produce.
Which choice of retirement plan, defined benefit or defined contribution, seems to be more popular with private employers?
Ever since the passage of the Employee Retirement Income Security Act (ERISA), a defined benefit plan exposes an employer to significant financial liability if the plan is terminated when there are unfunded liabilities for vested benefits. An employer's net worth is subject to a lien in favor of PBGC if necessary to meet any liabilities assumed by PBGC in this event. Because the vast majority of employees not covered by a private retirement program work for smaller companies, and these small employers, as well as newly formed companies, are apt to be reluctant to adopt a defined benefit plan and take on the potential liabilities that are imposed by ERISA, many such employers will find the defined contribution alternative, which has no such liabilities, to be a more palatable approach.
Summarize other vesting requirements with which employers must comply
Tax law establishes a number of other requirements concerning the vesting and payment of an employee's benefits. These include the following: (a) Vested amounts of less than $5,000 may be paid in a lump sum at termination of employment without employee consent; otherwise, an employee must consent to a lump-sum payment and must have the right to leave his or her accrued benefit in the plan until the later of the age of 62 or normal retirement age. A plan may not impose a significant detriment on a participant who does not consent to a distribution. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) made a direct rollover the default option for involuntary distributions that exceed $1,000 when the qualified retirement plan provides that nonforfeitable accrued benefits that do not exceed $5,000 must be distributed immediately. (b) If an employee receives payment for his or her accrued benefit and is later reemployed, the service for which the employee received payment may be disregarded in determining his or her accrued benefit after reemployment. The employee, however, must be permitted to "buy back" the accrued benefit attributable to such service by repaying the cash payment with compound interest. (In the case of a defined contribution plan, such a buyback is required only before the employee has incurred five consecutive one-year breaks in service, and interest need not be paid.) (c) Once vested, no forfeitures are permitted—even if termination of employment is due to dishonesty. If a plan has more liberal vesting provisions than the law requires, however, forfeitures are possible up to the time the employee would have to be vested under the law. (d) Any employee who terminates employment must be given written notification of his or her rights, the amount of his or her accrued benefits, the portion (if any) that is vested and the applicable payment provisions. (e) A terminated employee's vested benefit cannot be decreased by reason of increases in Social Security benefits that take place after the date of termination of employment. (f) If the plan allows an active employee to elect early retirement after attaining a stated age and completing a specified period of service, a terminated employee who has completed the service requirement must have the right to receive vested benefits after reaching the early retirement age specified. However, the benefit for the terminated employee can be reduced actuarially even though the active employee might have the advantage of subsidized early retirement benefits. (g) Any plan amendment cannot decrease the vested percentage of an employee's accrued benefit. Also, if the vesting schedule is changed, any participant with at least three years of service must be given the election to remain under the pre-amendment vesting schedule (for both pre- and post-amendment benefit accruals). (h) The accrued benefit of a participant may not be decreased by an amendment of the plan. This includes plan amendments that have the effect of eliminating or reducing an early retirement benefit or a retirement-type subsidy or of eliminating or reducing the value of an optional form of benefit with respect to benefits attributable to service before the amendment. In the case of a retirement-type subsidy, this applies only with respect to a participant who satisfies the pre-amendment condition for the subsidy, either before or after the amendment. Incomplete Learning Objective 5
Describe the limit on the amount of an employee's compensation that can be taken into account in determining contributions or benefits under a qualified plan per section 401(a)(17) of IRC and how this limit has changed since inception.
The Tax Reform Act of 1986 added Section 401(a)(17) to the IRC, limiting the amount of an employee's compensation that can be taken into account in determining contributions or benefits under a qualified plan. This limit was originally set at $200,000 and was increased for changes in the consumer price index (CPI). By 1993, it had increased to $235,840. However, beginning in 1994, it was rolled back to $150,000. This revised limit also increased with changes in the CPI but only when the cumulative changes increased the then-effective limit by at least $10,000. For 2001, the limit was $170,000. EGTRRA increased the includable compensation limit to $200,000 in 2002, with indexing in future years in $5,000 increments rather than $10,000 increments. By 2017 the includable compensation limit was $270,000.
Explain the Section 415 limits in connection with (a) annual additions to defined contribution plans
The basic Section 415 limit for annual additions to a defined contribution plan is that the amount added to an employee's account each year cannot exceed the smaller of: (1) 100% of the employee's compensation (2) $54,000. This $54,000 amount (as of 2017) is adjusted for changes in the CPI. The adjusted amount is then rounded down to the next lower multiple of $1,000.
What is the definition of a HCE, and how do employers determine the specific employees in the highly paid group?
The definition of HCE for plan nondiscrimination testing purposes has changed since the Tax Reform Act of 1986 started detailed numerical testing procedures. For years prior to 1997, the tax law contained extremely complicated provisions defining who was to be considered an HCE for purposes of various nondiscrimination requirements.
Explain the primary advantages of a defined benefit plan.
The primary advantages of a defined benefit plan are: (a) A defined benefit plan can be structured to achieve specific income replacement objectives. (b) A defined benefit plan can be integrated on the basis of Social Security benefits; defined contribution plans are forced to adjust contribution levels if integration is desired. (c) Since the typical defined contribution plan provides the employee's account balance is payable in full in the event of death and, frequently, in the case of disability, an employer interested primarily in providing retirement benefits can use available funds more efficiently for this purpose under a defined benefit plan. (d) A defined benefit plan may result in an equitable allocation of employer contributions, since the employee's age, past service and pay all may be taken into account implicitly. (e) The risk of inflation may be transferred from the employee to the employer by relating the benefit to the employee's final pay. (f) The investment risk will be borne by the employer, not the employee, in a defined benefit plan. (g) Benefits for employees who terminate employment at younger ages can be more costly under defined contribution plans than under defined benefit plans.
Explain the primary advantages of a defined contribution plan.
The primary advantages of a defined contribution plan are: (a) Deferred profit-sharing plans offer employers maximum flexibility in terms of cost commitment as well as opportunities to increase employee productivity. (b) Through the use of employer securities as a plan investment, greater employee identification with the company and its goals can be achieved. (c) If the employee group covered is relatively young, the defined contribution plan is apt to have greater employee relations value. (d) Another possible advantage is the ability of employees to make contributions on a before-tax basis to defined contribution plans under Section 401(k). (e) Defined contribution plans do not pay premiums to the Pension Benefit Guaranty Corporation (PBGC) and therefore may have lower administrative costs than defined benefit plans.
Explain the principal tax advantages of a qualified retirement plan.
The principal tax advantages of a qualified retirement plan are: (a) Contributions made by the employer, within the limitations prescribed, are deductible as a business expense. (b) Investment income on these contributions normally is not subject to federal income tax until paid out in the form of benefits. (c) An employee is not considered to be in receipt of taxable income until benefits are distributed—even though the employee may be fully vested and even though the employee has the right to receive the amounts involved without restriction. To obtain these tax benefits, the plan must achieve a qualified status by meeting the requirements of the Internal Revenue Code (IRC) and appropriate regulations and rulings issued by the Internal Revenue Service (IRS).