HR 205 Ch04 martocchio 6e

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Part Two: Retirement, Health Care and Life
Insurance
Chapter Four: Employer-Sponsored Retirement Plans
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.

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Learning Objectives
 In this chapter, you will gain an understanding of:
− how employer-sponsored retirement plans are
defined.
− differences between qualified plans and
nonqualified plans.
− features of defined benefit plans and defined
contribution plans.
− specific types of defined contribution plans.
− features of various hybrid plans.

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Overview
 Start by defining retirement plans and then
looking at qualified and nonqualified plans.
 Next is defined benefit plans including
requirements, rules, and limits.
 Followed by defined contribution plans
including different types of plans.
 Last is the different types of hybrid plans.

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Defining and Exploring Retirement
Plans
 First, two brief definitions.
− 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.
• Employers may match contributions.
• Participants receive amounts based on the performance
of the selected financial plan investments.

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Origins of Employer-Sponsored
Retirement Benefits
Timeline in the United States
1759 – the first plan was for families of
Presbyterian ministers.
1875 – the 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.

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Trends in Retirement Plan Coverage
and Costs
 55% of workers participated in a company-
sponsored retirement plan in 1992-1993.
− Declining to 49% in 2016.
 Defined benefit plans have decreased and
defined contribution plans have increased.
− 1992-93 – 32% participated in defined benefit
plans and 35% in defined contribution plans.
− 2016 – 15% participated in defined benefit plans
and 44% in defined contribution plans.

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Trends in Retirement Plan Coverage
and Costs
 Two important factors for these trends are:
− 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.
− Union status
• Unions secured high wages and benefits through the
early 1980s and maintain lucrative benefits though costs
have resulted in freezes or termination of pension plans.

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Exhibit 4.1
Characteristics of Qualified Retirement Plans

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Qualified vs. Nonqualified Plans
 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, or
• Average benefit test.
− Defined benefit plans must meet U.S. Department
of Treasury participation standards.

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 Vesting Rules.
− Vesting – an employee’s nonforfeitable rights to
retirement plan benefits.
• Defined benefit plans – employees vest in a specific
annual amount, each year after retirement.
• Defined contribution plans – employees vest in net
employer contributions.
− Title I of ERISA requires companies follow an
allowed schedule for vesting rights:
• Cliff vesting or six-year graduated schedule.

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Vesting Rules
Cliff vesting
• Grants employees
100% vesting after no
more than three years
from initial
participation.
Six-year graduated
schedule
• Allows workers to
become 20% vested
after two years and
continue vesting at 20%
each year until fully
vested after six years.

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 Accrual Rules.
− Specify the rate at which participants earn benefits.
 Nondiscrimination Rules: Testing.
− Prohibit favoring highly compensated employees.
• Fulfilled using
• safe harbors or a
• facts-and circumstances testing.
 Top-Heavy Provisions.
− Non-key employees receive a minimum benefit or a
minimum contribution and a special vesting schedule.

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 Minimum Funding Standards.
− Ensures employers contribute the minimum amount
necessary to provide promised benefits.
 Social Security Integration.
− Or permitted disparity rules - employers may
consider SS benefits within their defined benefit plan.
 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.

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Plan Distribution Rules
Events triggering
mandatory distribution
• Termination of
services
• 10th anniversary of
commencing the plan
• Employee reaches
retirement age
Three allowable
distribution methods
• Lump sum
• Annuities – a series
of payments for life
• Payments from a trust
fund

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 Qualified Survivor Annuities.
− Provides spouses with a qualified joint and survivor
annuity (QJSA) or a qualified preretirement
survivor annuity (QPSA).
 Qualified Domestic Relations Orders.
− Qualified domestic relations orders (QDROs)
provides benefits in the event of a divorce.
 Plan Termination Rules and Procedures.
− Plan termination rules – protect employees who
participated in a terminated plan.

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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.

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Flat benefit formula
 Flat amount formula – each
employee receives a flat
dollar amount.
 Flat percentage formula –
the dollar amount is based
on an employee’s pay.
 May lead to resentment as
years of service are not
acknowledged.
Unit benefit formula
 Recognize length of service.
 Annual benefits based on
age, years of service, and
final average wages/salary.
 Specifies annual retirement
benefits as a percentage of
final average salary.

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− Must meet several uniformity criteria, as well as
one additional safe harbor criterion.
• Uniform normal retirement benefit.
• Uniform post-normal retirement benefit.
• Uniform subsides.
• Uniform vesting and service crediting.
• No employee contributions.
• Period of accrual.

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 Accrual Rules.
− Accumulated benefit obligation is the present
value of benefits based on a designated date.
− To avoid backloading, use one of these three rules
• The Three Percent Rule – accrued benefit cannot be
less than 3% of the normal retirement benefit.
• The 1331/3 Percent Rule – accrual rate cannot exceed
1331/3% of accrual rate of previous year.
• The Fractional Rule – apples to early termination and
requires benefit be proportional to the normal benefit.

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− Non-key employees receive an accrued benefit of a
percentage times employee’s average pay.
 Minimum Funding Standards.
− ERISA imposes strict funding requirements.
 Benefits 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.

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 The PBGC’s program recognizes three types of
plan terminations:
− Distress terminations,
− Involuntary terminations, and
− Standard terminations.

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Defined Contribution Plans
Overview
• Companies set up an account for each
participating employee.
Defined
contribution
plans
• Permit an employer to defer a percentage of
pay into employee’s account.
Salary
reduction
agreements
• Come from accounts of employees who
terminated their employment prior to vesting.Forfeitures

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 Individual Accounts.
− Three possible contribution sources.
• Employee contributions – usually a percent of pay.
• Employer contributions – matching contributions.
− May make a full or partial match.
• Forfeitures from unvested former employees.
 Investments of Contributions.
− ERISA requires a fiduciary be named with several
responsibilities, including prudence.

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Exhibit 4.6
Conditions Relieving Fiduciary of Responsibility
with Employee Participation in Investments

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− Must meet one of two safe harbor conditions:
• A uniform allocation formula, or
• A uniform points allocation formula for profit-sharing.
 Accrual Rules.
− Accrued benefit equals individual account balance.
− Companies must contribute to non key-employee
accounts equal to either 3% of annual pay or the
highest contribution made to key-employee accounts.

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 Minimum Funding Standard.
− Less complex than defined benefit plans.
− The standard is met when account contributions
meet the minimum amounts specified in the plan.
 Contribution Limits.
− Annual addition is the annual maximum amount.
− Includes additions from all three sources.

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Types of Defined Contribution Plans
 401(k) Plans.
− Permits employees to defer part of their pay to an
individual account.
• Only private-sector or tax-exempt employers may
sponsor these plans.
− Three tax benefits.
• Employees do not pay income tax until withdrawn.
• Employers deduct contributions from taxable income.
• Gains are not taxed until funds are distributed.

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 Roth 401(k) Plans.
− Differ in two ways.
• An employee pays income tax on their contributions.
• Upon retirement, withdrawals are not taxed.
 Profit-Sharing Plans.
− Distribute a portion of profits to employees.
− Starts with a profit-sharing pool.
− Maximum annual contributions are limited.

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Profit-Sharing Plans
Employer Contributions
• Fixed first-dollar-of-
profits formula
• Graduated first-
dollar-of-profits
formula
• Profitability threshold
formulas
Allocation Formulas
• Equal payments
• Proportional
payments based on
annual salary
• Proportional
payments based on
contribution to profits

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 Stock Bonus Plans.
− A kind of profit-sharing paid in employer stock
instead of cash.
 Employee Stock Option Plans (ESOPs).
− Provides shares of company stock to employees.
− Nonleveraged ESOPs
− Leveraged ESOPs

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 Savings Incentive Match Plans for Employees
(SIMPLEs).
− Small companies meeting certain criteria may
establish accounts as IRAs or 401(k) plans.
 Section 403(b) Tax-Deferred Annuity Plans.
− A TDA is available to nonprofit organizations.
 Section 457 Plans.
− Nonqualified plans for government employees.

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Hybrid Plans
 Combine features of traditional defined benefit
and defined contribution plans.
− Many employers have replaced traditional defined
benefit plans with hybrid plans.
• “golden handcuffs”
− The traditional approach was not conducive to
attracting valuable employees due to younger
worker mobility.

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Exhibit 4.8
Comparison of Features of Pension
Equity Plans and Cash Balance Plans

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Hybrid Plans
 Cash balance plans differ from 401(k) plans.
− Participation – cash balance plans do not require a
contribution but 401(k) plans do.
− Investment risks – the employer managers 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.

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Hybrid Plans
 Concerns about Cash Balance Plans.
− Possible favorable treatment of younger workers.
− Converting tradition defined benefits to cash
balance plans.
 Target Benefit Plans.
− Calculate benefits on a formula that uses income
and years of service.
− The targeted benefit amount may differ based on
the investment performance of the plan’s assets.

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Hybrid Plans
 Money Purchase Plans.
− Defined as contribution plans because the benefit
is based on the account balance.
− However, they face funding requirements of
defined benefit plans.
 Age-Weighted Profit-Sharing Plans.
− Defined contribution plans because benefit
amounts fluctuate with investment performance.
− Consideration of age is a defined benefit plan
feature.

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Summary
 The chapter started by defining retirement
plans and then looking at qualified and
nonqualified plans.
 Next it defined benefit plans including
requirements, rules, and limits.
 Followed by defined contribution plans
including different types of plans.
 Last was the different types of hybrid plans.

HR 205 Ch04 martocchio 6e

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