Chapter 17

Employee Benefits: Retirement Plans

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Agenda
Fundamentals o Private !etirement Plans "e ined Contri#ution Plans "e ined $ene it Plans %e&tion '01()* Plans %e&tion '0+(#* Plans Pro it-sharing Plans !etirement Plans or the %el -,mployed %impli ied ,mployee Pension %imple !etirement Plans Funding Agen&y and Funding -nstruments Copyright 2008 Pearson AddisonWesley. All rights reserved.

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Fundamentals o Private !etirement Plans

Private retirement plans have an enormous so&ial and e&onomi& impa&t
.he ,mployee !etirement -n&ome %e&urity A&t o 1/7' (,!-%A* esta#lished minimum pension standards .he Pension Prote&tion A&t o 2000 also has had a signi i&ant impa&t on private pension plans Private plans that meet &ertain re1uirements are &alled 1uali ied plans and re&eive avora#le in&ome ta2 treatment .he employer3s &ontri#utions are dedu&ti#le4 to &ertain limits -nvestment earnings on the plan assets a&&umulate on a ta2de erred #asis

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Fundamentals o Private !etirement Plans

A 1uali ied plan must #ene it 5or)ers in general and not only highly &ompensated employees4 so &ertain minimum &overage re1uirements must #e satis ied
6nder the per&entage test4 the plan must &over at least 707 o all non-highly &ompensated employees 6nder the ratio test4 the per&entage o non-highly &ompensated employees &overed under the plan must #e at least 707 o the per&entage o highly &ompensated employees 5ho are &overed 6nder the average #ene its test8
.he plan must #ene it a reasona#le &lassi i&ation o employees and not dis&riminate in avor o highly &ompensated employees .he average #ene it or the non-highly &ompensated employees must #e at least 707 o the average #ene it provided to all highly &ompensated employees

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Fundamentals o Private !etirement Plans

9ost plans have a minimum age and servi&e re1uirement that must #e met
6nder &urrent la54 all eligi#le employees 5ho have attained age 21 and have &ompleted one year o servi&e must #e allo5ed to parti&ipate in the plan :ormal retirement age is the age that a 5or)er &an retire and re&eive a ull4 unredu&ed pension #ene it
Age 0; in most plans

An early retirement age is the earliest age that 5or)ers &an retire and re&eive a retirement #ene it .he de erred retirement age is any age #eyond the normal retirement age

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,mployees 5or)ing #eyond age 0; &ontinue to a&&rue #ene its under the plan

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Exhibit 17.1 .he $ene its o %tarting ,arly in a .a2-"e erred !etirement Plan

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Fundamentals o Private !etirement Plans

A #ene it ormula is used to determine &ontri#utions or #ene its -n a de ined-&ontri#ution ormula4 the &ontri#ution rate is i2ed4 #ut the retirement #ene it is varia#le -n a de ined-#ene it plan4 the retirement #ene it is )no5n4 #ut the &ontri#utions 5ill vary depending on the amount needed to und the desired #ene it
.he amount &an #e #ased on &areer-average earnings or on a inal average pay4 5hi&h generally is an average o the last +-; years earnings 6nder a unit-#ene it ormula4 #oth earnings and years o servi&e are &onsidered %ome plans pay a lat per&entage o annual earnings4 5hile some pay a lat amount or ea&h year o servi&e %ome plans pay a lat amount or ea&h employee4 regardless o earnings or years o servi&e

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Fundamentals o Private !etirement Plans

<esting re ers to the employee3s right to the employer3s &ontri#utions or #ene its attri#uta#le to the &ontri#utions i employment terminates prior to retirement
A 1uali ied de ined-#ene it plan must meet a minimum vesting standard8
6nder &li vesting4 the 5or)er must #e 1007 vested a ter ; years o servi&e 6nder graded vesting4 the 5or)er must #e 207 vested #y the +rd year o servi&e4 and the minimum vesting in&reases another 207 or ea&h year until the 5or)er is 1007 vested at year 7

Faster vesting is re1uired or 1uali ied de ined-&ontri#ution plans to en&ourage greater employee parti&ipation
,mployer &ontri#utions must #e 1007 vested a ter + years .he 5or)er must #e 207 vested #y the 2rd year o servi&e4 and the minimum vesting in&reases another 207 or ea&h year until the 5or)er is 1007 vested at year 0

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Fundamentals o Private !etirement Plans

Contri#utions to private retirement plans are limited8
For 20008
.he ma2imum annual &ontri#ution to a de ined-&ontri#ution plan is 1007 o earnings or =''40004 5hi&hever is lo5er 6nder a de ined-#ene it plan4 the ma2imum annual #ene it is limited to 1007 o the 5or)er3s average &ompensation or the three highest &onse&utive years or =17;40004 5hi&hever is lo5er .he ma2imum annual &ompensation that &an #e &ounted in the &ontri#ution o #ene its ormula or all plans is =2204000 .he Pension $ene it >uaranty Corporation (P$>C* is a ederal &orporation that guarantees the payment o vested #ene its to &ertain limits i a private pension plan is terminated

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Fundamentals o Private !etirement Plans

Funds 5ithdra5n rom a 1uali ied plan #e ore age ;/? are su#@e&t to a 107 ta2 penalty4 e2&ept under &ertain &ir&umstan&es4 e.g.4 or &ertain medi&al e2penses Pension &ontri#utions &annot remain in the plan inde initely
"istri#utions must start no later than April 1st o the &alendar year ollo5ing the year in 5hi&h the individual attains age 70?
- the parti&ipant is still 5or)ing4 the distri#utions &an #e delayed

Auali ied plans use advan&e unding to inan&e the #ene its
.he employer systemati&ally and periodi&ally sets aside unds prior to the employee3s retirement

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Fundamentals o Private !etirement Plans

9any 1uali ied private pension plans are integrated 5ith %o&ial %e&urity
-ntegration provides a method or in&reasing pension #ene its or highly &ompensated employees 5ithout in&reasing the &ost o providing #ene its to lo5er-paid employees

A top-heavy plan is a retirement plan in 5hi&h more than 007 o the plan assets are in a&&ounts attri#uted to )ey employees
.o retain its 1uali ied status4 a rapid vesting s&hedule must #e used or non)ey employees Certain minimum #ene its or &ontri#utions must #e provided or non)ey employees

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"e ined-Contri#ution Plans

!e&all8 in a de ined &ontri#ution plan4 the &ontri#ution rate is i2ed4 #ut the a&tual retirement #ene it varies
For e2ample4 a money pur&hase plan is an arrangement in 5hi&h ea&h parti&ipant has an individual a&&ount4 and the employer3s &ontri#ution is a i2ed per&entage o the parti&ipant3s &ompensation .he employer3s &ost is redu&ed #e&ause past-servi&e &redits are typi&ally not granted or servi&e prior to the plan3s in&eption date "isadvantages in&lude8
,mployees &an only estimate their retirement #ene its %ome employees invest a large proportion o their &ontri#utions in a sta#le value und

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"e ined-$ene it Plans

!e&all8 in a de ined #ene it plan4 the retirement #ene it is )no5n in advan&e4 #ut the &ontri#utions vary depending on the amount needed to und the desired #ene it
Plans typi&ally pay #ene its #ased on a unit-#ene it ormula A 5or)er3s retirement #ene it is guaranteed .he investment ris) alls on the employer .hese types o plans have de&lined in relative importan&e #e&ause they are more &omple2 and e2pensive to administer than de ined &ontri#ution plans

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"e ined-$ene it Plans

A &ash-#alan&e plan is a de ined-#ene it plan in 5hi&h the #ene its are de ined in terms o a hypotheti&al a&&ount #alan&e
A&tual retirement #ene its 5ill depend on the value o the parti&ipant3s a&&ount at retirement ,a&h year4 a parti&ipant3s Bhypotheti&alC a&&ount is &redited 5ith a pay &redit4 5hi&h is related to &ompensation4 and an interest &redit .he employer #ears the investment ris)s and realiDes any investment gains 9any employers have &onverted traditional de ined-#ene it plans into &ash-#alan&e plans to hold do5n pension &osts

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Exhibit 17.2 Eo5 Conversion to a Cash$alan&e Plan Potentially Fo5ers Annuity $ene its

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%e&tion '01()* Plans

A %e&tion '01()* plan is a 1uali ied &ash or de erred arrangement (CG"A*
.ypi&ally4 #oth the employer and the employees &ontri#ute4 and the employer mat&hes part or all o the employee3s &ontri#utions 9ost plans allo5 employees to determine ho5 the unds are invested
%ome plans allo5 the &ontri#utions to #e invested in &ompany sto&)

,mployees &an voluntarily ele&t to have part o their salaries invested in the %e&tion '01()* plan through an ele&tive de erral
Contri#utions a&&umulate ta2- ree4 and unds are ta2ed as ordinary in&ome 5hen 5ithdra5als are made For 20004 the ma2imum limit on ele&tive de errals is =1;4000 or 5or)ers under age ;0

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Exhibit 17.3 Permissi#le A&tual "e erral Per&entages (A"Ps* or Eighly Compensated ,mployees (EC,*

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%e&tion '01()* Plans

- unds are 5ithdra5n #e ore age ;/?4 a 107 ta2 penalty applies4 5ith some e2&eptions .he plan may permit the 5ithdra5al o unds or a hardship
-!% re&ogniDes our reasons or hardship8
.o pay &ertain unreim#ursa#le medi&al e2pense .o pur&hase a primary residen&e .o pay post-se&ondary edu&ation e2penses .o ma)e payments to prevent evi&tion or ore&losure on your home

.he 107 ta2 penalty applies4 #ut plans typi&ally have a loan provision that allo5s unds to #e #orro5ed 5ithout a ta2 penalty

-n the ne5 !oth '01()* plan4 you ma)e &ontri#utions 5ith a ter-ta2 dollars4 and 1uali ied distri#utions at retirement are re&eived in&ome-ta2 ree

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%e&tion '0+(#* plans

%e&tion '0+(#* plans are retirement plans designed or employees o pu#li& edu&ational systems and ta2-e2empt organiDations
,ligi#le employees voluntarily ele&t to redu&e their salaries #y a i2ed amount4 5hi&h is then invested in the plan ,mployers may ma)e a mat&hing &ontri#ution .he plan &an #e unded #y pur&hasing an annuity rom an insuran&e &ompany or #y investing in mutual unds -n 20004 the ma2imum limit on ele&tive de errals or 5or)ers under age ;0 is =1;4000

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Pro it-%haring Plans

A pro it-sharing plan is a de ined-&ontri#ution plan in 5hi&h the employer3s &ontri#utions are typi&ally #ased on the irm3s pro its
.here is no re1uirement that the employer must a&tually earn a pro it to &ontri#ute to the plan .he plan en&ourages employees to 5or) more e i&iently Funds are distri#uted to the employees at retirement4 death4 disa#ility4 or termination o employment (only the vested portion*4 or a ter a i2ed num#er o years For 20004 the ma2imum employer ta2-dedu&ti#le &ontri#ution is limited to 2;7 o the employee3s &ompensation or =''40004 5hi&hever is less

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!etirement Plans or the %el ,mployed

!etirement plans or the o5ners o unin&orporated #usiness irms are &ommonly &alled Heogh plans
Contri#utions to the plan are in&ome-ta2 dedu&ti#le4 up to &ertain limits -nvestment in&ome a&&umulates on a ta2-de erred #asis Amounts deposited and investment earnings are not ta2ed until the unds are distri#uted .he ma2imum annual &ontri#ution into a de ined-&ontri#ution Heogh plan is limited to 207 o net earnings a ter su#tra&ting ? o the %o&ial %e&urity sel -employment ta2 - the plan is a de ined-#ene it plan4 a sel -employed individual &an und or a ma2imum annual #ene it e1ual to 1007 o average &ompensation or the three highest &onse&utive years o &ompensation4 or =17;40004 5hi&hever is lo5er

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!etirement Plans or the %el ,mployed

%ome re1uirements or Heogh plans in&lude8
All employees at least age 21 and 5ith one year o servi&e must #e in&luded in the plan Certain annual reports must #e iled 5ith the -!% %pe&ial top-heavy rules must #e met

A sel -employed '01()* plan &om#ines a pro it sharing plan 5ith an individual '01()* plan
.a2 savings are signi i&ant .he plan is limited to sel -employed individuals or #usiness o5ners 5ith no employees other than a spouse

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%impli ied ,mployee Pension

A simpli ied employee pension (%,P* is a retirement plan in 5hi&h the employer &ontri#utes to an -!A esta#lished or ea&h eligi#le employee
.he annual &ontri#ution limits are su#stantially higher Popular 5ith smaller employers #e&ause they involve minimal paper5or) -n a %,P--!A4 the employer &ontri#utes to an -!A o5ned #y ea&h employee
9ust &over all 5or)ers 5ho are at least age 21 and have 5or)ed or at least three o the past ive years For 20004 the ma2imum annual ta2-dedu&ti#le &ontri#ution is limited to 2;7 o the employee3s &ompensation or =''40004 5hi&hever is less

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%-9PF, !etirement Plans

%maller employers are eligi#le to esta#lish a %avings -n&entive 9at&h Plan or ,mployees4 or %-9PF, plan
Fimited to employers that employ 100 or e5er employees and do not maintain another 1uali ied plan %maller employers are e2empt rom most nondis&rimination and administrative rules that apply to 1uali ied plans Can #e stru&tured as an -!A or '01()* plan For 20004 eligi#le employees &an ele&t to &ontri#ute up to 1007 o &ompensation up to a ma2imum o =104000 ,mployers &an &ontri#ute in one o t5o 5ays8
6nder a mat&hing option4 the employer mat&hes the employee3s &ontri#utions on a dollar- or-dollar #asis up to +7 o the employee3s &ompensation4 su#@e&t to a ma2imum limit 6nder the nonele&tive &ontri#ution option4 the employer must &ontri#ute 27 o &ompensation or ea&h eligi#le employee4 su#@e&t to a ma2imum limit Copyright 2008 Pearson Addison-

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Funding Agen&y and Funding -nstruments

A unding agen&y is a inan&ial institution that provides or the a&&umulation or administration o the unds that 5ill #e used to pay pension #ene its
.he plan is &alled a trust- und plan i it is administered #y a &ommer&ial #an) or individual trustee - the unding agen&y is a li e insurer4 the plan is &alled an insured plan - #oth unding agen&ies are used4 the plan is &alled a split- unded plan

A unding instrument is a trust agreement or insuran&e &ontra&t that states the terms under 5hi&h the unding agen&y 5ill a&&umulate4 administer4 and dis#urse the pension unds Copyright 2008 Pearson AddisonWesley. All rights reserved. 17-25

Funding Agen&y and Funding -nstruments

6nder a trust- und plan4 all &ontri#utions are deposited 5ith a trustee4 5ho invests the unds a&&ording to the trust agreement
.he trustee does not guarantee the ade1ua&y o the und4 the prin&ipal itsel 4 or interest rates

A separate investment a&&ount is a group pension produ&t 5ith a li e insuran&e &ompany

.he plan administrator &an invest in one or more o the separate a&&ounts o ered #y the insurer .hese a&&ounts are popular #e&ause pension &ontri#utions &an #e invested in a 5ide variety o investments4 in&luding sto&) unds4 #ond unds4 or similar investments

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Funding Agen&y and Funding -nstruments

A guaranteed investment &ontra&t (>-C* is an arrangement in 5hi&h the insurer guarantees the interest rate or a num#er o years on a lump sum deposit
.hese &ontra&ts are popular 5ith employers #e&ause o interest rate guarantees and prote&tion against the loss o prin&ipal

An investment guarantee &ontra&t is similar to a >-C4 e2&ept that the insurer re&eives the pension unds over a num#er o years4 and the guaranteed interest rate or the later years is only a pro@e&ted rate
.hese &ontra&ts are appealing to employers 5ho e2pe&t interest rates to rise in the uture

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Insight 17.1 Che&) -t GutI.he :e5 !oth '01()* Plan

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