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., 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 certain investment and fiduciary requirements.

A. Reporting and Disclosure Requirements

Retirement plans are highly regulated by various government agencies. Reporting requirements exist with the Internal Revenue Service (IRS), Department of Labor (DOL) and the Pension Benefit Guaranty Corporation (PBGC). The IRS is 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 plan's 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 helps 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. Terminations for most of these plans must be approved by the Pension Benefit Guaranty Corporation. 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 by them.

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