Retirement | Plan Types
Overview
Retirement plans can be either qualified plans or nonqualified plans. What's the difference?
- Qualified plans are subject to a number of income tax qualification requirements contained in the Internal Revenue Code that are generally intended to make certain that such plans do not discriminate in favor of highly compensated employees. If the retirement plan is a qualified plan, the employer is entitled to a current deduction for contributions to the plan, the participants are not taxed on the retirement benefits until they are received, and the plan's earnings grow tax-free. The different types of qualified plans are discussed below.
- Nonqualified plans are not subject to the same qualification requirements and are typically used to provide additional or special benefits for highly compensated employees. If an employer sponsors a nonqualified plan, the employer is entitled to a deduction only when the participants are taxed, the participants may be taxed on the retirement benefits even before they receive them, and the plan might not be funded at all. Nonqualified plans can be designed with much more freedom than qualified plans (although plans sponsored by tax-exempt organizations and governmental employers are subject to special rules). However, the types of plans are generally similar to the types of qualified plans discussed below.
Although it may seem as though there are countless different types of retirement plans, most fall into two basic categories: Defined Benefit Plans and Defined Contribution Plans. Basically, the difference between the two boils down to whether the employees will know how much they'll be getting upon retirement, or whether the employees will have to retire on whatever has been accumulated and earned within their participant accounts.
Defined Benefit Plans
Under a defined benefit plan, the benefit is defined so that the employees know the amount of the benefit that they will receive at retirement. These plans usually pay a specific monthly amount beginning at retirement and continuing for the remainder of the employee's life (and possibly the life of a surviving spouse). In many cases, the amount is calculated as a percentage of the employee's average compensation.
Defined benefit plans do not maintain an individual account for each participant. Instead, the assets are pooled together and the employer makes an agreement that the plan will pay a defined benefit to each employee. Since the rules for these plans make the employer responsible for contributing enough funds to the plan to pay the promised benefits, the employer bears the risks (and rewards) of the plan's investment experience. Thus, if the plan's investment returns are significantly less than expected, the employer may be required to make larger contributions than anticipated in order to make up for the shortfall.
In order to make sure that there will be sufficient funds contributed to and accumulated within the plan to pay the promised benefits, the services of an actuary are required. The actuary's job is to make economic projections to determine how much money will be required each year to provide the promised benefits upon retirement using various assumptions about the rate at which the plan's assets will grow, how many participants will stay until retirement, and how long retirees will live.
Many middle-sized and larger employers prefer this type of plan because it is easy for participants to understand what they will get and when they will get it. Defined benefit plans typically favor long-term and older employees and may not provide any significant advantage to those who leave the employer early in their careers. Businesses with many younger employees or frequent employee turnover often find that their employees do not view a defined benefit plan as a meaningful benefit.
A variation of the traditional defined benefit pension plan is the cash balance plan. A cash balance plan is a type of defined benefit pension plan that looks like a defined contribution plan. The benefit is defined by the plan (as in a typical defined benefit pension plan), rather than the amount of the contribution to each participant's account under the plan (as in a defined contribution plan), and the amount of the benefit does not vary with the actual investment performance of the plan's assets (as in a defined contribution plan). However, the big difference is the manner in which the normal retirement benefit is defined. A typical defined benefit pension plan defines a participant's normal retirement benefit by a formula that takes into account the participant's compensation and years of service. A cash balance plan, on the other hand, bases each participant's retirement benefit on a hypothetical account under the plan. Each participant's hypothetical account equals the sum of the participant's annual contribution credits (typically a percentage of compensation) as increased by the plan's interest credits to normal retirement age. Then, the plan's actuarial assumptions (mortality table and interest rate) are used to convert a participant's hypothetical account balance into an annuity, although the participant will have the option of receiving the hypothetical account balance as a single sum distribution.
Defined Contribution Plans
Defined contribution plans do not provide a predetermined level of benefits or amount of money upon retirement. Instead, the amount to be contributed to each participant's account under the plan each year is defined (by either a fixed formula or by giving the employer the discretion to decide how much to contribute each year). The size of a participant's benefit will depend on:
- The amounts of money contributed to the individual's account by the employer and, perhaps, by the employee as well;
- The rate of investment growth on the principal;
- How long the money remains in the plan (in most cases, the employee, upon retirement, has the option of either receiving the payment in a lump sum or by taking partial payments on a regular basis while the balance continues to earn interest); and
- Whether the forfeitures of participants who leave before they are fully vested can be shared among the remaining participants as a reward to long-term employees.
Since benefits accumulate on an individual basis, these plans are sometimes referred to as "individual account plans." In these plans, unlike in defined benefit plans, the risk (and reward) of investment experience is borne by the participant. Defined contribution plans can permit, and sometimes require, that employees make contributions to the plan on either a pre-tax basis (as in a 401(k) plan) or an after-tax basis (as in a thrift plan). They may also, but are not required to, permit employees to decide how the monies contributed into their accounts will be invested.
There are seven major types of defined contribution plans:
- Profit Sharing Plans
Profit sharing plans accumulate money through employer contributions to an account for each eligible employee. Each participant's share of the employer's contribution is generally based on the employee's level of compensation. These plans are popular because they allow the employer to determine (within certain limits) the amount of money to be contributed each year. The obvious advantage is that management is not locked into a potentially destabilizing expense if business is slow or the economy sour. In a good year, the employer might want to contribute as much as 25% of employee compensation to the profit sharing plan. In a devastating year, the employer might make no contribution at all. If, however, contributions are not made on a continuing basis, the IRS might rule that the plan has been terminated in which case the participants become fully vested. Another type of profit sharing plan that is gaining popularity is the "age-weighted" or "cross-tested" profit sharing plan. In this case, the employer still retains the discretion to decide how much it will contribute each year. Unlike a traditional profit sharing plan, however, an "age-weighted" or "cross-tested" profit sharing plan will allocate (or divide) the employer's contribution among participants based on their relative ages and years of service. This type of design, like a target benefit plan, generally favors older employees.
- Money Purchase Plans
A money purchase plan is similar to a profit sharing plan, except that the rate of contribution is a fixed percentage for each year, such as 15% of each eligible employees' compensation. Although the rate can be amended if necessary, small or newer businesses might be well-advised to avoid these plans until they are confident that they can meet the annual contribution requirement. Money purchase plans are subject to somewhat more cumbersome distribution rules than profit sharing plans. Prior to 2002, the advantage to money purchase plans over profit sharing plans was that the income tax deductible contribution was not limited to 15% of compensation. However, with the deduction limit for profit sharing plans increasing to 25% beginning in 2002, money purchase plans may become less popular.
- Target Benefit Plans
A target benefit plan is a variation of a money purchase plan. However, instead of starting with a fixed percentage for each employee, these plans specify a given benefit, such as 50% of salary at retirement, and base each participant's contribution on the amount of money needed to satisfy that obligation. The age of the employee plays a significant role here. Older workers, obviously, have a shorter time span to accumulate the necessary funds compared to their younger counterparts. In other words, the contribution for an older employee will be higher than the contribution for a younger employee making the same amount of money. It's also important to be aware that the actual retirement benefit is not guaranteed and will depend largely upon investment earnings.
- Cash Or Deferred Arrangements Or 401(k) Plans
A 401(k) plan, sometimes known as a salary deferral or cash or deferred arrangement, allows each eligible employee to specify the amount of pre-tax income that should be deducted from his or her pay check and placed into a retirement account on their behalf. Flexibility is key here, in that the participants are able to set the contribution level that best suits their personal situation. Unfortunately, some people fail to look very far in advance and, thus, discover a severe problem when retirement is just around the corner. To help counter this unfortunate element of human nature, many companies offer matching contributions to encourage their employees to make salary deferrals. The maximum amount that an employee can contribute is fixed each year by Congress and the Internal Revenue Service (e.g., $15,500 in 2008). 401(k) plans can and do involve complicated plan administration since the relative amounts of salary deferrals and matching contributions are subject to special nondiscrimination testing. Companies that wish to avoid the complications and burdens of 401(k) testing can adopt a "safe harbor" 401(k) plan design for which the special tests are partially or wholly eliminated. Furthermore, recent law changes allow employers to "automatically" enroll their employees in their 401(k) plans.
- Stock Bonus Plans And Employee Stock Ownership Plans
Stock bonus plans and employee stock ownership plans (ESOPs) are designed to use company stock as a mechanism for building equity that will become a retirement resource for your employees. There are several ways to use an ESOP and several ways to fund it with company stock. Stock can be contributed by the employer to the plan, or purchased by the plan (on the open market, form existing shareholders, or from the company) with cash that is contributed to the plan. An ESOP can even borrow money from a bank, the company, or a selling shareholder in order to purchase company stock. By contributing cash to the plan to allow the ESOP to pay off its loan, the principal and interest on the loan is deductible. Since the company can contribute stock instead of cash to the plan, it can obtain a "cash-less" tax deduction. In many respects, a stock bonus plan, or ESOP, has the attributes of either a profit sharing plan or a money purchase plan depending upon whether the plan has a fixed obligation to repay money which it has borrowed. Publicly traded companies can even allow employees to elect to purchase stock in their ESOP using pre-tax salary deferrals made to a 401k plan which is part of the ESOP. Privately held companies do not have this option and, in addition, must have the ESOP trustee appraise the company stock owned by the ESOP annually. ESOPs are sanctioned as a corporate finance tool as well as retirement plan under ERISA. They have been designed to allow privately held company owners to sell their stock to an ESOP using pre tax cash flow and without recognizing capital gain on the sale of the shares. Tax on the sale is deferred if the selling shareholder reinvests the proceeds within 12 months in stocks and bonds of other American companies. No tax is paid unless and until the reinvestment securities are sold. Finally, ESOPs are permitted shareholders in subchapter S corporations; thus allowing an ESOP owned company to be partially to 100% employee owned and tax exempt. For example a company owner is nearing retirement. However, he realizes that he has no one to pass his business to (his daughter has no interest in the business), that his young employees have expressed an interest in acquiring the business, and that their benefits under the existing retirement plan are not substantial. One solution would be for the company to adopt an ESOP and for the owner to sell his stock to the ESOP, over time using company cash contributions to the ESOP or by using money borrowed from the local bank which the ESOP repays over time.
- SEPs
SEPs (simplified employee pensions) are a unique type of defined contribution plan. They operate similar to a profit sharing plan or a money purchase plan in that the employer decides how much to contribute to each participant's account each year. However, instead of making a contribution to a retirement trust for all of the participants, the contribution for each employee is made to an IRA for that employee. The employee then has control over the amounts in his or her IRA.
- Tax Sheltered Annuities Or 403(b) Arrangements
A 403(b) arrangement, sometimes known as a tax sheltered annuity, allows each eligible employee of certain tax-exempt organizations to specify the amount of pre-tax income that should be deducted from his or her pay check and contributed to either an annuity contract or a custodial account on their behalf. Such an arrangement is similar to a 401(k) plan in many respects, although the administration of a 403(b) plan may be less complicated because it is possible to avoid nondiscrimination testing and annual returns/reports (Forms 5500) might not have to be filed.