Retirement plans in the United States
Encyclopedia
A retirement plan is a financial arrangement designed to replace employment
income upon retirement
. These plans may be set up by employers, insurance companies, trade unions, the government
, or other institutions. Congress
has expressed a desire to encourage responsible retirement planning by granting favorable tax treatment to a wide variety of plans. Retirement plans in the U.S. are defined in tax terms by the IRS
code and are regulated by the Department of Labor
's provisions under the Employee Retirement Income Security Act
.
) plan calculates benefits using a fixed formula that typically factors in final pay and service with an employer, and payments are made from a trust fund specifically dedicated to the plan. In a defined contribution plan, the payout is dependent upon both the amount of money contributed into an individual account and the performance of the investment vehicles utilized.
Some types of retirement plans, such as cash balance plans, combine features of both defined benefit and defined contribution schemes.
Examples of Defined contribution plan include Individual Retirement Account
(IRA), 401(k)
, and profit sharing plans
. In such plans, the participant is responsible for selecting the types of investment
s toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual fund
s to selecting individual stock
s or other securities
. Most self-directed retirement plans are characterized by certain tax advantage
s. The funds in such plans may not be withdrawn without penalty until the investor reaches retirement age, which is typically 59.5 years of age.
Money contributed can be from employee salary deferrals, employer contributions, or employer matching contributions. Defined contribution plan are subject to IRS section 415 limits on how much can be contributed. As of 2009, the total deferral amount including the employee and employer contribution is the lesser of $49,000 or 100% of compensation. The employee-only amount is $16,500 for 2009, but a plan can permit participants who are age 50 or older to make "catch-up" contributions of up to an additional $5,500.
in the US, a defined benefit plan pays benefits from a trust fund using a specific formula set forth by the plan sponsor. In other words, the plan defines a benefit that will be paid upon retirement. The statutory definition of defined benefit encompasses all pension plans that are not defined contribution and therefore do not have individual accounts.
While this catch-all definition has been interpreted by the courts to capture some hybrid pension plans like cash balance (CB) plans
and pension equity plans (PEP), most pension plans offered by large businesses or government
agencies are final average pay (FAP) plans, under which the monthly benefit is equal to the number of years worked multiplied by the member's salary at retirement multiplied by a factor known as the accrual rate. At a minimum, benefits are payable in normal form as a Single Life Annuity (SLA) for single participants or as a Qualified Joint and Survivor Annuity (QJSA) for married participants. Both normal forms are paid at Normal Retirement Age (usually 65) and may be actuarially adjusted for early or late commencement. Other optional forms of payment, such as lump sum distributions, may be available but are not required.
The cash balance plan
typically offers a lump sum at and often before normal retirement age. However, as is the case with all defined benefit plans, a cash balance plan must also provide the option of receiving the benefit as a life annuity
. The amount of the annuity benefit must be definitely determinable as per IRS regulation 1.412-1.
Defined benefit plans may be either funded or unfunded. In a funded plan, contributions from the employer and participants are invested into a trust fund dedicated solely to paying benefits to retirees under a given plan. The future returns on the investments and the future benefits to be paid are not known in advance, so there is no guarantee that a given level of contributions will meet future obligations. Therefore, fund assets and liabilities are regularly reviewed by an actuary
in a process known as valuation. A defined benefit plan is required to maintain adequate funding if it is to remain qualified.
In an unfunded plan, no funds are set aside for the specific purpose of paying benefits. The benefits to be paid are met immediately by contributions to the plan or by general assets. Most government-run retirement plans, including Social Security
, are unfunded, with benefits being paid directly out of current taxes and Social Security contributions. Most nonqualified plans are also unfunded.
, where the employee's notional account balance grows by some defined rate of interest and annual employer contribution.
In the US, conversions from traditional to hybrid plan designs have been controversial. Upon conversion, plan sponsors are required to retrospectively calculate employee account balances, and if the employee's actual vested benefit under the old design is more than the account balance, the employee enters a period of wear away. During this period, the employee would be eligible to receive the already accrued benefit under the old formula, but all future benefits are accrued under the new plan design. Eventually, the accrued benefit under the new design exceeds the grandfathered amount under the old design. To the participant, however, it appears as if there is a period where no new benefits are accrued. Hybrid designs also typically eliminate the more generous early retirement provisions of traditional pensions.
Since younger workers have more years in which to accrue interest and pay credits than those approaching retirement age, critics of cash balance plans have called the new designs discriminatory. On the other hand, the new designs may better meet the needs of a modern workforce and actually encourage older workers to remain at work, since benefit accruals continue at a constant pace as long as an employee remains on the job. As of 2008, the courts have generally rejected the notion that cash balance plans discriminate based on age, while the Pension Protection Act of 2006
offers relief for most hybrid plans on a prospective basis.
While a cash balance plan is technically a defined benefit plan designed to allow workers to evaluate the economic worth their pension benefit in the manner of a defined contribution plan (i.e., as an account balance), the target benefit plan is a defined contribution plan designed to express its projected impact in terms of lifetime income as a percent of final salary at retirement (i.e., as an annuity amount). For example, a target benefit plan may mimic a typical defined benefit plan offering 1.5% of salary per year of service times the final 3-year average salary. Actuarial assumptions like 5% interest, 3% salary increases and the UP84 Life Table for mortality are used to calculate a level contribution rate that would create the needed lump sum at retirement age. The problem with such plans is that the flat rate could be low for young entrants and high for old entrants. While this may appear unfair, the skewing of benefits to the old worker is a feature of most traditional defined benefit plans, and any attempt to match it would reveal this backloading feature.
(IRS) has promulgated rules that require that pension plans be permanent as opposed to a temporary arrangement used to capture tax benefits. Regulation 1.401-1(b)(2) states that "[t]hus, although the employer may reserve the right to change or terminate the plan, and to discontinue contributions
thereunder, the abandonment of the plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan from its inception was not a bona fide
program for the exclusive benefit of employees in general. Especially will this be true if, for example, a pension plan is abandoned soon after pensions have been fully funded for persons in favor of whom discrimination is prohibited..." The IRS would have grounds to disqualify the plan retroactively, even if the plan sponsor initially got a favorable determination letter.
plans are not considered qualified plans, but are treated and taxed almost identically.
The term qualified has special meaning regarding defined benefit plans. The IRS defines strict requirements a plan must meet in order to receive favorable tax treatment, including:
Failure to meet IRS requirements can lead to plan disqualification, which carries with it enormous tax consequences.
is a type of Individual Retirement Account (IRA) that is provided by an employer. It is similar to a 401(k)
but offers simpler and less costly administration rules. Like a 401(k) plan, the SIMPLE IRA is funded by a pre-tax salary reduction. However, contribution limits for SIMPLE plans are lower than for most other types of employer-provided retirement plans.
, is a variation of the Individual Retirement Account. SEP IRAs are adopted by business owners to provide retirement benefits for the business owners and their employees. There are no significant administration costs for self-employed person with no employees. If the self-employed person does have employees, all employees must receive the same benefits under a SEP plan. Since SEP accounts are treated as IRAs, funds can be invested the same way as any other IRA.
.
However, because the lump sum actuarial present value of a former worker's vested accrued benefit is uncertain, the IRS (in Section 417(e) of the Internal Revenue) Code specifies the interest and mortality that must be used. This has caused some employers as in the Berger versus Xerox case in the 7th Circuit (Richard A. Posner was the judge who wrote the opinion) with cash balance plans to have a higher liability for employers for a lump sum than was in the employee's "notional" or "hypothetical" account balance.
When the interest credit rate exceeds the IRS mandated Section 417(e) discounting rate, the legally mandated lump sum value payable to the employee [if the plan sponsor allows for pre-retirement lump sums] would exceed the notional balance in the employee's cash balance account. This has been colourfully dubbed the "Whipsaw" in actuarial parlance. The Pension Protection Act signed into law on August 17, 2006 contained added provisions for these types of plans allowing the distribution of the cash balance account as a lump sum.
Because Defined contribution plan have actual balances, employers can simply write a check because the amount of their liability at termination of employment which may be decades before actual normal (65) retirement date of the plan, is known with certainty. There is no legal requirement that the employer allow the former worker take his money out to roll over into an IRA, though it is relatively uncommon in the US not to allow this.
Just like there is no legal requirement to give portability to Defined contribution plan
, there is no mandated ban on portability for defined benefit plans. However, because the lump sum actuarial present value of a former worker's vested accrued benefit is uncertain, the IRS mandate in Section 417(e) of the Internal Revenue Code specifies the interest and mortality that must be used. This uncertainty discussed in valuaton of defined benefit lump sums has limited the practical portality of defined benefit plans.
(ERISA) does not provide insurance from the Pension Benefit Guaranty Corporation
(PBGC) for Defined contribution plan, but cash balance plans do get such insurance because they, like all ERISA-defined benefit plans, are covered by the PBGC.
Plans may also be either employer-provided or individual plans. Most types of retirement plans are employer-provided, though Individual Retirement Account
s (IRAs) are very common.
Currently two types of plan, the Roth IRA
and the newly introduced Roth 401(k)
, offer tax advantages that are essentially reversed from most retirement plans. Contributions to Roth IRAs and Roth 401(k)s must be made with money that has been taxed as income, but after meeting the various restrictions, money withdrawn from the account is tax-free.
(EGTRRA) brought significant changes to retirement plans, generally easing restrictions on the ability to roll money from one type of account to the other and increasing contributions limits. Most of the changes were designed to phase in over a period of 4–10 years. Unless they are extended, it will "sunset
," or revert, at the end of 2010 to the previous laws.
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
income upon retirement
Retirement
Retirement is the point where a person stops employment completely. A person may also semi-retire by reducing work hours.Many people choose to retire when they are eligible for private or public pension benefits, although some are forced to retire when physical conditions don't allow the person to...
. These plans may be set up by employers, insurance companies, trade unions, the government
Government
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
, or other institutions. Congress
United States Congress
The United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....
has expressed a desire to encourage responsible retirement planning by granting favorable tax treatment to a wide variety of plans. Retirement plans in the U.S. are defined in tax terms by the IRS
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
code and are regulated by the Department of Labor
United States Department of Labor
The United States Department of Labor is a Cabinet department of the United States government responsible for occupational safety, wage and hour standards, unemployment insurance benefits, re-employment services, and some economic statistics. Many U.S. states also have such departments. The...
's provisions under the Employee Retirement Income Security Act
Employee Retirement Income Security Act
The Employee Retirement Income Security Act of 1974 is an American federal statute that establishes minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans...
.
Types of retirement plans
Retirement plans are classified as defined benefit or defined contribution according to how benefits are determined. A defined benefit (or pensionPension
In general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...
) plan calculates benefits using a fixed formula that typically factors in final pay and service with an employer, and payments are made from a trust fund specifically dedicated to the plan. In a defined contribution plan, the payout is dependent upon both the amount of money contributed into an individual account and the performance of the investment vehicles utilized.
Some types of retirement plans, such as cash balance plans, combine features of both defined benefit and defined contribution schemes.
Defined contribution plan
According to the Internal Revenue Code Section 414, a defined contribution plan is an employer-sponsored plan with an individual account for each participant. The accrued benefit from such a plan is solely attributable to contributions made into an individual account and investment gains on those funds, less any losses and expense charges. The contributions are invested (e.g., in the stock market), and the returns on the investment are credited to or deducted from the individual's account. Upon retirement, the participant's account is used to provide retirement benefits, often through the purchase of an annuity. Defined contribution plan have become more widespread over recent years and are now the dominant form of plan in the private sector. The number of defined benefit plans in the US has been steadily declining, as more employers see pension funding as a financial risk they can avoid by freezing the plan and instead offering a defined contribution plan.Examples of Defined contribution plan include Individual Retirement Account
Individual Retirement Account
An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
(IRA), 401(k)
401(k)
A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
, and profit sharing plans
Profit-sharing agreement (USA)
A profit-sharing agreement in the United States is the agreement that establishes a pension plan maintained by the employer to share its profits with its employees.-History:...
. In such plans, the participant is responsible for selecting the types of investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
s toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s to selecting individual stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s or other securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
. Most self-directed retirement plans are characterized by certain tax advantage
Tax advantage
Tax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free...
s. The funds in such plans may not be withdrawn without penalty until the investor reaches retirement age, which is typically 59.5 years of age.
Money contributed can be from employee salary deferrals, employer contributions, or employer matching contributions. Defined contribution plan are subject to IRS section 415 limits on how much can be contributed. As of 2009, the total deferral amount including the employee and employer contribution is the lesser of $49,000 or 100% of compensation. The employee-only amount is $16,500 for 2009, but a plan can permit participants who are age 50 or older to make "catch-up" contributions of up to an additional $5,500.
Defined benefit plans
Commonly referred to as a pensionPension
In general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...
in the US, a defined benefit plan pays benefits from a trust fund using a specific formula set forth by the plan sponsor. In other words, the plan defines a benefit that will be paid upon retirement. The statutory definition of defined benefit encompasses all pension plans that are not defined contribution and therefore do not have individual accounts.
While this catch-all definition has been interpreted by the courts to capture some hybrid pension plans like cash balance (CB) plans
Cash balance plan
A cash balance plan is a defined benefit retirement plan that maintains hypothetical individual employee accounts like a defined contribution plan...
and pension equity plans (PEP), most pension plans offered by large businesses or government
Government
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
agencies are final average pay (FAP) plans, under which the monthly benefit is equal to the number of years worked multiplied by the member's salary at retirement multiplied by a factor known as the accrual rate. At a minimum, benefits are payable in normal form as a Single Life Annuity (SLA) for single participants or as a Qualified Joint and Survivor Annuity (QJSA) for married participants. Both normal forms are paid at Normal Retirement Age (usually 65) and may be actuarially adjusted for early or late commencement. Other optional forms of payment, such as lump sum distributions, may be available but are not required.
The cash balance plan
Cash balance plan
A cash balance plan is a defined benefit retirement plan that maintains hypothetical individual employee accounts like a defined contribution plan...
typically offers a lump sum at and often before normal retirement age. However, as is the case with all defined benefit plans, a cash balance plan must also provide the option of receiving the benefit as a life annuity
Life annuity
A life annuity is a financial contract in the form of an insurance product according to which a seller — typically a financial institution such as a life insurance company — makes a series of future payments to a buyer in exchange for the immediate payment of a lump sum or a series...
. The amount of the annuity benefit must be definitely determinable as per IRS regulation 1.412-1.
Defined benefit plans may be either funded or unfunded. In a funded plan, contributions from the employer and participants are invested into a trust fund dedicated solely to paying benefits to retirees under a given plan. The future returns on the investments and the future benefits to be paid are not known in advance, so there is no guarantee that a given level of contributions will meet future obligations. Therefore, fund assets and liabilities are regularly reviewed by an actuary
Actuary
An actuary is a business professional who deals with the financial impact of risk and uncertainty. Actuaries provide expert assessments of financial security systems, with a focus on their complexity, their mathematics, and their mechanisms ....
in a process known as valuation. A defined benefit plan is required to maintain adequate funding if it is to remain qualified.
In an unfunded plan, no funds are set aside for the specific purpose of paying benefits. The benefits to be paid are met immediately by contributions to the plan or by general assets. Most government-run retirement plans, including Social Security
Social Security (United States)
In the United States, Social Security refers to the federal Old-Age, Survivors, and Disability Insurance program.The original Social Security Act and the current version of the Act, as amended encompass several social welfare and social insurance programs...
, are unfunded, with benefits being paid directly out of current taxes and Social Security contributions. Most nonqualified plans are also unfunded.
Hybrid and Cash Balance Plans
Hybrid plan designs combine the features of defined benefit and defined contribution plan designs. In general, they are treated as defined benefit plans for tax, accounting, and regulatory purposes. As with defined benefit plans, investment risk is largely borne by the plan sponsor. As with defined contribution designs, plan benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. These features make them more portable than traditional defined benefit plans and perhaps more attractive to a highly mobile workforce. A typical hybrid design is the Cash Balance PlanCash balance plan
A cash balance plan is a defined benefit retirement plan that maintains hypothetical individual employee accounts like a defined contribution plan...
, where the employee's notional account balance grows by some defined rate of interest and annual employer contribution.
In the US, conversions from traditional to hybrid plan designs have been controversial. Upon conversion, plan sponsors are required to retrospectively calculate employee account balances, and if the employee's actual vested benefit under the old design is more than the account balance, the employee enters a period of wear away. During this period, the employee would be eligible to receive the already accrued benefit under the old formula, but all future benefits are accrued under the new plan design. Eventually, the accrued benefit under the new design exceeds the grandfathered amount under the old design. To the participant, however, it appears as if there is a period where no new benefits are accrued. Hybrid designs also typically eliminate the more generous early retirement provisions of traditional pensions.
Since younger workers have more years in which to accrue interest and pay credits than those approaching retirement age, critics of cash balance plans have called the new designs discriminatory. On the other hand, the new designs may better meet the needs of a modern workforce and actually encourage older workers to remain at work, since benefit accruals continue at a constant pace as long as an employee remains on the job. As of 2008, the courts have generally rejected the notion that cash balance plans discriminate based on age, while the Pension Protection Act of 2006
Pension Protection Act of 2006
The Pension Protection Act of 2006 , 120 Stat. 780, was signed into law by U.S. President George W. Bush on August 17, 2006.-Pension reform:...
offers relief for most hybrid plans on a prospective basis.
While a cash balance plan is technically a defined benefit plan designed to allow workers to evaluate the economic worth their pension benefit in the manner of a defined contribution plan (i.e., as an account balance), the target benefit plan is a defined contribution plan designed to express its projected impact in terms of lifetime income as a percent of final salary at retirement (i.e., as an annuity amount). For example, a target benefit plan may mimic a typical defined benefit plan offering 1.5% of salary per year of service times the final 3-year average salary. Actuarial assumptions like 5% interest, 3% salary increases and the UP84 Life Table for mortality are used to calculate a level contribution rate that would create the needed lump sum at retirement age. The problem with such plans is that the flat rate could be low for young entrants and high for old entrants. While this may appear unfair, the skewing of benefits to the old worker is a feature of most traditional defined benefit plans, and any attempt to match it would reveal this backloading feature.
Requirement of Permanence
To guard against tax abuse in the United States, the Internal Revenue ServiceInternal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
(IRS) has promulgated rules that require that pension plans be permanent as opposed to a temporary arrangement used to capture tax benefits. Regulation 1.401-1(b)(2) states that "[t]hus, although the employer may reserve the right to change or terminate the plan, and to discontinue contributions
thereunder, the abandonment of the plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan from its inception was not a bona fide
Bona Fide
Bona Fide is a studio album from rock band Wishbone Ash. It is the first studio album in six years and is the only studio album to feature guitarist Ben Granfelt...
program for the exclusive benefit of employees in general. Especially will this be true if, for example, a pension plan is abandoned soon after pensions have been fully funded for persons in favor of whom discrimination is prohibited..." The IRS would have grounds to disqualify the plan retroactively, even if the plan sponsor initially got a favorable determination letter.
Qualified retirement plans
Qualified plans receive favorable tax treatment and are regulated by ERISA. The technical definition of qualified does not agree with the commonly used distinction. For example, 403(b)403(b)
A 403 plan, also known as a tax-sheltered annuity, is a tax-advantaged retirement savings plan available for public education organizations, some non-profit employers , cooperative hospital service organizations, and self-employed ministers in the United States...
plans are not considered qualified plans, but are treated and taxed almost identically.
The term qualified has special meaning regarding defined benefit plans. The IRS defines strict requirements a plan must meet in order to receive favorable tax treatment, including:
- A plan must offer life annuitiesLife annuityA life annuity is a financial contract in the form of an insurance product according to which a seller — typically a financial institution such as a life insurance company — makes a series of future payments to a buyer in exchange for the immediate payment of a lump sum or a series...
in the form of a Single Life Annuity (SLA) and a Qualified Joint & Survivor Annuity (QJSA). - A plan must maintain sufficient funding levels.
- A plan must be administered according to the plan document.
- Benefits are required to commence at retirement age (usually age 65 if no longer working, or age 70 1/2 if still employed).
- Once earned, benefits may not be forfeited.
- A plan may not discriminate in favor of highly-compensated employees.
- A plan must be insured by the PBGCPension Benefit Guaranty CorporationThe Pension Benefit Guaranty Corporation is an independent agency of the United States government that was created by the Employee Retirement Income Security Act of 1974 to encourage the continuation and maintenance of voluntary private defined benefit pension plans, provide timely and...
.
Failure to meet IRS requirements can lead to plan disqualification, which carries with it enormous tax consequences.
SIMPLE IRAs
A SIMPLE IRASIMPLE IRA
A SIMPLE IRA, or "Savings Incentive Match Plan for Employees Individual Retirement Account", is a type of tax-deferred employer-provided retirement plan in the United States that allows employees to set aside money and invest it to grow for later use. Specifically, it is a type of Individual...
is a type of Individual Retirement Account (IRA) that is provided by an employer. It is similar to a 401(k)
401(k)
A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
but offers simpler and less costly administration rules. Like a 401(k) plan, the SIMPLE IRA is funded by a pre-tax salary reduction. However, contribution limits for SIMPLE plans are lower than for most other types of employer-provided retirement plans.
SEP IRAs
A Simplified Employee Pension Individual Retirement Account, or SEP IRASEP IRA
A Simplified Employee Pension Individual Retirement Arrangement is a variation of the Individual Retirement Account used in the United States. SEP IRAs are adopted by business owners to provide retirement benefits for the business owners and their employees. There are no significant administration...
, is a variation of the Individual Retirement Account. SEP IRAs are adopted by business owners to provide retirement benefits for the business owners and their employees. There are no significant administration costs for self-employed person with no employees. If the self-employed person does have employees, all employees must receive the same benefits under a SEP plan. Since SEP accounts are treated as IRAs, funds can be invested the same way as any other IRA.
Keogh or HR10 Plans
Keogh plans are full-fledged pension plans for the self-employed. Named for U.S. Representative Eugene James Keogh of New York, they are sometimes called HR10 plans.Nonqualified plans
Plans that do not meet the guidelines required to receive favorable tax treatment are considered nonqualified and are exempt from the restrictions placed on qualified plans. They are typically used to provide additional benefits to key or highly-paid employees, such as executives and officers. Examples include SERP (Supplemental Executive Retirement Plans) and 457(f) plans457 plan
The 457 plan is a type of non-qualified tax advantaged deferred-compensation retirement plan that is available for governmental and certain non-governmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pre-tax basis...
.
Contrasting types of retirement plans
Advocates of Defined contribution plan point out that each employee has the ability to tailor the investment portfolio to his or her individual needs and financial situation, including the choice of how much to contribute, if anything at all. However, others state that these apparent advantages could also hinder some workers who might not possess the financial savvy to choose the correct investment vehicles or have the discipline to voluntarily contribute money to retirement accounts.Portability, Valuation
Defined contribution plan have actual balances, that workers can simply know the value of with certainty by simply checking the balance. There is no legal requirement that the employer allow the former worker take his money out to roll over into an IRA, though it is relatively uncommon in the US not to allow this (and many companies such as Fidelity run numerous TV ads encouraging individuals to transfer their old plans into current ones).However, because the lump sum actuarial present value of a former worker's vested accrued benefit is uncertain, the IRS (in Section 417(e) of the Internal Revenue) Code specifies the interest and mortality that must be used. This has caused some employers as in the Berger versus Xerox case in the 7th Circuit (Richard A. Posner was the judge who wrote the opinion) with cash balance plans to have a higher liability for employers for a lump sum than was in the employee's "notional" or "hypothetical" account balance.
When the interest credit rate exceeds the IRS mandated Section 417(e) discounting rate, the legally mandated lump sum value payable to the employee [if the plan sponsor allows for pre-retirement lump sums] would exceed the notional balance in the employee's cash balance account. This has been colourfully dubbed the "Whipsaw" in actuarial parlance. The Pension Protection Act signed into law on August 17, 2006 contained added provisions for these types of plans allowing the distribution of the cash balance account as a lump sum.
Portability: Practical, not a Legal difference
A practical difference is that a defined contribution plan's assets generally remain with the employee (generally, amounts contributed by the employee and earnings on them remain with the employee, but employer contributions and earnings on them do not vest with the employee until a specified period has elapsed), even if he or she transfers to a new job or decides to retire early, whereas in many countries defined benefit pension benefits are typically lost if the worker fails to serve the requisite number of years with the same company. Self-directed accounts from one employer may usually be 'rolled-over' to another employer's account or converted from one type of account to another in these cases.Because Defined contribution plan have actual balances, employers can simply write a check because the amount of their liability at termination of employment which may be decades before actual normal (65) retirement date of the plan, is known with certainty. There is no legal requirement that the employer allow the former worker take his money out to roll over into an IRA, though it is relatively uncommon in the US not to allow this.
Just like there is no legal requirement to give portability to Defined contribution plan
Defined contribution plan
In economics, a defined contribution plan is a type of retirement plan in which the amount of the employer's annual contribution is specified. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts plus any investment earnings on the money...
, there is no mandated ban on portability for defined benefit plans. However, because the lump sum actuarial present value of a former worker's vested accrued benefit is uncertain, the IRS mandate in Section 417(e) of the Internal Revenue Code specifies the interest and mortality that must be used. This uncertainty discussed in valuaton of defined benefit lump sums has limited the practical portality of defined benefit plans.
Investment Risk borne by Employee or Employer
It is commonly said that the employee bears investment risk for Defined contribution plan while the employer bears that risk in defined benefit plans. This is true for practically all cases, but pension law in the United States does not require that employees bear investment risk, it only provides an ERISA Section 404(c) exemption from fiduciary liability if the employer provides the mandated investment choices and gives employees sufficient control to customize his pension investment portfolio APPROPRIATE to his risk tolerance.PBGC insurance: a legal difference
The Employee Retirement Income Security ActEmployee Retirement Income Security Act
The Employee Retirement Income Security Act of 1974 is an American federal statute that establishes minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans...
(ERISA) does not provide insurance from the Pension Benefit Guaranty Corporation
Pension Benefit Guaranty Corporation
The Pension Benefit Guaranty Corporation is an independent agency of the United States government that was created by the Employee Retirement Income Security Act of 1974 to encourage the continuation and maintenance of voluntary private defined benefit pension plans, provide timely and...
(PBGC) for Defined contribution plan, but cash balance plans do get such insurance because they, like all ERISA-defined benefit plans, are covered by the PBGC.
Plans may also be either employer-provided or individual plans. Most types of retirement plans are employer-provided, though Individual Retirement Account
Individual Retirement Account
An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
s (IRAs) are very common.
Tax advantages
Most retirement (the exception being most non qualified plans) plans offer significant tax advantages. Most commonly the money contributed to the account is not taxed as income to the employee, but in the case of employer provided plans, the employer is able to receive a tax deduction for the amount contributed as if it were regular employee compensation. This is known as pre-tax contributions, and the amounts allowed to be contributed vary significantly among various plan types. The other significant advantage is that the money in the plan is allowed to grow through investing without being taxed on the growth each year. Once the money is withdrawn it is taxed fully as income. There are many restrictions on contributions, especially with 401(k) and defined benefit plans that are designed to make sure that highly compensated employees do not gain too much tax advantage at the expense of lesser paid employees.Currently two types of plan, the Roth IRA
Roth IRA
A Roth IRA is a special type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA is named for its chief legislative sponsor, Senator...
and the newly introduced Roth 401(k)
Roth 401(k)
The Roth 401 is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A, and represents a unique combination of features of the Roth IRA and a traditional 401 plan. As of January 1, 2006 U.S...
, offer tax advantages that are essentially reversed from most retirement plans. Contributions to Roth IRAs and Roth 401(k)s must be made with money that has been taxed as income, but after meeting the various restrictions, money withdrawn from the account is tax-free.
EGTRRA and later changes
The Economic Growth and Tax Relief Reconciliation Act of 2001Economic Growth and Tax Relief Reconciliation Act of 2001
The Economic Growth and Tax Relief Reconciliation Act of 2001 , was a sweeping piece of tax legislation in the United States by President George W. Bush...
(EGTRRA) brought significant changes to retirement plans, generally easing restrictions on the ability to roll money from one type of account to the other and increasing contributions limits. Most of the changes were designed to phase in over a period of 4–10 years. Unless they are extended, it will "sunset
Sunset provision
In public policy, a sunset provision or clause is a measure within a statute, regulation or other law that provides that the law shall cease to have effect after a specific date, unless further legislative action is taken to extend the law...
," or revert, at the end of 2010 to the previous laws.
History of pensions in the United States
- 1717: The Presbyterian Church creates a Fund for Pious Uses to provide for retired ministers.
- 1875: The American Express Company creates its first pension plan in the United States.
- 1884: Baltimore and Ohio Railroad establishes the first pension plan by a major employer, allowing workers at age 65 who had worked for the railroad for at least 10 years to retire and receive benefits ranging from 20 to 35% of wages.
- The Revenue Act of 1913, passed following the passage of the 16th amendment to the constitution which permitted income taxation, recognized the tax exempt nature of pension trusts. At the time, several large pension trusts were already in existence- including the pension trust for ministers of the Anglican Church in the United States.
- 1924: The Presbyterian Church, USA, creates its current pension program
- 1940s: General Motors chairman Charles Erwin WilsonCharles Erwin WilsonCharles Erwin Wilson , American businessman and politician, was United States Secretary of Defense from 1953 to 1957 under President Eisenhower. Known as "Engine Charlie", he previously worked as CEO for General Motors. In the wake of the Korean War, he cut the defense budget significantly.-Early...
designed GM's first modern pension fund. He said that it should invest in all stockStockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, not just GM. - 1963: StudebakerStudebakerStudebaker Corporation was a United States wagon and automobile manufacturer based in South Bend, Indiana. Founded in 1852 and incorporated in 1868 under the name of the Studebaker Brothers Manufacturing Company, the company was originally a producer of wagons for farmers, miners, and the...
terminated its underfunded pension plan, leaving employees with no legal recourseLegal recourseA legal recourse is an action that can be taken by an individual or a corporation to attempt to remedy a legal difficulty.* A lawsuit if the issue is a matter of civil law* Many contracts require mediation or arbitration before a dispute can go to court...
for their pension promises. - 1974: Employee Retirement Income Security Act (ERISA) – imposed reporting and disclosure obligations and minimum standards for participation, vesting, accrual and funding on U.S. plan sponsors, established fiduciary standards applicable to plan administrators and asset managers, established the Pension Benefit Guaranty CorporationPension Benefit Guaranty CorporationThe Pension Benefit Guaranty Corporation is an independent agency of the United States government that was created by the Employee Retirement Income Security Act of 1974 to encourage the continuation and maintenance of voluntary private defined benefit pension plans, provide timely and...
to ensure benefits for participants in terminated defined benefit plans, updated the Internal revenue Code rules for tax qualification, and authorized Employee Stock Ownership Plans ("ESOPs") and Individual Retirement Accounts ("IRAs"). Championed by Senators Jacob K. JavitsJacob K. JavitsJacob Koppel "Jack" Javits was a politician who served as United States Senator from New York from 1957 to 1981. A liberal Republican, he was originally allied with Governor Nelson Rockefeller, fellow U.S...
, Harrison A. Williams, Russell Long, and Gaylord Nelson, and by Representatives John Dent and John Erlenborn. - 1985: The First Cash Balance Plan - Kwasha LiptonKwasha LiptonKwasha Lipton was an employee benefits consulting firm located in Fort Lee, New Jersey. It was founded in 1944 by H. Charles "Chick" Kwasha and Maurice Lipton....
creates it by amending the plan document of Bank of AmericaBank of AmericaBank of America Corporation, an American multinational banking and financial services corporation, is the second largest bank holding company in the United States by assets, and the fourth largest bank in the U.S. by market capitalization. The bank is headquartered in Charlotte, North Carolina...
pension plan. The linguistic move was to avoid mentioning actual individual accounts but using the words hypothetical account or notional account. - 1991: A Magazine article claims that pension- and retirement fundPension fundA pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
s own 40% of American common stockCommon stockCommon stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
and represent $2.5 trillion in assets. - Growth and Decline of Defined Benefit Pension Plans in the United States. In 1980 there were approximately 250,000 qualified defined benefit pension plans covered by the Pension Benefit Guaranty CorporationPension Benefit Guaranty CorporationThe Pension Benefit Guaranty Corporation is an independent agency of the United States government that was created by the Employee Retirement Income Security Act of 1974 to encourage the continuation and maintenance of voluntary private defined benefit pension plans, provide timely and...
. By 2005, there are less than 80,000 qualified plans.
See also
- Employee Retirement Income Security ActEmployee Retirement Income Security ActThe Employee Retirement Income Security Act of 1974 is an American federal statute that establishes minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans...
- Retirement plan
- Individual Retirement AccountIndividual Retirement AccountAn individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
(IRA) - Public Employee Pension PlansPublic Employee Pension Plans (United States)In the United States, public sector pensions are offered by federal, state and local levels of government. They are available to most, but not all, public sector employees. These employer contributions to these plans typically vest after some period of time...
- 401(k)401(k)A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
- 403(b)403(b)A 403 plan, also known as a tax-sheltered annuity, is a tax-advantaged retirement savings plan available for public education organizations, some non-profit employers , cooperative hospital service organizations, and self-employed ministers in the United States...
- Similar to the 401(k), but for educational, religious, public healthcare, or non-profit workers - 401(a) and 457 plan457 planThe 457 plan is a type of non-qualified tax advantaged deferred-compensation retirement plan that is available for governmental and certain non-governmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pre-tax basis...
s - For employees of state and local governments and certain tax-exempt entities - Roth IRARoth IRAA Roth IRA is a special type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA is named for its chief legislative sponsor, Senator...
- Similar to the IRA, but funded with after-tax dollars, with distributions being tax-free - Roth 401(k)Roth 401(k)The Roth 401 is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A, and represents a unique combination of features of the Roth IRA and a traditional 401 plan. As of January 1, 2006 U.S...
- Introduced in 2006; a 401(k) plan with the tax features of a Roth IRA
External links
- Fool.com Retirement Plan Primer
- IRS Retirement Plans Community site
- http://www.enotes.com/wests-law-encyclopedia/pension