A retirement plan
is an arrangement to provide people with an income, possibly a pension
, during retirement
, when they are no longer earning a steady income from employment
, or an asset from which a person may draw an income from as needed. There are significant, though varied and complicated tax
advantages for many types of retirement plans. In passing the laws offering those advantages, Congress
has expressed a desire to encourage plans that provide retirement security. Plans designed to replace a specific amount of steady income are known as defined benefit plans (though exceptions do apply), and those designed to accumulate as an asset without requiring a specified income are known as defined contribution plans. Retirement plans may be set up by employers, insurance companies, the government
or other institutions such as employer associations or trade unions
. Retirement plans have increased in importance and in being utilized by more of the US population over the last half century but especially since 1980. Since 1980 and increasingly since 2000, there has been a shift from defined benefit plans to defined contribution plans. Fewer defined benefit plans are being offered because they represent a large and not fully predictable cost to employers. As of 2005, most defined benefit plans are offered by large and/or governmental employers.
Retirement plans are defined in tax terms by the IRS code and most are also regulated by the Department of Labor's ERISA provisions. There are a wide variety of plans available and a very large amount of tax laws and regulations affecting them.
Types of retirement plans
Retirement plans may be classified as defined benefit
or defined contribution
according to how the benefits are determined. A defined benefit plan guarantees a certain payout after retirement, according to a fixed formula which usually depends on the member's salary and the number of years' membership of the plan. In a defined contribution plan, the payout is dependent upon the amount of money contributed, 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 plans
A defined contribution plan, according to the Internal Revenue Code Section 414, is an employer sponsored plan with an individual account for each employee. The accrued benefit from such a plan for an employee must be solely attributed to contributions made into his individual account and investment gains less any losses and expense charges. The contributions are invested, for example in the stock market, and the returns on the investment (which may be positive or negative) are credited to the individual's account. On retirement, the member's account is used to provide retirement benefits, sometimes through the purchase of an annuity
which provides a regular income. Defined contribution plans have become more widespread all over the world in recent years, and are now the dominant form of plan in the private sector in many countries. For example, the number of DB plans in the US has been steadily declining, as more and more employers see the large pension contributions as a large expense that they can avoid by disbanding the plan and instead offering a defined contribution plan.
Examples of defined contribution plans include Individual Retirement Accounts (IRAs), 401(k), and profit sharing plans. In such plans, the employee is responsible, to one degree or another, for selecting the types of investments toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual funds to selecting individual stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages, and some provide for a portion of the employee's contributions to be matched by the employer. In exchange, the funds in such plans may not be withdrawn by the investor prior to reaching a certain age—typically the year the employee reaches 59.5 years old— (with a small number of exceptions) without incurring a substantial penalty.
Money contributed can either be from employee salary deferral or from employer contributions or matching. Defined contribution plans are subject to IRS limits on how much can be contributed, known as the section 415 limit. The total deferral amount including the employee and employer contribution is the lesser of $40,000 or 100% of compensation. The employee only amount is $14,000 for 2004 with a $4,000 catch up. These amounts increase in 2006.
Defined benefit plans
The statutory definition of the defined benefit plan encompasses all pension plans that are not defined contribution, i.e. that do not have individual accounts.
While this catchall definition has been interpreted by the courts to capture some hybrid pension plans like Cash balance plans and pension equity plans (PEP), traditional retirement plans by large businesses, or, for government workers, by the government itself are in the form of the final salary plan, under which the pension paid 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.
The cash balance plan with or without a formula that specifies an exact benefit at retirement, whatever amount is accumulated can be available as a monthly pension at retirement or a lump sum at retirement and possibly before. The only requirement is that it must provide a benefit in the form of a lifetime annuity at normal retirement age as required (by the Internal Revenue Code) of all defined benefit plans. The amount of the annuity benefit must be definitely determinable as per IRS regulation 1.412-1.
Social Security is a form of state-sponsored retirement benefits, beyond those provided by employers, which are funded by payroll taxes.
Defined benefit plans may be either funded or unfunded. In a funded plan, contributions from the employer, and sometimes also from plan members, are invested in a fund towards meeting the benefits. 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 be enough to meet the benefits. Typically, the contributions to be paid are regularly reviewed in a valuation of the plan's assets and liabilities, carried out by an actuary. In many countries, such as the USA, the UK and Australia, most private defined benefit plans are funded, because governments there provide tax incentives to funded plans.
In an unfunded plan, no funds are set aside. The benefits to be paid are met immediately by contributions to the plan. Most government run retirement plans, such as the social security system in the USA and most European countries, are unfunded, with benefits being paid directly out of current taxes and social security contributions. In some countries, such as Germany, Austria and Sweden, company run retirement plans are often unfunded.
Hybrid and Cash Balance Plans
Hybrid plan designs combine the features of defined benefit and defined contribution plan
designs. In general, they are usually treated as defined benefit plans
for tax, accounting and regulatory purposes. As with defined benefit plans, investment risk in hybrid designs 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 more highly mobile workforce. A typical hybrid design is the Cash Balance Plan
, where the employee's notional account balance grows by some defined rate of interest and annual employer contribution.
In the US, plan conversions from traditional to hybrid plan designs have been controversial, notably at IBM in the late 1990s. Upon conversion, some plan sponsors retrospectively calculated employee account balances — if the employee's actual vested benefit under the old design was more than the account balance, the employee entered a period of wear away where he or she accrued no new benefits. Hybrid designs also typically eliminated the generous early retirement provisions in traditional pensions.
As a result, critics of cash balance plans have seen the new designs as discriminatory against older workers. 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. Court cases have split on this issue and therefore not resolved these problems. Currently both the Senate and House have legislation to clarify the legal status of future cash balance plans. In the interim, Treasury has placed a moratorium on future determination letters on cash balance plans. The proposed legislation on cash balance age discrimination (much like the principle in criminal appeal that convicts convicted under the old procedure cannot win on appeal by applying the new rule retroactively US v. Teague, 489 US 288 (1989)) does not cover the legal status of current plans in existence.
While the Cash Balance Plan mentioned above is hybrid which is a defined benefit plan designed enable workers to evaluate the economic worth their pension benefit in the manner of a defined contribution plan (the Defined Benefit design of Cash Balance plans provides the advantage of PBGC insurance but the risk of insolvency), 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 and targeted to match a defined benefit plan. In a Target Benefit plan, a typical Defined Benefit design, say 1.5% of salary per year of service times the final 3-year average salary, is used to provide the target. Actuarial assumptions like 5% interest, 3% salary increases and the UP84 Life Table for mortality are used to calculate a level flat contribution rate that would create the needed lump sum at retirement age 65 for each entering employee.
The problem with such Target Benefit DC plans is that the flat rate could be low for young entrants, like 8% for a 21 year old, and high for old entrants. This may appear unfair. But 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.
This points out the key difference among DC and DB plans for ordinary workers — awareness. The DC plan like the 401(k) is easy for workers to understand the value of, while the DB plan is typically undervalued by workers until they get really close to retirement age.
Requirement of Permanence
To guard against tax abuse in the United States, the Internal Revenue Service
(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. Determination letters like "'no-action letters'" from the Securities and Exchange Commission
(SEC) are advisory and to the extent the tax-payer's actions have pandered the taxpayer is on the hook.
Qualified retirement plans
Receive the normally discussed tax advantages and are regulated by ERISA. The technical definition of qualified does not agree with the commonly used distinction. For example 403(b)
plans are not considered qualified plans, but are treated and taxed almost identically.
'HR 10' or Keogh Plans
Plans that do not meet the guidelines required to receive the tax advantages that qualified plans do. They are typically used to provide additional benefits to key or highly paid employees such as executives and officers without the restrictions that qualified plans carry. Most offer little or no tax advantages, but are used for their flexibility as incentives for key employees. Examples are SERP (supplemental executive retirement plans
) and 457(f) plans
For additional info, see the constructive receipt theory and related doctrines of the cash equivalence and economic benefit, as well as Amend v. Commissioner, 13 Tax Court 178 (1949), Pulsifer v. Commissioner, Irish sweepstakes, 64 Tax Court 245 (1975), and Revenue Ruling 60-31.
Contrasting types of retirement plans
Advocates of defined contribution plans 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.
Defined contribution plans 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 plans 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 plans, 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 specfies 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 plans 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 Act
(ERISA) does not provide insurance from the Pension Benefit Guaranty Corporation
(PBGC) for defined contribution plans, 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 Accounts (IRAs) are very common.
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 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 and later changes
The Economic Growth and Tax Relief Reconciliation Act of 2001
(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.
History of pensions 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.
- 1940s: General Motors chairman Charles Erwin Wilson designed GM's first modern pension fund. He said that it should invest in all stocks, not just GM.
- 1963: Studebaker terminated its underfunded pension plan, leaving employees with no legal recourse 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 Corporation 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. Javits, Harrison A. Williams, Russell Long, and Gaylord Nelson, and by Representatives John Dent and John Erlenborn.
- 198?: The First Cash Balance Plan - Kwasha Lipton creates it by amending the plan document of 'fill in employer name' 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 funds own 40% of American common stock 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 Corporation. By 2005, there are less than 80,000 qualified plans.