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Learning Objectives
In this section we elaborate on the various qualified plansavailable through employers or on an individual basis:
- Defined benefit pension plans: traditional defined benefitplan, cash balance plan
- Defined contribution retirement plans: cash balance plan,401(k), profit sharing
- Special types of qualified plans: 403(b), Section 457, Keogh,SEP, SIMPLE
- Individual retirement accounts (IRAs): traditional IRA, RothIRA, Roth 401(k), Roth 403(b)
Types of Qualified Plans
As noted above and as shown in Figure 21.1.2, employers choose apension plan from two types: defined benefit or definedcontribution. Both are qualified plans that provide tax-favoredarrangements for retirement savings.
Figure 21.1.2 displays the different qualified retirement plans.Defined benefit (DB) and defined contribution (DC) pension plansare shown in the first two left-hand squares. The definedcontribution profit-sharing (PS) plan is shown in the thirdleft-hand rectangle. The leftmost square represents the highestlevel of financial commitment by an employer; the profit-sharingrectangle represents the least commitment. The profit-sharing planis funded at the discretion of the employer during periods ofprofits, whereas pension plans require annual minimum funding. Thisis why the employer is giving greater commitment to pensionplans—contributions are required even in bad years. Among thepension plans, the traditional defined benefit plan represents thehighest level of employer’s commitment. It is a promise that theemployee will receive a certain amount of income replacement atretirement. The benefits are defined by a mathematical formula, aswill be shown later. Actuaries calculate the amount of the annualcontribution necessary to fund the retirement promise given by theemployer. As noted above, the PBGC provides insurance to guaranteethese benefits (up to the maximum shown above) at a cost to theemployer of $34 per employee per year (since 2009). Because thetraditional defined benefit pension plan is the plan with thegreatest commitment, usually a high level of contribution isallowed for older employees. The annual compensation limit underIRS sections 401(a)(17), 404(l), 408(k)(3)(C), and 408(k)(6)(D)(ii)has increased from $230,000 in 2008 to $245,000 in 2009, and thelimitation on the annual benefit under a defined benefit plan underSection 415(b)(1)(A) has increased from $185,000 to $195,000 in2009 or 100 percent of compensation.Internal Revenue Service (IRS),“IRS Announces Pension Plan Limitations for 2009,” IR-2008-118,October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009). These are shown in Figure 21.1.2.
Another defined benefit plan is the cash balance plan. Asdiscussed above, it is a hybrid of the traditional defined benefitplan and defined contribution plans. In a cash balance plan, theemployer commits to contribute a certain percentage of compensationeach year and guarantees a rate of return. Under this arrangement,employees are able to calculate the exact lump sum that will beavailable to them at retirement because the employer guaranteesboth contributions and earnings. This plan favors youngeremployees. It is currently the topic of court cases and debatebecause many large corporations such as IBM converted theirtraditional defined benefits plans to cash balance, grandfatheringthe older employees’ benefits under the plan.For more information,see coverage of this topic in the following sample of articles:“Sun Moves to Cash Balance Pensions,” Employee Benefit PlanReview 45, no. 9 (1991): 50–51; Arleen Jacobius, “MotorolaWorkers Embrace New Hybrid Pension Plan,” BusinessInsurance 34, no. 45 (2000): 36–37; Karl Frieden, “The CashBalance Pension Plan: Wave of the Future or Shooting Star?”CFO: The Magazine for Chief Financial Officers 3,no. 9 (1987): 53–54; September 1987; Avra Wing, “Employers Wary ofCash Balance Pensions,” Business Insurance 20, no. 39(1986): 15–20; September 29, 1986; Arleen Jacobius, “60 percent ofWorkers at Motorola, Inc. Embrace Firm’s New PEP Plan,”Pensions & Investment Age 28, no. 19 (2000): 3, 58;Jerry Geisel, “Survey Aims to Find Facts About Cash Balance Plans,”Business Insurance 34, no. 21 (2000): 10–12; “AmericanBenefits Council President Discusses Cash Balance Plans, PensionReform,” Employee Benefit Plan Review 55, no. 4 (2000):11–13; Donna Ritter Mark, “Planning to Implement a Cash BalancePension Plan? Examine the Issues First,” Compensation &Benefits Review 32, no. 5 (2000): 15–16; Vineeta Anand, “Youngand Old Hurt in Switch to Cash Balance,” Pensions &Investment Age 28, no. 20 (2000): 1, 77; Vineeta Anand,“Employees Win Another One in Cash Balance Court Cases,”Pensions & Investment Age 28, no. 19 (2000): 2, 59;Regina Shanney-Saborsky, “The Cash Balance Controversy: Navigatingthe Issues,” Journal of Financial Planning 13, no. 9(2000): 44–48. See the box, “Cash Balance Conversions: Who GetsHurt?”
A cash balance plan is considered a hybrid plan because thecontributions are guaranteed. The benefits are not explicitlydefined but are the outcome of the length of time the employee isin the pension plan. Because both the contributions and rates ofreturn are guaranteed, the amount available at retirement istherefore also guaranteed. It is an insured plan under the PBGC,and all funds are kept in one large account administered by theemployer. The employees have only hypothetical accounts that aremade of the contributions and the guaranteed returns. As notedabove, it is a defined benefit plan that looks like a definedcontribution plan.
The simplest of the defined contribution pension plans is themoney purchase plan. Under this plan, the employer guarantees onlythe annual contribution but not any returns. As opposed to adefined benefit plan, where the employer keeps all the monies inone account, the defined contribution plan has separate accountsunder the control of the employees. The investment vehicles inthese accounts are limited to those selected by the employer whocontracts with various financial institutions to administer theinvestments. If employees are successful in their investmentstrategy, their retirement benefits will be larger. The employeesare not assured an amount at retirement, and they have theinvestment risk, not the employer. This aspect is illuminated bythe 2008–2009 recession and discussed in the box “RetirementSavings and the Recession.” Because the employer is at less of aninvestment risk here and the employer’s commitment is lower, thetax benefit is not as great (especially for older employees). Thelimitation for defined contribution plans under Section415(c)(1)(A) has increased from $46,000 in 2008 to $49,000 in 2009or 100 percent of the employee’s compensation.Internal RevenueService (IRS), “IRS Announces Pension Plan Limitations for 2009,”IR-2008-118, October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009).
Another defined contribution plan is the target pension plan,which favors older employees. This is another hybrid plan, but thisis actually a defined contribution plan (subject to the $49,000 and100 percent limitation in 2009) that looks like a traditionaldefined benefits plan in its first year only. Details about thisplan are beyond the scope of this text.
For employers seeking the least amount of commitment, theprofit-sharing plan is the solution. These are defined contributionplans that are not pension plans. There is no minimum fundingrequirements each year. As of 2003 and onward, the maximum allowedtax deductible contribution by employer per year is 25 percent ofpayroll. This is also a major change in effect after the enactmentof EGTRRA 2001. The level used to be only 15 percent of payroll,with limits of an annual addition to each account of $35,000 or 25percent in 2001. The additions to each account are up to the lesserof $49,000 or 100 percent of compensation in 2009.Internal RevenueService (IRS), “IRS Announces Pension Plan Limitations for 2009,”IR-2008-118, October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009). The 401(k) is part of the tax code for aprofit-sharing plan, but it is not designed as an employercontribution. Rather, it is a pretax-deferred compensationcontribution by the employee with possible matching by an employer.See Tables 21.6 and 21.7 later in this chapter for the limits ifthe employer meets the discrimination testing or falls undercertain safe-harbor provisions. As shown, EGTRRA 2001 increased thepermitted deferred compensation under 401(k) plans gradually up to$16,500Internal Revenue Service (IRS), “IRS Announces Pension PlanLimitations for 2009,” IR-2008-118, October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009). (in 2009) from the level of $10,500 in 2001. OnJanuary 1, 2006, Internal Revenue Code (IRC) §402A providing forRoth 401(k)s and Roth 403(b)s (discussed later) became effective.This also is an outcome of EGTRRA 2001 with a delayed effectivedate. Roth 401(k) and Roth 403(b) means that the contributions areafter-tax, but earnings are never taxed. EGTRRA 2001 has catch-upprovisions. The explanation of the 401(k) plan includes an exampleof the average deferral percentage (ADP) discrimination test usedfor 401(k) plans. When an employer adds matching, profit sharing,or any other defined contribution plans, the amount of annualadditions to the individual accounts cannot exceed the lesser of$49,000 or 100 percent of compensation, including the 401(k)deferral in 2009.Internal Revenue Service (IRS), “IRS AnnouncesPension Plan Limitations for 2009,” IR-2008-118, October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009). The combination of 401(k) and any otherprofit-sharing contributions cannot exceed 25 percent of payroll.Nearly two-thirds of all U.S. large employers consider the 401(k)as the main retirement plan for their employees.“New Research fromEBRI: Defined Contribution Retirement Plans Increasingly Seen asPrimary Type,” Reuters, February 9, 2009,www.reuters.com/article/pressRelease/idUS166119+09-Feb-2009+PRN20090209,accessed March 10, 2009.
An employee stock ownership plan (ESOP) is another type ofprofit-sharing plan. An ESOP is covered only briefly in this text.This section also provides a brief description of other qualifiedplans such as 403(b), 457, Savings Incentive Match Plan forEmployees (SIMPLE), Simplified Employee Pension (SEP), traditionalIRA, and Roth IRA. EGTRRA 2001 made major changes to these plans,as well as to the plans discussed so far. Traditional IRA and RothIRA are not sponsored by the employer, but require employeecompensation through employment.
Cash Balance Conversions: Who Gets Hurt?
Over the past two decades, a number of employers have switchedtheir traditional defined benefit pension plans to cash balanceplans. Employers like cash balance plans because they are lessexpensive than traditional plans, in part, because they do notrequire the high administrative cost and large contributions foremployees who are near retirement. Also, cash balance benefit plansmay pay out less because they base their benefits on an employee’scareer earnings, while defined benefit plans are based on the finalyears of salary, when earnings usually peak.
In November 2002, Delta Airlines joined the cash balance trend,citing the soaring costs of its underfunded traditional pensionplan as the reason. Like Delta, many companies have implementedcash balance plans by converting their old defined benefit plans.In doing so, they determine an employee’s accrued benefit under theold plan and use it to set an opening balance for a cash balanceaccount. While the opening account of a cash balance account canend up being less than the actual present value of the benefits anemployee has already accrued (called wear away), cash balance planshave the advantage of portability. The traditional defined benefitsplan is not portable because an employee who leaves a job may needto leave the accrued and vested benefits with the employer untilretirement. Cash balance plans are considered very portable. Theplan is similar to defined contribution plans because the employeeknows at any moment the value of his or her hypothetical accountthat is built up as an accumulation of employer’s contributions andguaranteed rate of return. For this reason, cash balance plans areadvertised as advantageous for today’s mobile work force. Also,cash balance plans are considered best for younger workers becausethese employees have many years to accumulate their hypotheticalaccount balances.
However, these conversions have not been free of majorcontroversies. Older employees, who do not have a long enough timeto accumulate the account balance, in most cases are grantedcontinuation under the old plan, under a grandfather clause.Midcareer employees in their forties have most to risk because itis uncertain whether the new cash balance plans can actually catchup to the old promise of defined benefits at age sixty-five. Plancritics have repeatedly charged that pay credits discriminateagainst older employees because the credits they receive wouldpurchase a smaller annuity at normal retirement age than wouldthose received by younger employees. Numerous lawsuits allegingdiscrimination have been filed against employers offering theplans.
IBM’s conversion in 1999 provides a notorious example of thepitfalls of conversion for midcareer employees. When IBM announcedthe conversion, it was inundated with hundreds of thousands ofe-mails complaining about the change, so the company repeatedlytweaked its plan. Still, many employees are not satisfied when theycompare the new plan with the defined benefit plan they mightotherwise have received. A federal court gave a final approval topartial settlement between IBM and tens of thousands of current andformer employees about the conversion. Under one part of thesettlement, IBM has to pay more than $300 million to planparticipants in the form of enhanced benefits. Since the partialsettlement was proposed, IBM had frozen its cash balance plan, withemployees hired as of January 1, 2005, receiving pension coverageunder an enriched 401(k) plan.
The 2005 U.S. Government Accountability Office (GAO) reportregarding cash balance pension plans concluded that cash balanceplans do cut benefits. In July 2005, congressional committeespassed legislation to make clear that cash balance plans do notviolate age discrimination law, but the measures do not apply toexisting plans. This relates to a court case that provided victoryfor employers. The judge dismissed a case against PNC FinancialServices Group that was brought on behalf of its employees andretirees in connection with the company’s switch to a cash balanceplan. The Pittsburgh-based PNC replaced its traditional definedbenefit plan in 1999. The plaintiffs filed suit against the companyand its pension plan in December 2004, arguing that the plan wasage discriminatory, among other allegations. Judge D. Davis Legromeof the U.S. District Court in Philadelphia dismissed all thecharges against the company in his decision (Sandra Register v.PNC Financial Services Group, Inc.).
To soften the effects of cash balance conversion, many companiesoffer transitional benefits to older employers. Some companiesallow their workers to choose between the traditional plan and thecash balance plan. Others offer stock options or increasedcontributions to employee 401(k) plans to offset the reduction inpension benefits.
Questions for Discussion
- Who actually is the beneficiary of the conversions? Theemployer? All employees? Or only some? Is it ethical to changepromises to employees?
- Are conversions to cash balance plans a reflection of thelowering of the noncash compensation (pension offering) ofemployers in the last two decades? Or are they just a smart move toaccommodate the mobile work force? Is it ethical to make a noncashcompensation reduction without reaching an agreement withemployees?
- Is the fact that many employers are trying to get away from thetraditional defined benefits plans that are similar to the currentSocial Security system a signal that Social Security will beprivatized? Would it be ethical to make changes that may not beclear to employees (see Chapter 18)?
Sources: Jerry Geisel, “Delta’s New Pension Plan to Generate BigSavings,” Business Insurance, November 25, 2002,www.businessinsurance.com/cgi-bin/article.pl?articleId=12013&a=a&bt=delta’s+new+pension+plan(accessed April 17, 2009); Jonathan Barry Forman, “Legal Issues inCash Balance Pension Plan Conversions,” Benefits Quarterly, January1, 2001, 27–32; Lawrence J. Sher, “Survey of Cash BalanceConversions,” Benefits Quarterly, January 1, 2001, 19–26; Robert L.Clark, John J. Haley, and Sylvester J. Schieber, “Adopting HybridPension Plans: Financial and Communication Issues,” BenefitsQuarterly, January 1, 2001, p. 7–17; “Cash Balance Plans Questions& Answers,” U.S. Department of Labor, November 1999,www.dol.gov/ebsa/publications/cb_pension_plans.html(accessed April 17, 2009); Jerry Geisel, “Proposed Rules ClarifyCash Balance Plan Status,” Business Insurance, December 10, 2002.;Jerry Geisel “Court Gives Final Approval in IBM Pension Case,”Business Insurance, August 15, 2005,www.businessinsurance.com/cgi-bin/article.pl?articleId=17389&a=a&bt=court+gives+final+approval+ibm(accessed April 17, 2009); Jerry Geisel, “Effort to Dispel CashBalance Doubts Criticized for Ignoring Existing Plans,” BusinessInsurance , August 1, 2005,www.businessinsurance.com/cgi-bin/article.pl?articleId=17312&a=a&bt=effort+to+dispel+cash+balance(accessed April 17, 2009); Judy Greenwald, “Court Ruling FavorsCash Balance Conversions,” Business Insurance, November 23, 2005,www.businessinsurance.com/cgi-bin/news.pl?newsId=6781,accessed April 17, 2009; Jerry Geisel “Cash Balance PlanConversions Cut Benefits: GAO,” Business Insurance, November 4,2005.
Defined Benefit Plans
A defined benefit (DB) plan has thedistinguishing characteristic of clearly defining, by its benefitformula, the amount of benefit that will be available atretirement. That is, the benefit amount is specified in the writtenplan document, although the amount that must be contributed to fundthe plan is not specified.
Traditional Defined Benefit Plan
In a defined benefit plan, any of several benefit formulas maybe used in the following:
- A flat dollar amount
- A flat percentage of pay
- A flat amount unit benefit
- A percentage unit benefit
Each type has advantages and disadvantages, and the employerselects the formula that best meets both the needs of employees foreconomic security and the budget constraints of the employer.
The defined benefit formula may specify a flat dollar amount,such as $500 per month. It may provide a formula by which theamount can be calculated, yielding a flat percentage of currentannual salary (or the average salary of the past five years or so).For example, a plan may specify that each employee with at leasttwenty years of participation in the plan receives 50 percent ofhis or her average annual earnings during the three consecutiveyears of employment with the highest earnings. A flat amount unitbenefit formula assigns a flat amount (e.g., $25) with each unit ofservice, usually with each year. Thus, an employee with thirtyunits of service at retirement would receive a benefit equal tothirty times the unit amount.
The most popular defined benefit formula is the percentage unitbenefit plan. It recognizes both the employee’s years of serviceand level of compensation. See Table 21.1 for an example. Tables21.1 through 21.5 feature different qualified retirement plans forthe Slone-Jones Dental Office. The dental office is used as anexample to demonstrate how each plan would work for the same mix ofemployees.
| (1) | (2) | (3) | (4) | (5) | (6) | (7) | |
|---|---|---|---|---|---|---|---|
| Employees | Current Age | Current Salary | Allowable Compensation | Years of Service | Years of Service to Age 65 | Maximum Allowed Benefit | Expected Benefit at Age 65 2% × (3) ×(5) |
| Dr. Slone | 55 | $250,000 | $245,000 | 20 | 30 | $195,000 | $90,000 |
| Diane | 45 | $55,000 | $55,000 | 10 | 30 | 55,000 | $11,000 |
| Jack | 25 | $30,000 | $30,000 | 5 | 45 | 30,000 | $3,000 |
When the compensation base is described as compensation for arecent number of years (e.g., the last three or highest consecutivefive years), the formula is referred to as a final averageformula. Relative to a career averageformula, which bases benefits on average compensation forall years of service in the plan, a final average plan tends tokeep the initial retirement benefit in line with inflation.
Two types of service are involved in the benefit formula: pastservice and future service. Past service refers to service prior tothe installation of the plan. Future service refers to servicesubsequent to the installation of the plan. If credit is given forpast service, the plan starts with an initial past serviceliability at the date of installation. To reduce the size of thisliability, the percentage of credit for past service may be lessthan that for future service, or a limit may be put on the numberof years of past service credit. Initial past service liability maybe a serious financial problem for the employer starting orinstalling a pension plan. Past service liability orsupplemental liability can be amortized over acertain number of years, not to exceed thirty years for a singleemployer.
Cash Balance Plan
The cash balance plan does not provide anamount of benefit that will be available for the employee atretirement. Instead, the cash balance plan sets up a hypotheticalindividual account for each employee, and credits each participantannually with a plan contribution (usually a percentage ofcompensation). The employer also guarantees a minimum interestcredit on the account balance. For example, an employer mightcontribute 10 percent of an employee’s salary to the employee’splan each year and guarantee a minimum rate of return of 4 percenton the fund, as shown in Table 21.2. If investment returns turn outto be higher than 4 percent, the employer may credit the employeeaccount with the higher rate. The amount available to the employeeat retirement varies, based on wage rates and investment rates ofreturn. Although the cash balance plan is technically a definedbenefit plan, it has many of the same characteristics as definedcontribution plans. These characteristics include hypotheticalindividual employee accounts, a fixed employer contribution rate,and an indeterminate final benefit amount because employeecompensation changes over time and interest rates may turn out tobe well above the minimum guaranteed rate.
| (1) | (2) | (3) | (4) | (5) | (6) | (7) | (8) | |
|---|---|---|---|---|---|---|---|---|
| Employees | Current Age | Current Salary | Allowed Compensation | Maximum Benefit | Contribution Year (10%) | Years to Retirement | Future Value of $1 Annuity at4% | Lump Sum at Age 65 (7) ×(5) |
| Dr. Slone | 55 | $250,000 | $245,000 | $195,000 | $24,500 | 10 | 12.006 | $294,147 |
| Diane | 45 | $55,000 | $55,000 | 55,000 | $5,500 | 20 | 29.778 | $163,779 |
| Jack | 25 | $30,000 | $30,000 | 30,000 | $3,000 | 40 | 95.024 | $285,072 |
Features of Defined Benefit Plans
All defined benefit plans may provide for adjustments to accountfor inflation during the retirement years. A plan that includes acost-of-living adjustment (COLA) clause has theideal design feature. Benefits increase automatically with changesin a cost-of-living or wage index.
Many plans integrate the retirement benefit with Social Securitybenefits. An integrated plan coordinates SocialSecurity benefits (or contributions) with the private plan’sbenefit (or contribution) formula. Integration reduces privateretirement benefits based on the amount received through SocialSecurity, thus reducing the cost to employers of the private plan.On the other hand, integration allows employees with higher incometo receive greater benefits or contributions, depending on theformula. The scope of this text is too limited to explore the exactmechanism of integrated plans. There are two kinds of plans. Theoffset method reduces the private plan benefit by a set fraction.This approach is applicable only to defined benefit plans. Thesecond method is the integration-level method. Here, a threshold ofcompensation, such as the wage base level shown in "18: Social Security", is specified, and the rate of benefitsor contributions provided below this compensation threshold islower than the rate for compensation above the threshold. Theintegration-level method may be used for defined benefit or definedcontribution pension plans.
As noted above, defined benefits up to specified levels areguaranteed by the Pension Benefit Guarantee Corporation(PBGC), a federal insurance program somewhat like theFederal Deposit Insurance Corporation (FDIC) for commercial bankaccounts, and like the Guarantee Funds for Insurance. All definedbenefit plans contribute an annual fee (or premium) per pensionplan participant to finance benefits for members of insolventterminated plans. The premium amount takes into account, to adegree, the financial soundness of the particular plan, measured bythe plan’s unfunded vested benefit. Thus, plans with a greaterunfunded vested benefit pay a greater PBGC premium (up to a maximumamount), providing an incentive to employers to adequately fundtheir pension plans. Despite this incentive, there is nationalconcern about the number of seriously underfunded pension plansinsured by the PBGC. If these plans were unable to pay promisedretirement benefits, the PBGC would be liable, and PBGC funds maybe insufficient to cover the claims. Taxpayers could end up bailingout the PBGC. Careful monitoring of PBGC fund adequacy continues,and funding rules may be tightened to keep the PBGC financiallysound.
Defined Benefit Cost Factors
Annual pension contributions and plan liabilities for a definedbenefit plan must be estimated by an actuary. (Actuaries withpension specialties are called enrolled actuaries.) The time valueof money explained in "4: Evolving Risk Management - Fundamental Tools" is usedextensively in the computations of pensions. The defined amount ofbenefits becomes the employer’s obligation, and contributions mustequal whatever amount is necessary to fund the obligation. Theestimate of cost depends on factors such as salary levels; normalretirement age; current employee ages; and assumptions aboutmortality, turnover, investment earnings, administrative expenses,and salary adjustment factors (for inflation and productivity).These factors determine estimates of how many employees willreceive retirement benefits, how much they will receive, whenbenefits will begin, and how long benefits will be paid.
Normal costs reflect the annual amount neededto fund the pension benefit during the employee’s working years.Supplemental costs are the amounts necessary toamortize any past service liability, which is explained above, overa period that may vary from ten to thirty years. Total cost for ayear is the sum of normal and supplemental costs. Under somemethods of calculation, normal and supplemental costs are estimatedas one item. Costs may be estimated for each employee and thenadded to yield total cost, or a calculation may be made for allparticipants on an aggregate basis.
Defined benefit plan administration is expensive compared withdefined contribution plans because of actuarial expense andcomplicated ERISA regulations. This explains in part why about 75percent of the plans established since the passage of ERISA havebeen defined contribution plans.
Defined Contribution Plans
A defined contribution (DC) plan is a qualifiedpension plan in which the contribution amount is defined but thebenefit amount available at retirement varies. This is in directcontrast to a defined benefit plan, in which the benefit is definedand the contribution amount varies. As with the defined benefitplan, when the defined contribution plan is initially designed, theemployer makes decisions about eligibility, retirement age,integration, vesting schedules, and funding methods.
The most common type of defined contribution plan is themoney purchase plan. This plan establishes anannual rate of employer contribution, usually expressed as apercentage of current compensation; for example, a plan may specifythat the employer will contribute 10 percent of an employee’ssalary, as shown in the example in Table 21.3. Separate accountsare maintained to track the current balance attributable to eachemployee, but contributions may be commingled for investmentpurposes.
| (1) | (2) | (3) | (4) | (5) | (6) | (7) | (8) | (9) | |
|---|---|---|---|---|---|---|---|---|---|
| Employees | Age | Current Salary | Allowed Compensation | Service | Maximum ContributionAllowed | Contribution at 10.00% (3) ×0.10 | Years to Retirement | Future Value of $1 Annuity at10% | Lump Sum at Retirement (6) ×(8) |
| Dr. Slone | 55 | $250,000 | $245,000 | 20 | $49,000 | $24,500 | 10 | 15.937 | $390,457 |
| Diane | 45 | $55,000 | $55,000 | 10 | $49,000 | $5,500 | 20 | 57.274 | $315,007 |
| Jack | 25 | $30,000 | $30,000 | 5 | $30,000 | $3,000 | 40 | 442.58 | $1,327,740 |
The benefit available at retirement varies with the contributionamount, the length of covered service, investment earnings, andretirement age, as you can see in Column 9 of Table 21.3. Someplans allow employees to direct the investment of their own pensionfunds, offering several investment options. Generally, retirementage has no effect on a distribution received as a lump sum, fixedamount, or fixed period annuity. Retirement age affects the amountof income received only under a life annuity option.
From the perspective of an employer or employee concerned withthe adequacy of retirement income, the contributions that typicallyhave the longest time to accumulate with compound investmentreturns are the smaller ones. They are smaller because thecompensation base (to which the contribution percentage is applied)is lowest in an employee’s younger years. This is perhaps the majordisadvantage of defined contribution plans. It is also difficult toproject the amount of retirement benefit until retirement is near,which complicates planning. In addition, the speculative risk ofinvestment performance (positive or negative returns) is bornedirectly by employees.
From an employer’s perspective, however, such plans have thedistinct advantage of a reasonably predictable level of pensioncost because they are expressed as a percentage of current payroll.Because the employer promises only to specify a rate ofcontribution and prudently manage the plan, actuarial estimates ofannual contributions and liabilities are unnecessary. The employeralso does not contribute to the Pension Benefit GuarantyCorporation, which applies only to defined benefit plans. Most newplans today are defined contribution plans, which is not surprisinggiven their simplicity, lower administrative cost, and limitedemployer liability for funding.
Other Qualified Defined Contribution Plans
Employers may offer a variety of defined contribution plansother than money purchase plans to assist employees in saving forretirement. These may be the only retirement plans offered by theorganization, or they may be offered in addition to a definedbenefit plan or a defined contribution money purchase plan, as youcan see in Case 2 of "23: Cases in Holistic Risk Management". One such definedcontribution plan is the target plan, which is anage-weighted pension plan. Under this plan, each employee istargeted to receive the same formula of benefit at retirement (agesixty-five), but the benefits are not guaranteed. Because olderemployees have less time to accumulate the funds for retirement,they receive a larger contribution as a percentage of compensationthan the younger employees do. The target plan is a hybrid ofdefined benefits and defined contribution plans, but it is adefined contribution pension plan with the same limits andrequirements as defined contribution plans.
Profit-Sharing Plans
All profit-sharing plans are definedcontribution plans. They are considered incentive plans rather thanpension plans because they do not have annual funding requirements.Profit-sharing plans provide economic incentives for employeesbecause firm profits are distributed directly to employees. In adeferred profit-sharing plan, a firm puts part ofits profits in trust for the benefit of employees. Typically, theshare of profit allocated is related to salary; that is, the shareeach year is the percentage determined by the employee’s salarydivided by total salaries for all participants in the plan. PerEGTRRA 2001, the maximum amount of contribution is 25 percent ofthe total payroll of all employees.
Table 21.4, featuring again the Slone-Jones Dental Office, showsan allocation of profit sharing should the employer decide tocontribute $30,000 to the profit-sharing plan. The allocation isbased on the percentage of each employee’s pay from total payrollallowed (see Column 4 in Table 21.4). The maximum profits to beshared in 2009 cannot be greater than an allocation of $49,000 fortop employees.Internal Revenue Service (IRS), “IRS AnnouncesPension Plan Limitations for 2009,” IR-2008-118, October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009). If the maximum compensation allowed is $245,000and the maximum contribution is $49,000, in essence thecontribution to the account of an employee making $245,000 or morewould not be more than 20 percent.
| (1) | (2) | (3) | (4) | (5) | |
|---|---|---|---|---|---|
| Employees | Current Age | Salary | Maximum AllowedCompensation | Percentage of Pay fromTotal Adjusted Payroll (3)/330,000 | Allocation of $30,000Profits (4) × 30,000 |
| Dr. Slone | 55 | $250,000 | $245,000 | 74.24% | $22,272 |
| Diane | 45 | $55,000 | $55,000 | 16.67% | $5,001 |
| Jack | 25 | $30,000 | $30,000 | 9.09% | $2,727 |
| Total | $330,000 | 100.00% | $30,000 |
Employee Stock Ownership Plans
An employee stock ownership plan (ESOP) is aspecial form of profit-sharing plan. The unique feature of an ESOPis that all investments are in the employer’s common stock.Proponents of ESOPs claim that this ownership participationincreases employee morale and productivity. Critics regard it as atie-in of human and economic capital in a single firm, which maylead to complete losses when the firm is in trouble. Anillustration of the hardship that can occur when employees investin their company is Enron, a case we noted earlier.
An ESOP represents the ultimate in investment concentrationbecause all contributions are invested in one security. This isdistinctly different from the investment diversification found inthe typical pension or profit-sharing plan. To alleviate the ESOPinvestment risk for older employees, employers are required toallow at least three diversified investment portfolios for personsover age fifty-five who also have at least ten years ofparticipation in the plan. Each diversified portfolio containsseveral issues of nonemployer securities, such as common stocks orbonds. One option might even be a low-risk investment, such as bankcertificates of deposit. This allows use of an incentive-typequalified retirement plan without unnecessarily jeopardizing thefuture retiree’s benefits.
401(k) Plans
Another qualified defined contribution plan is the401(k) plan, which allows employees to defercompensation for retirement before taxes. Refer to the example ofdeferral in Table 21.5. As you can see, contributions to a 401(k)plan are limited per the description in Figure 21.1.2 and Tables21.6 and 21.7. The total contribution amount to a 401(k) plan, byboth employee and employer, cannot exceed $49,000 or 100 percent ofthe employee’s income. In 2009, the deferral by the employee cannotexceed $16,500, unless the employee is over age fifty.InternalRevenue Service (IRS), “IRS Announces Pension Plan Limitations for2009,” IR-2008-118, October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009).
| (1) | (2) | (3) | (4) | (5) | |
|---|---|---|---|---|---|
| Employees | Current Age | Salary | Allowable Compensation | Voluntary 401(k)Contribution | Contribution as a Percentage ofCompensation (4)/(3) |
| Dr. Slone | 55 | $250,000 | $245,000 | $16,500 | 5.92% |
| Diane | 45 | $55,000 | $55,000 | 3,000 | 5.45% |
| Jack | 25 | $30,000 | $30,000 | 1,200 | 4.00% |
| ADP Test 1: AverageJack’s and Diane’s contributions ([5.45% + 4.00%]/2) = 4.73%;multiply 4.73% × 1.25 = 5.91%. This figure is less than Dr. Slone’scontribution. Failed. | |||||
| ADP Test 2: 4.73% ×2 = 9.46%. 4.73% + 2 = 6.73%. The lesser of these is more than Dr.Slone’s contribution. Passed. | |||||
| Taxable Year | Salary Reduction Limit |
|---|---|
| 2005 | $14,000 |
| 2006 | $15,000 |
| 2007 | $15,500 |
| 2008 | $15,500 |
| 2009 | $16,500 |
| Taxable Year | Additional Deferral Limit (Age 50 and Older) |
|---|---|
| 2005 | $4,000 |
| 2006 | $5,000 |
| 2007 | $5,000 |
| 2008 | $5,000 |
| 2009 | $5,500 |
| 2010 | Indexedto inflation |
To receive the tax credits for 401(k), employers have to passthe average deferral percentage (ADP) test, unless they either (1)match 100 percent of the employee contribution up to 3 percent ofcompensation and 50 percent of the employee contribution between 3percent and 5 percent of compensation or (2) make a nonelective(nonmatching) contribution for all eligible nonhighly-compensatedemployees equal to at least 3 percent of compensation. Theseemployers’ contributions are considered a safe harbor. The ADP testis shown in Table 21.5 for a hypothetical elective deferral of theemployees of the Slone-Jones Dental Office.
As you can see, the ADP has two parts:
- Average the deferral percentages of the nonhighly-compensatedemployees. Multiply this figure by 1.25. Is the result greater thanthe average for the highly compensated employees? If it is, theemployer passed the test. If it is not, proceed to the nexttest.
- Take the average of the deferral percentages ofnonhighly-compensated employees. Double this percentage or add twopercentage points, whichever is less. Is the result greater thanthe average for the highly compensated employees?
If the answer is no, the employer did not pass the ADP test andthe highly compensated employees have to pay taxes on the amountsthey cannot defer. Most employers give incentives to employees tovoluntarily defer greater amounts.
As noted, strict requirements are put on withdrawals, such asallowing them only for hardships (that is, heavy and immediatefinancial needs), disability, death, retirement, termination ofemployment, or reaching age fifty-nine and a half. As in all otherqualified retirement plans, a 10 percent penalty tax applies towithdrawals made by employees before age fifty-nine and a half. Thepenalty undoubtedly discourages contributions from employees whowant easier access to their savings. Most employees would rathertake loans.
Other Qualified Plans
Tax-deferred programs for employees include individualretirement accounts (IRAs); employer-sponsored Internal RevenueCode (IRC) Section 401(k) savings/profit-sharing plans, discussedabove; IRC Section 403(b) tax-sheltered annuity (TSA) plans foremployees of educational and certain other tax-exemptorganizations; and IRC Section 457 plans for state and localgovernment employees. The TSA is a retirement plan of tax-exemptorganizations and educational organizations of state or localgovernments.
403(b) and 457 Plans
Employees of tax-exempt groups, such as hospitals or publicschools, can elect to defer a portion of their salaries forretirement in what are called 403(b) plans. Theyare similar to 401(k) plans. Section 457 plans,offered to employees of state and local governments and nonprofit,noneducational institutions, were created in 1978. They are similarto 401(k) and 403(b) plans because the money in the plan must beheld separately from employer assets, in a trust, custodialaccount, or annuity contract. The 457 plan may be offered inconjunction with another defined-contribution plan such as a 401(k)or 403(b) or a defined benefit pension plan. EGTRRA 2001 changedthe 457’s unique features and made it more comparable to the 401(k)and 403(b). Employees of governmental educational institutions candefer compensation in both 403(b) and 457 plans up to the maximumof each. Tables 21.6 and 21.7 show the new maximums for the plansunder EGTRRA 2001.
Self-employed workers can make tax-deferred contributionsthrough a Keogh plan or a simplified employee plan (SEP). Smallemployers also can establish a SEP or a savings incentive matchplan for employees of small employers (SIMPLE).
Keogh Plans
Keogh plans (also known as HR-10 plans) are forpeople who earn self-employment income. Contributions can be madebased on either full- or part-time employment. Even if the employeeis a retirement plan participant with an organization that has oneor more qualified defined benefit or defined contribution plans,the employee can establish a Keogh plan based on self-employmentearned income. For example, the employee may work full-time forwages or salary but part-time as a consultant or accountant in theevenings and on weekends. Saving part of net income fromself-employment is what Keogh is all about. Proprietors, partners,and employees can be covered in the same plan. The Keogh plan maybe designed as either a regular defined benefit or money purchaseplan with the same contribution limits.
Simplified Employee Pension Plans
A Simplified Employee Pension (SEP) is similarto an employer-sponsored individual retirement account (IRA). Witha SEP, the employer makes a deductible contribution to the IRA, butthe contribution limit is much higher than the annual deductionlimit of the typical IRA (explained in the next section). The SEPcontribution is limited to the lesser of $49,000 or 25 percent ofthe employee’s compensation in 2009.Internal Revenue Service (IRS),“IRS Announces Pension Plan Limitations for 2009,” IR-2008-118,October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009). Coverage requirements ensure that a broad crosssection of employees is included in the SEP. Employers are notlocked into an annual contribution amount, but when contributionsare made, they must be allocated in a way that does notdiscriminate in favor of highly compensated employees. The mainadvantage of the SEP is low administrative cost.
SEPs allow employers to establish and make contributions toIRAs. The two critical differences between SEP-IRAs and other IRAsare that SEP contributions are generally made by employers, notemployees, and that the limits of SEP are substantially larger.
SIMPLE Plans
Savings Incentive Match Plan for Employees(SIMPLE) plans are for employers with one hundredemployees or less. This plan was authorized by the Small BusinessJob Protection Act of 1996. Small businesses comprise over 38percent of the nation’s private work force. The maximumcontributions under EGTRRA 2001 are shown in Tables 21.8 and 21.9.Under the new limits, eligible employees can contribute up to$11,500 in 2009Internal Revenue Service (IRS), “IRS AnnouncesPension Plan Limitations for 2009,” IR-2008-118, October 16, 2008,www.irs.gov/newsroom/article/0,,id=187833,00.html (accessedApril 17, 2009). through convenient payroll deductions. Employersoffer matching contributions equal to employee contributions (up to3 percent of employee wages) or fixed contributions equal to 2percent of employee wages. This plan, like SEP, eliminates many ofthe administrative costs associated with larger retirement plans.The employees who can participate are those who earned $5,000 ormore during the preceding calendar year. This plan cannot beestablished with other qualified plans. As in all other definedcontribution plans, the employee may make the initial choice offinancial institution to receive contributions.
| Taxable Year | Salary Reduction Limit |
|---|---|
| 2005 | $10,000 |
| 2006 | $10,000 |
| 2007 | $10,500 |
| 2008 | $10,500 |
| 2009 | $11,500 |
| Taxable Year | Additional Deferral Limit (Age 50 and Older) |
|---|---|
| 2005 | $2,000 |
| 2006 | $2,500 |
| 2007 | $2,500 |
| 2008 | $2,500 |
| 2009 | $2,500 |
| 2010 | Indexedto inflation |
Individual Retirement Accounts (IRAs)
Traditional IRA and Roth IRA
When discussing other retirement plans, we includetraditional IRA and Roth IRAdespite the fact that these programs are not provided by theemployer. But they do require some level of income forparticipation. An employee cannot make contributions to an IRAwithout some level of compensation. An employee who is not part ofan employer’s program can defer compensation by establishing anindividual retirement account (IRA) or Roth IRA. This is also thevehicle for rolling over employers’ sponsored retirement accountsin order to avoid penalties and tax issues. An employee whoparticipates in the employer’s retirement plans but earns a lowincome can open an IRA or a Roth IRA. A traditional IRA allows theemployee to defer taxes on the contributions and the earning on thecontributions until the accounts are withdrawn. A Roth IRA isfunded with after-tax dollars, but the earnings on the account arenever taxed, even after the employee retires and begins drawingfrom the account. The Roth IRA is considered a wonderful programfrom a taxation planning point of view, especially during lowearning years when the tax rate is very low. The maximum allowedcontributions to the traditional IRA and Roth IRA are featured inTable 21.10 and Table 21.11.
| Taxable Year | Maximum Deductible Amount |
|---|---|
| 2002–2004 | $3,000 |
| 2005 | $4,000 |
| 2006–2007 | $4,000 |
| 2008 | $5,000 |
| 2009 | $5,000 |
| 2010 | Indexed toinflation |
| Taxable Year | Maximum Deductible Amount (Age 50 and Older) |
|---|---|
| 2002-2004 | $3,500 |
| 2005 | $4,500 |
| 2006-2007 | $5,000 |
| 2008 | $6,000 |
| 2009 | $6,000 |
| 2010 | Indexed toInflation |
Who is eligible to make tax-deferred IRA contributions? Anemployee who does not participate in an employer-sponsoredretirement plan in a particular year can make contributions up tothe amount shown in Tables 21.10 and 21.11 (or 100 percent of theemployee’s earned income if he or she is making less than thatshown in Tables 21.10 and 21.11). If the employee participates inan employer-sponsored retirement plan (that is, an employer makescontributions or provides credits on the employee’s behalf), themaximum amount of tax-deferred IRA contribution depends on incomeearned from work, but not from investments, Social Security, andother nonemployment sources. The maximum contributions for thefollowing income levels in 2009 are the following:Internal RevenueService (IRS), “2009 IRA Contribution and Deduction Limits—Effectof Modified AGI on Deduction if You Are Covered by a RetirementPlan at Work,” January 13, 2009,www.irs.gov/retirement/participant/article/0,,id=202516,00.html(accessed April 17, 2009).
The advantage of making tax-deferred contributions to any of theseveral tax-deferred, qualified programs is the deferral of incometaxes until the employee withdraws the funds from the annuity (orother tax-deferred plan such as a mutual fund). Ideally, withdrawaltakes place in retirement, many years in the future. If theemployee had not made the qualified contributions, a significantportion would have gone to government treasuries in the years theywere earned. When contributions are made to qualified plans, themoney that would otherwise have gone to pay income taxes insteadearns investment returns, along with the remainder of theemployee’s contributions.
A 10 percent federal penalty tax applies to prematurewithdrawals (those made prior to age fifty-nine and a half). Thepenalty does not apply to the following:
The Roth IRA is a program for retirement without tax implicationupon distribution, but the contributions are made with after-taxincome. The Roth IRA was instituted on January 1, 1998, as a resultof the Taxpayer Relief Act of 1997. It provides no tax deductionfor contributions, which is not a great incentive to save, butinstead it provides a benefit that is not available for any otherform of retirement savings. If certain earning requirements aremet, all earnings are tax-free when withdrawn. Other benefitsincluded under the Roth IRA are avoiding the early distributionpenalty on certain withdrawals and avoiding the need to takeminimum distributions after age seventy and a half. Roth IRA is nota pretax contribution type of retirement savings account, but it isthe only plan that allows earnings to accumulate without taximplication ever. A regular IRA provides a pretax saving, but theearnings are taxed when they are withdrawn.
Eligibility for the Roth IRA is available even if the employeeparticipates in a retirement plan maintained by the employer. Thecontribution limits are shown in Tables 21.10 and 21.11. There areearning requirements: (1) for the maximum contribution, the incomelimits are less than $105,000 for single individuals and less than$166,000 for married individuals filing joint returns; (2) theamount that can be contributed is reduced gradually and thencompletely eliminated when adjusted gross income is $120,000 ormore (single) and $176,000 or more (married, filingjointly).Internal Revenue Service (IRS), “2009 Contribution andDeduction Limits—Amount of Roth IRA Contributions That You Can Makefor 2009,” February 16, 2009,www.irs.gov/retirement/participant/article/0,,id=202518,00.html(accessed April 17, 2009).
A regular IRA can be converted to a Roth IRA if (a) the modifiedadjusted gross income is $100,000 or less, and (b) the employee issingle or files jointly with a spouse.Internal Revenue Service(IRS), “Individual Retirement Arrangements (IRAs),” Publication 590(2008),www.irs.gov/publications/p590/ch01.html#en_US_publink10006253(accessed April 17, 2009). Taxes will have to be paid in the yearof the conversion.
The Pension Protection Act of 2006 allows IRA owners who are ageseventy and a half and over to make tax-free distributions of up to$100,000 directly to tax-exempt charities. Otherwise, if nodistribution has been taken, the owner is required to take minimaldistribution and pay taxes on that amount as noted above.
The brief description presented here is introductory, and youare advised to consult the many sources for each pension plan onthe Internet and in the many books written on the topic.
Roth 401(k) and Roth 403(b) Plans
On January 1, 2006, the IRS provided for Roth 401(k) andRoth 403(b)—a new after-tax contribution feature that ispart of the EGTRRA 2001 (with a delayed effective date). The samelimits that apply to regular 401(k) and 403(b) plans apply to bothRoth plans. Thus, if an employee decides to contribute to 401(k)and Roth 401(k), the maximum combined for 2009 is $16,500, plus$5,500 for an employee over the age fifty.Internal Revenue Service(IRS) “COLA Increases for Dollar Limitations on Benefits andContributions,” February 18, 2009,www.irs.gov/retirement/article/0,,id=96461,00.html (accessedApril 17, 2009). Both Roth 401(k) and Roth 403(b) work like a RothIRA. The deferral is on an after-tax basis and the account is nevertaxed if it is held for five years. Distributions are allowed afterage fifty-nine and a half and after five years in the program.There are no income limits and no coordination limits between aRoth IRA and a Roth 403(b) or Roth IRA and Roth 401(k). ERISA401(k) plans must include the Roth contributions in the ADP test,but ADP tests do not apply to 403(b) plans, as you already know.The IRS provides ample explanation about these new accounts.Forfrequently asked questions regarding Roth 401(k) and Roth 403(b),visit the IRS Web site atwww.irs.gov/retirement/article/0,,id=152956,00.html#1(accessed April 17, 2009).
The 2006 act also permanently extended the Roth 401(k) and403(b) features that were introduced in 2006 and were scheduled tosunset in 2010. Under these provisions, employees are allowed tomake after-tax contributions to those accounts. Like the Roth IRA,there is never tax on the earnings for the Roth contributions. Thisis subject to keeping the money in the account for five years or atleast until the account holder reaches age fifty-nine and ahalf.
Retirement Savings and the Recession
The prevalence of defined contribution plans, while notpreferred by many Americans compared to the security of definedbenefit plans, has at least come to be accepted as the way of theworld. Individuals understand that the extent to which they areable to accumulate funds for retirement is largely a matter oftheir own design. A study by the Employee Benefit ResearchInstitute (EBRI) indicates that 67 percent of workers considereddefined contribution plans their primary retirement vehicle in2006, over twice the percentage reported twenty years prior.Conversely, about 31 percent of workers had defined benefit plansas their primary retirement option in 2006 compared to almost 57percent in 1988. In times of economic prosperity, retirementsavings from defined contribution plans can be a boon to employees.In return for accepting the greater risk associated with individualresponsibility for funding retirement, employees are rewarded. Onthe other hand, the negative aspects of shouldering more of thisrisk are brought into play during economic downturns. The 2008–2009recession is perhaps the first large-scale test of the resiliencyof defined contribution retirement plans under significant marketpressures.
The S&P 500 lost 37 percent of its value in 2008. Thisdecline just barely trailed the S&P’s worst-ever year of 1937(during the Great Depression). Many managed funds such as mutualfunds, exchange traded funds, and pension funds are made up ofinvestments that are representative of the S&P 500 index’sperformance. Consequently, proportionate losses were recorded inmany individuals’ retirement funds, particularly those in definedcontribution plans. Even before the negative stock returns could bequantified for the year, the director of Congressional BudgetOffice, Peter Orszag, reported in October 2008 that retirementsavings plans had lost $2 trillion over the previous fifteen monthsalone. Defined benefit plans lost 15 percent of their assets, anddefined contribution plans eroded slightly more. According to EBRI,account balances for 401(k) plans fell between 7.2 and 11.2percent. Public pension plans (like the 403[b] and Section 457plans discussed in this chapter) have also been hit hard, losing$300 billion between the second quarter of 2007 and the firstquarter of 2008. Investments in equities, like those in the S&P500, are primarily to blame for these widespread losses and are dueto the overall depreciation in stock prices. Also of note areinstitutional investments by fund managers in mortgage-backedsecurities (MBSs) that defaulted (as detailed in the box “ProblemInvestments and the Credit Crisis” in "7: Insurance Operations"), which in turn devalued portfoliosdesigned for retirement savings.
Those with defined benefit plans may be somewhat comforted bythe fact that these plans are insured by the Pension BenefitGuaranty Corporation (PBGC), as discussed in this chapter. Definedbenefit recipients will at least get something in the event ofprivate pension fund insolvency. Defined contribution planparticipants, however, are largely left to fend for themselves. Asa direct consequence of the recession, these employees have seentheir account balances shrink and their employers who contributedfunds go out of business. EBRI reports that 401(k) account balancesin excess of $200,000 have lost 25 percent of their value. Thismost affects workers between the ages of thirty-six and forty-fivewho have long tenures with their employers. Much of the growth theyhave directly contributed to and actively managed over years ordecades has been erased in short order—and these employees haveless time until retirement to rebuild their accounts than doyounger workers. EBRI posits several scenarios under whichdiminished account balances could be replenished in the future. Ata 5 percent return-on-equity rate, for example, workers agedthirty-six to forty-five who incurred moderate losses would needclose to two years to restore accounts to their 2008 end-of-yearpositions. Workers in this age range with the most severe losseswould need five years.
Burdens of the recession affecting other areas of workers’ liveshave also had carryover effects on retirement plans. Individualsstruggling to make ends meet are turning to savings, includingwithdrawals from retirement accounts. Prudential Retirement reportsthat hardship withdrawals from defined contribution plans increasedat a rate of 45 percent throughout 2007 and most of 2008. Theshort-term benefit of using such funds today produces a long-termshortfall in the form of a future needs funding gap, but for manyAmericans, this is the only option left. The American Associationfor Retired Persons (AARP) reports that 20 percent of baby boomershad stopped making voluntary contributions altogether as aconsequence of the recession. On the other side of this issue, manyemployers too announced they were suspending (at least temporarily)matching contributions to employees’ 401(k) plans. Such employersinclude companies like Coca-Cola Bottling, Motorola, UPS, GeneralMotors, and (ironically enough) the AARP. The end result of allthese problems is that more and more U.S. workers are choosing todelay their retirement plans. History is bearing this pattern out,and the recession will only serve to accelerate it.
In 1990, 22 percent of individuals aged fifty-five and olderwere working full-time; by 2007, this had increased to 30 percent.By 2016, it is not inconceivable to speculate that 80 percent ofpersons fifty-five and older will remain in the work force. Asfurther proof, an AARP poll indicates that 65 percent of workersover age forty-five believe they will need to work for a longerperiod of time if the economic trend is not soon reversed. Whenemployees do retire, they have little confidence that retirementincome will be sufficient to maintain their standards of living, assuggested by the 69 percent of respondents who anticipate cuttingback on spending during retirement. Continuing to work beyond one’snormal retirement age buys more time to accumulate income fornonworking years and increases the benefit amounts from SocialSecurity and individual retirement options. Working longer may meanputting plans and dreams on hold, but for many Americans lookingforward to enjoying any retirement at all, it is the most practicalsolution. If there’s any good news, it’s that workers today are inthe best position to afford this luxury, with life expectancies(and quality of life) of the population substantially improved overprevious generations (as discussed in "17: Life Cycle Financial Risks").
Employees unaccustomed to making long-term investment decisionshave understandably found the shift to defined contribution plansjarring. There is some evidence that employers could do a betterjob of informing workers about the realities of theirresponsibilities. EBRI found that one in four workers in thefifty-six to sixty-five age range had more than 90 percent of their401(k) account balances in equities at year-end 2007; two in fivehad more than 70 percent in equities. This degree of risk isalarming to see for individuals so close to retirement. Rather thandazzling their workers with the array and complexity of investmentoptions available to defined contribution plan participants,employers could instead emphasize sound, basic principles offinancial planning. How many employees are guided by the notionthat investments should become more conservative over time topreserve accumulated earnings and reduce risk? For example,subtracting one’s age from one hundred is a general rule of thumbthat could be used to give a rough estimate as to the proportion ofretirement assets that should be invested in stocks (with theremainder in lower-risk investments). The financial planningcommunity also stresses the importance of diversification not justto balance risk between bonds and equities, but across differentinvestment sources to ensure that one’s savings will not be spoiledbecause it was concentrated in only a few funds that performedbadly. A family needs analysis, incorporating projected futureincome requirements against earnings from Social Security, personalsavings, investments, and employer plans (like the hypotheticalcases in "23: Cases in Holistic Risk Management" and "17.6: Appendix - How Much Life Insurance to Buy?"), is anothercomponent of responsible retirement planning.
Sources: Nancy Trejos, “Retirement Savings Lose $2Trillion in 15 Months,” Washington Post, October 8, 2008,www.washingtonpost.com/wp-dyn/content/article/2008/10/07/AR2008100703358.html?sid=ST2008100702063&s_pos=,accessed March 10, 2009; “New Research from EBRI: DefinedContribution Retirement Plans Increasingly Seen as Primary Type,”Reuters, February 9, 2009,www.reuters.com/article/pressRelease/idUS166119+09-Feb-2009+PRN20090209,accessed March 10, 2009; Jack VanDerhei, “The Impact of the RecentFinancial Crisis on 401(k) Account Balances,” Employee BenefitResearch Institute (EBRI), February 2009,ebri.org/publications/ib/index.cfm?fa=ibDisp&content_id=4192,accessed March 10, 2009; Jim Connolly, “Pru Panelists: Recovery MayBe Slow,” National Underwriter Life/Health Edition,January 7, 2009,www.lifeandhealthinsurancenews.com/News/2009/1/Pages/Pru-Panelists—Recovery-May-Be-Slow.aspx,accessed March 13, 2009; “AARP to Stop Matching 401(k)Contributions,” All Things Considered (National PublicRadio), March 11, 2009, http://www.npr.org/templates/story/story.php?storyId=101751588,accessed March 13, 2009; Chris Farrell, “Why You’ll Work ThroughYour Retirement,” BusinessWeek, January 21, 2009,http://www.businessweek.com/investor/content/jan2009/pi20090121_749273.htm,accessed March 10, 2009; Peter Grier, “Fallout of Stock Market’sPlunge: Retirement Woes,” Christian Science Monitor,October 17, 2008, http://www.csmonitor.com/2008/1017/p01s06-usec.html,accessed March 10, 2009.
Key Takeaways
In this section you studied the types and features of qualifieddefined benefit plans and defined contribution plans:
- Defined benefit plans require the greatest degree of employercommitment by guaranteeing specified retirement benefits foremployees.
- Defined benefit plans use a benefit formula based on a flatdollar amount, flat percentage of pay, amount unit benefit, orpercentage unit benefit.
- The cash balance plan sets up hypothetical individualretirement accounts for employees and credits participants annuallywith plan contributions and guarantees minimum interest credit(similar to defined contribution plans, making it a hybridplan).
- Defined benefit plans may be integrated with Social Security,they provide cost-of-living adjustments, and all are insured by thePBGC.
- Salary levels, normal retirement age, employee ages, mortalityassumptions, and more influence employer funding obligations, asactuarially determined.
- Defined contribution plans require less employer commitment byguaranteeing only contribution amounts toward employees’ retirementaccounts
- Money purchase plan—most common, establishes rate of annualemployer contributions such that the benefit at retirement varieswith the contribution amount, length of participation, investmentearnings, and retirement age
- Profit-sharing plans—distribute a portion of company profitsamong participants in relation to salary
- 401(k) plans—allow employees to defer compensation forretirement before taxes, but employers must pass ADP test toreceive tax credits
- Other qualified plans allowing tax-deferred contributionsinclude 403(b), Section 457, Keogh, SEP, and SIMPLE
- 403(b)—for employees of tax-exempt organizations
- Section 457—for employees of state and local governments andnonproft, noneducational institutions
- Keogh plans—for the self-employed
- SEP—individual retirement accounts (IRAs) that employers cancontribute toward on a tax-deductible basis
- SIMPLE—for employees of small businesses
- Contributions toward qualified plans and benefits are subjectto annual IRS limits, and tax penalties are imposed for takingearly distributions
- Individual Retirement Accounts (IRAs)
- Traditional IRA—allows individuals to defer taxes on accountcontributions and earnings on contributions until account iswithdrawn, subject to annual income and contribution limits; alsothe vehicle for rolling over employers’ sponsored retirementaccounts in order to avoid penalties and tax issues
- Roth IRA—funded with after-tax dollars, but earnings on theaccount are never taxed, even when drawn upon at retirement,subject to annual income and contribution limits
- Roth 401(k) and Roth 403(b)—after-tax contribution planscreated from EGTRRA 2001 that work like the Roth IRA subject to afive-year waiting period and attainment of age fifty-nine and ahalf for distributions; have no income limits and no coordinationlimits
Discussion Questions
- As an employee with a defined benefit pension plan, which wouldyou prefer: a flat amount benefit formula that specifies $1,000 permonth, or a percentage unit benefit formula that figures yourbenefit to be 1.5 percent per year times your average annual salaryfor your highest three consecutive years of employment? Explainyour answer.
- As an employer, would you prefer a defined contribution pensionplan or a defined benefit plan? Explain your answer.
- What are the primary differences between a defined benefit planand a defined contribution plan? Create a matrix and includediscussion about:
- Who bears the risk of investment?
- What are the actuarial complexities?
- What is fixed, contributions or benefits?
- Are there separate accounts?
- Is the plan insured?
- Is the plan better for older or for younger employees?
- What is a cash balance plan? What is a cash balance conversionand what employees does it favor?
- What are the different types of deferred compensation plansavailable to employers?
- Some employers have deferred profit-sharing plans instead ofdefined benefit or defined contribution money purchase plans.Why?
- As an employee, would you prefer a deferred or an immediate(cash at the end of the year) profit-sharing plan? If your incomedoubled, would your choice change? Explain your answer.
- Compare the traditional IRA with the Roth IRA.
- What conditions need to be met for an employer to receive taxcredits for a 401(k) plan?
- What type of pension benefit plan best meet the needs of smallemployers? What are its advantages over other types of plans?