21.2: The Nature of Qualified Pension Plans

Learning Objectives

In this section we elaborate on distinguishing aspects of qualified retirement plans:

• Legislation affecting qualified retirement plans and their key provisions
• Eligibility criteria for qualified plans
• Determination of retirement age
• What is meant by vesting
• Nondiscrimination tests for qualified plans
• Treatment of plan distributions
• Loan provisions

A retirement plan may be qualified or nonqualified. The distinction is important to both employer and employee because qualification produces a plan with a favorable tax status. In a qualified plan, employer contributions to an employee’s pension during the employee’s working years are deductible as a business expense but are not taxable income to the employee until they are received as benefits. Investment earnings on funds held by the trustee for the plan are not subject to income taxes as they are earned.

Most nonqualified plans do not allow employer funding contributions to be deducted as a business expense unless they are classified as compensation to the employee, in which case they become taxable income for the employee. Investment earnings on these nonqualified accumulated pension funds are also subject to taxation. Retirement benefits from a nonqualified plan are a deductible business expense when they are paid to the employee, if not previously classified as compensation. Most nonqualified plans are for executives and designed to benefit only a small number of highly paid executives.

ERISA Requirements for Qualified Pension Plans

To be qualified, a plan must fulfill various requirements. These requirements prevent those in control of the organization from using the plan primarily for their own benefit. The following requirements are enforced by the United States Internal Revenue Service, the United States Department of Labor, and the Pension Benefit Guaranty Corporation (PBGC).

• The plan must be legally binding, in writing, and communicated clearly to all employees.
• The plan must be for the exclusive benefit of the employees or their beneficiaries.
• The principal or income of the pension plan cannot be diverted to any other purpose, unless the assets exceed those required to cover accrued pension benefits.
• The plan must benefit a broad class of employees and not discriminate in favor of highly compensated employees.
• The plan must be designed to be permanent and have continuing contributions.
• The plan must comply with the Employee Retirement Income Security Act and subsequent federal laws.

The Employee Retirement Income Security Act (ERISA) of 1974 and subsequent amendments and laws—in particular, the Tax Reform Act of 1986 (TRA86)—are federal laws that regulate the design, funding, and communication aspects of private, qualified retirement plans. The most recent amendments include the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 and the Pension Protection Act of 2006. In practice, the term ERISA is used to refer to the 1974 act and all subsequent amendments and related laws. The purpose of ERISA is twofold: to protect the benefits of plan participants and to prevent discrimination in favor of highly compensated employees (that is, those who control the organization).ERISA defines highly compensated and nonhighly compensated employees based on factors such as employee salary, ownership share of the firm, and whether the employee is an officer in the organization.

Within the guidelines and standards established by ERISA and subsequent federal laws, the employer must make some choices regarding the design of a qualified retirement plan. The main items covered by ERISA and subsequent laws and amendments are the following:

• Employee rights
• Reporting and disclosure rules
• Participation coverage
• Vesting
• Funding
• Fiduciary responsibilities
• Amounts contributed or withdrawn
• Nondiscrimination
• Tax penalties

ERISA and all subsequent laws provide significant protection to plan participants. Over time, however, the nature of the work force changed from stable and permanent positions to mobile and transient positions, and it appeared that ERISA failed to address portability issues when employees changed jobs. ERISA and subsequent laws are also considered to have administrative difficulties and to be a burden on employers. While the percentage of the working population covered is still unchanged since 1974, the number of defined benefit plans has dropped significantly, from a high of 175,000 plans in 1983, and more employees are now covered under defined contribution plans. ERISA has a safety valve for defined benefit plans with the insurance provided by the PBGC. Plans such as 401(k)s do not have such a safety valve. Information on how to protect your pensions is available from the Department of Labor and is featured in the box “Ten Warning Signs That Pension Contributions Are Being Misused” in "20: Employment-Based Risk Management (General)".

In 2001, EGTRRA addressed some of ERISA’s shortfalls and the 2006 Pension Protection Act provided some permanency to some of the EGTRRA laws. The new laws offer employers that sponsor plans more flexibility in plan funding and incentives by allowing greater tax deductions. The major benefits of EGTRRA are the increases in retirement savings limits and mandates of faster participant vesting in employers’ matching contributions to 401(k) plans. These changes became permanent with the adoption of the Pension Protection Act of 2006. Also, all employers’ contributions are now subject to faster vesting requirements. The new laws provide greater portability, increased flexibility in plan funding and design, and administrative simplification. The EGTRRA ten-year sunset provision was eliminated with the 2006 act.See information about the Pension Protection Act of 2006 at www.dol.gov/ebsa/pensionreform.html. For information about the pension laws, see many sources from the media, among them Vineeta Anand, “Lawyer Steven J. Sacher Says That for the Most Part ERISA Has Performed ‘Smashingly Well,’” Pensions & Investments, September 6, 1999, 19; Barry B. Burr, “Reviewing Options: Enron Fallout Sparks Much Soul-Searching; Experts Debate Need for Change Following Huge Losses in 401(k),” Pensions & Investments, 30 (2002): 1; William G. Gale et. al, “ERISA After 25 Years: A Framework for Evaluating Pension Reform,” Benefits Quarterly, October 1, 1998; Lynn Miller, “The Ongoing Growth of Defined Contribution and Individual Account Plans: Issues and Implications,” EBRI Issue Brief, no. 243 (2002), www.ebri.org/publications/ib/index.cfm?fa=ibDisp&content_id=160, accessed April 17, 2009; Martha Priddy Patterson, “A New Millennium for Retirement Plans: The 2001 Tax Act and Employer Flexibility,” Benefits Quarterly, January 1, 2002.

Eligibility and Coverage Requirements

A pension plan must establish eligibility criteria for determining who is covered. Most plans exclude certain classes of employees. For example, part-time or seasonal employees may not be covered. Separate plans may be set up for those paid on an hourly basis. Excluding certain classes of employees is allowed, provided the plan does not discriminate in favor of highly compensated employees, meets minimum eligibility requirements, and passes the tests noted below.

Under ERISA, the minimum eligibility requirements are the attainment of age twenty-one and one year of service. A year of service is defined as working at least 1,000 hours within a calendar year.The service requirement may be extended to two years in the small minority of plans that have immediate vesting. Vesting is defined later in the chapter. This is partly to reduce costs of enrolling employees who cease employment shortly after being hired, and partly because most younger employees attach a low value to benefits they will receive many years in the future. The Age Discrimination in Employment Act eliminates all maximum age limits for eligibility. Even when an employee is hired at an advanced age, such as seventy-one, the employee must be eligible for the pension plan within the first year of service if the plan is offered to other, younger hires in the same job.

In addition to eligibility rules, ERISA has coverage requirements that are designed to improve participation by nonhighly compensated employees. All employees of businesses with related ownership (called a controlled group) are treated for coverage requirements as if they were employees of one plan.

Retirement Age Limits

To make a reasonable estimate of the cost of some retirement plans, mainly defined benefit plans, it is necessary to establish a retirement age for plan participants. For other types of plans, mainly defined contribution plans, setting a retirement age clarifies the age at which no additional employer contributions will be made to the employee’s plan. The normal retirement age is the age at which full retirement benefits become available to retirees. Most private retirement plans specify age sixty-five as the normal retirement age.

Early retirement may be allowed, but that option must be specified in the pension plan description. Usually, early retirement permanently reduces the benefit amount. For example, an early retirement provision may allow the participant to retire as early as age fifty-five if he or she also has at least thirty years of service with the employer. The pension benefit amount, however, would be reduced to take into account the shorter time available for fund accumulation and the likely longer period that benefits will be paid out.

Early retirement plans used to be very appealing both to long-timers and to employers who saw replenishment of the work force. In 2001, companies such as Procter & Gamble, Tribune Company, and Lucent Technologies used early retirement as an alternative to layoffs. Since the decline of old-fashioned defined benefit pensions, employees have less incentive to take early retirement. With defined contribution plans, employees continue to receive the employer’s contribution or defer their compensation to a 401(k) plan as long as they work. The benefits are not frozen at a certain point, as in the traditional defined benefit plans. Mandatory retirement is considered age discrimination, except for executives in high policy-making positions. Thus, a plan must allow for late retirement. Deferral of retirement beyond the normal retirement age does not interfere with the accumulation of benefits. That is, working beyond normal retirement age may produce a pension benefit greater than would have been received at normal retirement age. However, a plan can set some limits on total benefits (e.g., $50,000 per year) or on total years of plan participation (e.g., thirty-five years). These limits help control employer costs.

Vesting Provisions

A pension plan may be contributory or noncontributory. A contributory plan requires the employee to pay all or part of the pension fund contribution. A noncontributory plan is funded only by employer contributions; that is, the employee does not contribute at all to the plan. ERISA requires that if an employee contributes to a pension plan, the employee must be able to recover all these contributions, with or without interest, if she or he leaves the firm.

Employer contributions and earnings are available to employees who leave their employment only if the employees are vested. Vesting, or the employee’s right to benefits for which the employer has made contributions, depends on the plan provisions. The TRA86 amendment to the original ERISA vesting schedule and EGTRRA 2001 established minimum standards to ensure full vesting within a reasonable period of time. The Pension Protection Act of 2006 provides that the minimum vesting requirements for employers’ contributions matches those that were required for 401(k)s by EGTRRA. For defined contribution plans, the employer can choose one of the two minimum vesting schedules (or better) as follows:

• Cliff vesting: full vesting of employer contributions after three years, as was the case for top-heavy plans and the employer-matching portion of 401(k) plans.
• Graded vesting: 20 percent vesting of employer contributions after two years, 40 percent after three years, 60 percent after four years, 80 percent after five years, and 100 percent after six years, as was the case in top-heavy plans and the employer-matching portion of 401(k) plans.

For defined benefit plans, the employer can choose one of the two minimum vesting schedules (or better) as follows:

• Cliff vesting: full vesting of employer contributions after five years, as was the case for top-heavy plans and the employer-matching portion of 401(k) plans.
• Graded vesting: 20 percent vesting of employer contributions after three years, 40 percent after four years, 60 percent after five years, 80 percent after six years, and 100 percent after seven years.

Top-heavy plans are those in which the owners or highest-paid employees hold over 60 percent of the value of the pension plan. The dollar limitation under Section 416(i)(1)(A)(i) concerning the definition of key employee in a top-heavy plan has increased from $150,000 in 2008, to $160,000 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, accessed April 17, 2009. If an employer has a top-heavy defined benefit plan, the minimum vesting schedule is as of the defined contribution plans.

Nondiscrimination Tests

The employer’s plan must meet one of the following coverage requirements:

• Percentage ratio test: The percentage of covered nonhighly compensated employees must be at least 70 percent of highly compensated employees who are covered under the pension plan. For example, if only 90 percent of the highly compensated employees are in the pension plan, only 63 percent (70 percent times 90 percent) of nonhighly compensated employees must be included.
• Average benefit test: The average benefit (expressed as a percentage of pay) for nonhighly compensated employees must be at least 70 percent of the average benefit for the highly compensated group.

The limitation used in the definition of highly compensated employee under Section 414(q)(1)(B) has increased from $105,000 in 2008 to $110,000 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, accessed April 17, 2009. Although the objective of coverage rules is to improve participation by nonhighly compensated employees, the expense and administrative burden of compliance discourages small employers from having a qualified retirement plan.

Distributions

Distributions are benefits paid out to participants or their beneficiaries, usually at retirement. Tax penalties are imposed on plan participants who receive distributions (except for disability benefits) prior to age fifty-nine and a half. However, the law requires that benefits begin by age seventy and a half, whether retirement occurs or not. Depending on the provisions of the particular plan, distributions may be made (1) as a lump sum, (2) as one of several life annuity options (as explained in the settlement options in "19: Mortality Risk Management - Individual Life Insurance and Group Life Insurance"), or (3) over the participant’s life expectancy. At age seventy and a half, the distribution requirements under ERISA direct the retiree to collect a minimum amount each year based on longevity tables.April K. Caudill, “More Clarity and Simplicity in New Required Minimum Distribution Rules,” National Underwriter, Life & Health/Financial Services Edition, May 13, 2002. Because of recent census data, Congress directed changes in the required minimum distribution calculations under EGTRRA 2001.The regulations state that the new method can be used to calculate substantially equal periodic payments under Section 72(t)—distributions of retirement funds after age seventy and a half.

The longest time period over which benefits may extend is the participant’s life expectancy. ERISA requires that pension plan design make spousal benefits available. Once the participant becomes vested, the spouse automatically becomes eligible for a qualified preretirement survivor annuity. This provision gives lifetime benefits to the spouse if the participant dies before the earliest retirement age allowed by the plan. Once the participant reaches the earliest retirement age allowed by the plan, the spouse becomes eligible for benefits under a joint and survivor annuity option. This qualifies the spouse for a lifetime benefit in the event of the participant’s death. In most cases, the spouse receives 50 percent of the annuity. Upon the employee’s retirement, the spouse remains eligible for this benefit. These benefits may be waived only if the spouse signs a notarized waiver.

Loans

Employees who need to use their account balances are advised to take a loan rather than terminate their employment and receive distribution. The distribution results not only in tax liability but also in a 10 percent penalty if the employee is younger than 59½ years old. The loan provisions require that an employee can take only up to 50 percent of the vested account balance for not more than $50,000. A loan of $10,000 may be made even if it is greater than 50 percent of the vested account balance. The number of loans is not limited as long as the total amount is within the required limits. Some employers do not provide loan provisions in their retirement plan.

Key Takeaways

In this section you studied qualified employee retirement plans, which allow tax-deductible contributions for employees and tax deferral for employees:

• Requirements are set forth by ERISA, EGTRRA 2001, TRA86, the Pension Protection Act, the IRS, and the PBGC for plans to meet qualified status.
• Eligibility criteria establish which employees are covered under a plan, and the eligibility criteria must comply with ERISA coverage requirements and the Age Discrimination in Employment Act regarding the rights of older workers.
• Normal retirement age is stipulated by employers; if allowed, early retirement reduces benefits; late retirement increases benefits.
• TRA86, ERISA, EGTRAA 2001, and the Pension Protection Act of 2006 establish minimum vesting standards regarding employees’ rights to employers’ contributions to retirement plans.
• Qualified plans must meet either the percentage ratio or average benefit nondiscrimination tests.
• The IRS imposes tax penalties on participants who receive distributions from retirement plans prior to age fifty-nine and a half and requires that benefits begin by age seventy and a half (regardless of retirement occurring).
• Spouses are entitled to preretirement survivor and joint and survivor annuity options once participants are vested or reach the earliest allowed retirement age.
• Some plans allow a participant to take loans in amounts of up to 50 percent of a vested account balance, for no more than $50,000, at a 10 percent tax penalty if the participant is under 59½ years old.

Discussion Questions

1. What is the PBGC? Why is it an important agency?
2. List ERISA requirements for qualified pension plans.
3. If an employer has 1,000 employees with 30 percent made up of highly compensated employees and 70 percent made up of nonhighly compensated employee, would the employers pass the ratio test
   1. if 200 nonhighly compensated employees are in the pension plan and all highly compensated employees are in the pension plan? Explain.
   2. if 200 nonhighly compensated employees are in the pension plan and only 50 percent of the highly compensated employees are in the pension plan? Explain.
4. Why was the ratio test created for qualified pension plans?
5. Explain briefly the changes brought about by the Pension Protection Act of 2006.
6. What happens to an employee’s retirement benefits if he or she leaves a job after five years?
7. An employer is considering the following vesting schedules. Determine if these schedules comply with the laws governing qualified retirement plans:
   1. In a defined benefit plan, full vesting after six years.
   2. In a defined benefit plan, 60 percent vesting after six years and 100 percent vesting after seven years.
   3. In a defined contribution plan, 40 percent vesting after three years and 100 percent vesting at six years
   4. In a defined contribution plan, 100 percent vesting after two years.
8. There has been a proposal that all private pension plans be required to provide full vesting at the end of one year of participation. If you were the owner of a firm employing fifty people and had a qualified pension plan, how would you react to this proposal? Explain your answer.
9. Under what circumstances would an employee elect to take a loan out of his or her defined contribution plan, rather than ask for the money?