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21.2 Types of Qualified Plans, Defined Benefit Plans, Defined Contribution Plans, Other Qualified Plans, and Individual Retirement Accounts

Learning Objectives

In this section we elaborate on the various qualified plans available through employers or on an individual basis:

  • Defined benefit pension plans: traditional defined benefit plan, 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, Roth IRA, Roth 401(k), Roth 403(b)

Types of Qualified Plans

As noted above and as shown in Figure 21.2 "Retirement Plans by Type, Limits as of 2009", employers choose a pension plan from two types: defined benefit or defined contribution. Both are qualified plans that provide tax-favored arrangements for retirement savings.

Figure 21.2 "Retirement Plans by Type, Limits as of 2009" displays the different qualified retirement plans. Defined benefit (DB) and defined contribution (DC) pension plans are shown in the first two left-hand squares. The defined contribution profit-sharing (PS) plan is shown in the third left-hand rectangle. The leftmost square represents the highest level of financial commitment by an employer; the profit-sharing rectangle represents the least commitment. The profit-sharing plan is funded at the discretion of the employer during periods of profits, whereas pension plans require annual minimum funding. This is why the employer is giving greater commitment to pension plans—contributions are required even in bad years. Among the pension plans, the traditional defined benefit plan represents the highest level of employer’s commitment. It is a promise that the employee will receive a certain amount of income replacement at retirement. The benefits are defined by a mathematical formula, as will be shown later. Actuaries calculate the amount of the annual contribution necessary to fund the retirement promise given by the employer. As noted above, the PBGC provides insurance to guarantee these benefits (up to the maximum shown above) at a cost to the employer of $34 per employee per year (since 2009). Because the traditional defined benefit pension plan is the plan with the greatest commitment, usually a high level of contribution is allowed for older employees. The annual compensation limit under IRS 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 the limitation on the annual benefit under a defined benefit plan under Section 415(b)(1)(A) has increased from $185,000 to $195,000 in 2009 or 100 percent of compensation.Internal Revenue Service (IRS), “IRS Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009). These are shown in Figure 21.2 "Retirement Plans by Type, Limits as of 2009".

Another defined benefit plan is the cash balance plan. As discussed above, it is a hybrid of the traditional defined benefit plan and defined contribution plans. In a cash balance plan, the employer commits to contribute a certain percentage of compensation each year and guarantees a rate of return. Under this arrangement, employees are able to calculate the exact lump sum that will be available to them at retirement because the employer guarantees both contributions and earnings. This plan favors younger employees. It is currently the topic of court cases and debate because many large corporations such as IBM converted their traditional defined benefits plans to cash balance, grandfathering the 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 Plan Review 45, no. 9 (1991): 50–51; Arleen Jacobius, “Motorola Workers Embrace New Hybrid Pension Plan,” Business Insurance 34, no. 45 (2000): 36–37; Karl Frieden, “The Cash Balance 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 of Cash Balance Pensions,” Business Insurance 20, no. 39 (1986): 15–20; September 29, 1986; Arleen Jacobius, “60 percent of Workers 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; “American Benefits Council President Discusses Cash Balance Plans, Pension Reform,” Employee Benefit Plan Review 55, no. 4 (2000): 11–13; Donna Ritter Mark, “Planning to Implement a Cash Balance Pension Plan? Examine the Issues First,” Compensation & Benefits Review 32, no. 5 (2000): 15–16; Vineeta Anand, “Young and 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: Navigating the Issues,” Journal of Financial Planning 13, no. 9 (2000): 44–48. See the box, “Cash Balance Conversions: Who Gets Hurt?”

A cash balance plan is considered a hybrid plan because the contributions are guaranteed. The benefits are not explicitly defined but are the outcome of the length of time the employee is in the pension plan. Because both the contributions and rates of return are guaranteed, the amount available at retirement is therefore also guaranteed. It is an insured plan under the PBGC, and all funds are kept in one large account administered by the employer. The employees have only hypothetical accounts that are made of the contributions and the guaranteed returns. As noted above, it is a defined benefit plan that looks like a defined contribution plan.

The simplest of the defined contribution pension plans is the money purchase plan. Under this plan, the employer guarantees only the annual contribution but not any returns. As opposed to a defined benefit plan, where the employer keeps all the monies in one account, the defined contribution plan has separate accounts under the control of the employees. The investment vehicles in these accounts are limited to those selected by the employer who contracts with various financial institutions to administer the investments. If employees are successful in their investment strategy, their retirement benefits will be larger. The employees are not assured an amount at retirement, and they have the investment risk, not the employer. This aspect is illuminated by the 2008–2009 recession and discussed in the box “Retirement Savings and the Recession.” Because the employer is at less of an investment risk here and the employer’s commitment is lower, the tax benefit is not as great (especially for older employees). The limitation for defined contribution plans under Section 415(c)(1)(A) has increased from $46,000 in 2008 to $49,000 in 2009 or 100 percent of the employee’s compensation.Internal Revenue Service (IRS), “IRS Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009).

Another defined contribution plan is the target pension plan, which favors older employees. This is another hybrid plan, but this is actually a defined contribution plan (subject to the $49,000 and 100 percent limitation in 2009) that looks like a traditional defined benefits plan in its first year only. Details about this plan are beyond the scope of this text.

For employers seeking the least amount of commitment, the profit-sharing plan is the solution. These are defined contribution plans that are not pension plans. There is no minimum funding requirements each year. As of 2003 and onward, the maximum allowed tax deductible contribution by employer per year is 25 percent of payroll. This is also a major change in effect after the enactment of 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 25 percent in 2001. The additions to each account are up to the lesser of $49,000 or 100 percent of compensation in 2009.Internal Revenue Service (IRS), “IRS Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009). The 401(k) is part of the tax code for a profit-sharing plan, but it is not designed as an employer contribution. Rather, it is a pretax-deferred compensation contribution by the employee with possible matching by an employer. See Tables 21.6 and 21.7 later in this chapter for the limits if the employer meets the discrimination testing or falls under certain safe-harbor provisions. As shown, EGTRRA 2001 increased the permitted deferred compensation under 401(k) plans gradually up to $16,500Internal Revenue Service (IRS), “IRS Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009). (in 2009) from the level of $10,500 in 2001. On January 1, 2006, Internal Revenue Code (IRC) §402A providing for Roth 401(k)s and Roth 403(b)s (discussed later) became effective. This also is an outcome of EGTRRA 2001 with a delayed effective date. Roth 401(k) and Roth 403(b) means that the contributions are after-tax, but earnings are never taxed. EGTRRA 2001 has catch-up provisions. The explanation of the 401(k) plan includes an example of the average deferral percentage (ADP) discrimination test used for 401(k) plans. When an employer adds matching, profit sharing, or any other defined contribution plans, the amount of annual additions 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 Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009). The combination of 401(k) and any other profit-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 from EBRI: Defined Contribution Retirement Plans Increasingly Seen as Primary Type,” Reuters, February 9, 2009, http://www.reuters.com/article/pressRelease/idUS166119+09-Feb-2009+PRN20090209, accessed March 10, 2009.

An employee stock ownership plan (ESOP) is another type of profit-sharing plan. An ESOP is covered only briefly in this text. This section also provides a brief description of other qualified plans such as 403(b), 457, Savings Incentive Match Plan for Employees (SIMPLE), Simplified Employee Pension (SEP), traditional IRA, and Roth IRA. EGTRRA 2001 made major changes to these plans, as well as to the plans discussed so far. Traditional IRA and Roth IRA are not sponsored by the employer, but require employee compensation through employment.

Cash Balance Conversions: Who Gets Hurt?

Over the past two decades, a number of employers have switched their traditional defined benefit pension plans to cash balance plans. Employers like cash balance plans because they are less expensive than traditional plans, in part, because they do not require the high administrative cost and large contributions for employees who are near retirement. Also, cash balance benefit plans may pay out less because they base their benefits on an employee’s career earnings, while defined benefit plans are based on the final years of salary, when earnings usually peak.

In November 2002, Delta Airlines joined the cash balance trend, citing the soaring costs of its underfunded traditional pension plan as the reason. Like Delta, many companies have implemented cash balance plans by converting their old defined benefit plans. In doing so, they determine an employee’s accrued benefit under the old plan and use it to set an opening balance for a cash balance account. While the opening account of a cash balance account can end up being less than the actual present value of the benefits an employee has already accrued (called wear away), cash balance plans have the advantage of portability. The traditional defined benefits plan is not portable because an employee who leaves a job may need to leave the accrued and vested benefits with the employer until retirement. Cash balance plans are considered very portable. The plan is similar to defined contribution plans because the employee knows at any moment the value of his or her hypothetical account that is built up as an accumulation of employer’s contributions and guaranteed rate of return. For this reason, cash balance plans are advertised as advantageous for today’s mobile work force. Also, cash balance plans are considered best for younger workers because these employees have many years to accumulate their hypothetical account balances.

However, these conversions have not been free of major controversies. Older employees, who do not have a long enough time to accumulate the account balance, in most cases are granted continuation under the old plan, under a grandfather clause. Midcareer employees in their forties have most to risk because it is uncertain whether the new cash balance plans can actually catch up to the old promise of defined benefits at age sixty-five. Plan critics have repeatedly charged that pay credits discriminate against older employees because the credits they receive would purchase a smaller annuity at normal retirement age than would those received by younger employees. Numerous lawsuits alleging discrimination have been filed against employers offering the plans.

IBM’s conversion in 1999 provides a notorious example of the pitfalls of conversion for midcareer employees. When IBM announced the conversion, it was inundated with hundreds of thousands of e-mails complaining about the change, so the company repeatedly tweaked its plan. Still, many employees are not satisfied when they compare the new plan with the defined benefit plan they might otherwise have received. A federal court gave a final approval to partial settlement between IBM and tens of thousands of current and former employees about the conversion. Under one part of the settlement, IBM has to pay more than $300 million to plan participants in the form of enhanced benefits. Since the partial settlement was proposed, IBM had frozen its cash balance plan, with employees hired as of January 1, 2005, receiving pension coverage under an enriched 401(k) plan.

The 2005 U.S. Government Accountability Office (GAO) report regarding cash balance pension plans concluded that cash balance plans do cut benefits. In July 2005, congressional committees passed legislation to make clear that cash balance plans do not violate age discrimination law, but the measures do not apply to existing plans. This relates to a court case that provided victory for employers. The judge dismissed a case against PNC Financial Services Group that was brought on behalf of its employees and retirees in connection with the company’s switch to a cash balance plan. The Pittsburgh-based PNC replaced its traditional defined benefit plan in 1999. The plaintiffs filed suit against the company and its pension plan in December 2004, arguing that the plan was age discriminatory, among other allegations. Judge D. Davis Legrome of the U.S. District Court in Philadelphia dismissed all the charges against the company in his decision (Sandra Register v. PNC Financial Services Group, Inc.).

To soften the effects of cash balance conversion, many companies offer transitional benefits to older employers. Some companies allow their workers to choose between the traditional plan and the cash balance plan. Others offer stock options or increased contributions to employee 401(k) plans to offset the reduction in pension benefits.

Questions for Discussion

  1. Who actually is the beneficiary of the conversions? The employer? All employees? Or only some? Is it ethical to change promises to employees?
  2. Are conversions to cash balance plans a reflection of the lowering of the noncash compensation (pension offering) of employers in the last two decades? Or are they just a smart move to accommodate the mobile work force? Is it ethical to make a noncash compensation reduction without reaching an agreement with employees?
  3. Is the fact that many employers are trying to get away from the traditional defined benefits plans that are similar to the current Social Security system a signal that Social Security will be privatized? Would it be ethical to make changes that may not be clear to employees (see Chapter 18 "Social Security")?

Sources: Jerry Geisel, “Delta’s New Pension Plan to Generate Big Savings,” Business Insurance, November 25, 2002, http://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 in Cash Balance Pension Plan Conversions,” Benefits Quarterly, January 1, 2001, 27–32; Lawrence J. Sher, “Survey of Cash Balance Conversions,” Benefits Quarterly, January 1, 2001, 19–26; Robert L. Clark, John J. Haley, and Sylvester J. Schieber, “Adopting Hybrid Pension Plans: Financial and Communication Issues,” Benefits Quarterly, January 1, 2001, p. 7–17; “Cash Balance Plans Questions & Answers,” U.S. Department of Labor, November 1999, https://www.dol.gov/ebsa/publications/cb_pension_plans.html (accessed April 17, 2009); Jerry Geisel, “Proposed Rules Clarify Cash Balance Plan Status,” Business Insurance, December 10, 2002.; Jerry Geisel “Court Gives Final Approval in IBM Pension Case,” Business Insurance, August 15, 2005, http://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 Cash Balance Doubts Criticized for Ignoring Existing Plans,” Business Insurance , August 1, 2005, http://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 Favors Cash Balance Conversions,” Business Insurance, November 23, 2005, http://www.businessinsurance.com/cgi-bin/news.pl?newsId=6781, accessed April 17, 2009; Jerry Geisel “Cash Balance Plan Conversions Cut Benefits: GAO,” Business Insurance, November 4, 2005.

Defined Benefit Plans

A defined benefit (DB) planType of pension plan that assures employees of a certain amount at retirement, leaving all risk to the employer to meet the specified commitment; accumulated funds for all participants are managed in one account. has the distinguishing characteristic of clearly defining, by its benefit formula, the amount of benefit that will be available at retirement. That is, the benefit amount is specified in the written plan document, although the amount that must be contributed to fund the plan is not specified.

Traditional Defined Benefit Plan

In a defined benefit plan, any of several benefit formulas may be 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 employer selects the formula that best meets both the needs of employees for economic 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 the amount can be calculated, yielding a flat percentage of current annual salary (or the average salary of the past five years or so). For example, a plan may specify that each employee with at least twenty years of participation in the plan receives 50 percent of his or her average annual earnings during the three consecutive years of employment with the highest earnings. A flat amount unit benefit formula assigns a flat amount (e.g., $25) with each unit of service, usually with each year. Thus, an employee with thirty units of service at retirement would receive a benefit equal to thirty times the unit amount.

The most popular defined benefit formula is the percentage unit benefit plan. It recognizes both the employee’s years of service and level of compensation. See Table 21.1 "The Slone-Jones Dental Office: Standard Defined Benefit Pension Plan (Service Unit Formula, 2009)" for an example. Tables 21.1 through 21.5 feature different qualified retirement plans for the Slone-Jones Dental Office. The dental office is used as an example to demonstrate how each plan would work for the same mix of employees.

Table 21.1 The Slone-Jones Dental Office: Standard Defined Benefit Pension Plan (Service Unit Formula, 2009)

(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 a recent number of years (e.g., the last three or highest consecutive five years), the formula is referred to as a final average formulaSets the compensation base as compensation for a recent number of years (e.g., the last three or highest consecutive five years) in computing the retirement benefit in a defined benefit plan; tends to keep the initial benefit in line with inflation.. Relative to a career average formulaBases benefits on average compensation for all years of service under the plan in computing the retirement benefit in a defined benefit plan., which bases benefits on average compensation for all years of service in the plan, a final average plan tends to keep the initial retirement benefit in line with inflation.

Two types of service are involved in the benefit formula: past service and future service. Past service refers to service prior to the installation of the plan. Future service refers to service subsequent to the installation of the plan. If credit is given for past service, the plan starts with an initial past service liability at the date of installation. To reduce the size of this liability, the percentage of credit for past service may be less than that for future service, or a limit may be put on the number of years of past service credit. Initial past service liability may be a serious financial problem for the employer starting or installing a pension plan. Past service liability or supplemental liabilityIn a retirement benefit formula, past service liability giving credit to employees’ service prior to the adoption of a defined benefits plan; can be amortized over a certain number of years. can be amortized over a certain number of years, not to exceed thirty years for a single employer.

Cash Balance Plan

The cash balance planDefined benefit plan that is a hybrid of the traditional defined benefit plan and a defined contribution plan where the employer commits to contribute a certain percentage of compensation each year and guarantees a rate of return such that employees can calculate the exact lump sum that will be available at retirement (since the employer guarantees both contributions and earnings). does not provide an amount of benefit that will be available for the employee at retirement. Instead, the cash balance plan sets up a hypothetical individual account for each employee, and credits each participant annually with a plan contribution (usually a percentage of compensation). The employer also guarantees a minimum interest credit on the account balance. For example, an employer might contribute 10 percent of an employee’s salary to the employee’s plan each year and guarantee a minimum rate of return of 4 percent on the fund, as shown in Table 21.2 "The Slone-Jones Dental Office: Standard Cash Balance Plan (2009)". If investment returns turn out to be higher than 4 percent, the employer may credit the employee account with the higher rate. The amount available to the employee at retirement varies, based on wage rates and investment rates of return. Although the cash balance plan is technically a defined benefit plan, it has many of the same characteristics as defined contribution plans. These characteristics include hypothetical individual employee accounts, a fixed employer contribution rate, and an indeterminate final benefit amount because employee compensation changes over time and interest rates may turn out to be well above the minimum guaranteed rate.

Table 21.2 The Slone-Jones Dental Office: Standard Cash Balance Plan (2009)

(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 at 4% 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 account for inflation during the retirement years. A plan that includes a cost-of-living adjustment (COLA)Increases retirement benefits automatically with changes in a cost-of-living or wage index to account for inflation during retirement years. clause has the ideal design feature. Benefits increase automatically with changes in a cost-of-living or wage index.

Many plans integrate the retirement benefit with Social Security benefits. An integrated planDefined benefit plan that coordinates Social Security benefits (or contributions) with the benefit (or contribution) formula, thus reducing private retirement benefits based on the amount received through Social Security and lowering employer costs. coordinates Social Security benefits (or contributions) with the private plan’s benefit (or contribution) formula. Integration reduces private retirement benefits based on the amount received through Social Security, thus reducing the cost to employers of the private plan. On the other hand, integration allows employees with higher income to receive greater benefits or contributions, depending on the formula. The scope of this text is too limited to explore the exact mechanism of integrated plans. There are two kinds of plans. The offset method reduces the private plan benefit by a set fraction. This approach is applicable only to defined benefit plans. The second method is the integration-level method. Here, a threshold of compensation, such as the wage base level shown in Chapter 18 "Social Security", is specified, and the rate of benefits or contributions provided below this compensation threshold is lower than the rate for compensation above the threshold. The integration-level method may be used for defined benefit or defined contribution pension plans.

As noted above, defined benefits up to specified levels are guaranteed by the Pension Benefit Guarantee Corporation (PBGC)Federal agency that ensures the benefits of defined benefit plans up to annual limits in case the pension plan cannot meet its obligations., a federal insurance program somewhat like the Federal Deposit Insurance Corporation (FDIC) for commercial bank accounts, and like the Guarantee Funds for Insurance. All defined benefit plans contribute an annual fee (or premium) per pension plan participant to finance benefits for members of insolvent terminated plans. The premium amount takes into account, to a degree, the financial soundness of the particular plan, measured by the plan’s unfunded vested benefit. Thus, plans with a greater unfunded vested benefit pay a greater PBGC premium (up to a maximum amount), providing an incentive to employers to adequately fund their pension plans. Despite this incentive, there is national concern about the number of seriously underfunded pension plans insured by the PBGC. If these plans were unable to pay promised retirement benefits, the PBGC would be liable, and PBGC funds may be insufficient to cover the claims. Taxpayers could end up bailing out the PBGC. Careful monitoring of PBGC fund adequacy continues, and funding rules may be tightened to keep the PBGC financially sound.

Defined Benefit Cost Factors

Annual pension contributions and plan liabilities for a defined benefit plan must be estimated by an actuary. (Actuaries with pension specialties are called enrolled actuaries.) The time value of money explained in Chapter 4 "Evolving Risk Management: Fundamental Tools" is used extensively in the computations of pensions. The defined amount of benefits becomes the employer’s obligation, and contributions must equal whatever amount is necessary to fund the obligation. The estimate of cost depends on factors such as salary levels; normal retirement age; current employee ages; and assumptions about mortality, turnover, investment earnings, administrative expenses, and salary adjustment factors (for inflation and productivity). These factors determine estimates of how many employees will receive retirement benefits, how much they will receive, when benefits will begin, and how long benefits will be paid.

Normal costsIn defined benefit plans, the annual amount needed to fund pension benefits during an employee’s working years. reflect the annual amount needed to fund the pension benefit during the employee’s working years. Supplemental costsIn defined benefit plans, the amounts necessary to amortize any past service liability over a period that may vary from ten to thirty years. are the amounts necessary to amortize any past service liability, which is explained above, over a period that may vary from ten to thirty years. Total cost for a year is the sum of normal and supplemental costs. Under some methods of calculation, normal and supplemental costs are estimated as one item. Costs may be estimated for each employee and then added to yield total cost, or a calculation may be made for all participants on an aggregate basis.

Defined benefit plan administration is expensive compared with defined contribution plans because of actuarial expense and complicated ERISA regulations. This explains in part why about 75 percent of the plans established since the passage of ERISA have been defined contribution plans.

Defined Contribution Plans

A defined contribution (DC) planType of pension plan that promises only to contribute an amount to the employee’s separate or individual account; the employee has the investment risk and no assurances of the level of retirement amount; has separate accounts under the control of each participant. is a qualified pension plan in which the contribution amount is defined but the benefit amount available at retirement varies. This is in direct contrast to a defined benefit plan, in which the benefit is defined and the contribution amount varies. As with the defined benefit plan, when the defined contribution plan is initially designed, the employer makes decisions about eligibility, retirement age, integration, vesting schedules, and funding methods.

The most common type of defined contribution plan is the money purchase planIn this simplest of the defined contribution plans, the employer guarantees only the annual contribution to an employee’s retirement account, but not any returns.. This plan establishes an annual rate of employer contribution, usually expressed as a percentage of current compensation; for example, a plan may specify that the employer will contribute 10 percent of an employee’s salary, as shown in the example in Table 21.3 "The Slone-Jones Dental Office: Standard Money Purchase Plan (2009)". Separate accounts are maintained to track the current balance attributable to each employee, but contributions may be commingled for investment purposes.

Table 21.3 The Slone-Jones Dental Office: Standard Money Purchase Plan (2009)

(1) (2) (3) (4) (5) (6) (7) (8) (9)
Employees Age Current Salary Allowed Compensation Service Maximum Contribution Allowed Contribution at 10.00% (3) × 0.10 Years to Retirement Future Value of $1 Annuity at 10% 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 contribution amount, the length of covered service, investment earnings, and retirement age, as you can see in Column 9 of Table 21.3 "The Slone-Jones Dental Office: Standard Money Purchase Plan (2009)". Some plans allow employees to direct the investment of their own pension funds, offering several investment options. Generally, retirement age has no effect on a distribution received as a lump sum, fixed amount, or fixed period annuity. Retirement age affects the amount of income received only under a life annuity option.

From the perspective of an employer or employee concerned with the adequacy of retirement income, the contributions that typically have the longest time to accumulate with compound investment returns are the smaller ones. They are smaller because the compensation base (to which the contribution percentage is applied) is lowest in an employee’s younger years. This is perhaps the major disadvantage of defined contribution plans. It is also difficult to project the amount of retirement benefit until retirement is near, which complicates planning. In addition, the speculative risk of investment performance (positive or negative returns) is borne directly by employees.

From an employer’s perspective, however, such plans have the distinct advantage of a reasonably predictable level of pension cost because they are expressed as a percentage of current payroll. Because the employer promises only to specify a rate of contribution and prudently manage the plan, actuarial estimates of annual contributions and liabilities are unnecessary. The employer also does not contribute to the Pension Benefit Guaranty Corporation, which applies only to defined benefit plans. Most new plans today are defined contribution plans, which is not surprising given their simplicity, lower administrative cost, and limited employer liability for funding.

Other Qualified Defined Contribution Plans

Employers may offer a variety of defined contribution plans other than money purchase plans to assist employees in saving for retirement. These may be the only retirement plans offered by the organization, or they may be offered in addition to a defined benefit plan or a defined contribution money purchase plan, as you can see in Case 2 of Chapter 23 "Cases in Holistic Risk Management". One such defined contribution plan is the target planHybrid age-weighted defined contribution plan in which each employee is targeted to receive the same formula of benefit at retirement, but the benefits are not guaranteed; older employees receive a larger contribution as a percentage of compensation than younger employees since they have less time to accumulate funds to retirement., which is an age-weighted pension plan. Under this plan, each employee is targeted to receive the same formula of benefit at retirement (age sixty-five), but the benefits are not guaranteed. Because older employees have less time to accumulate the funds for retirement, they receive a larger contribution as a percentage of compensation than the younger employees do. The target plan is a hybrid of defined benefits and defined contribution plans, but it is a defined contribution pension plan with the same limits and requirements as defined contribution plans.

Profit-Sharing Plans

All profit-sharing plansIncentive defined contribution plans whereby employers may voluntarily elect to annually distribute a specified portion of company profits among employees in relation to salary. are defined contribution plans. They are considered incentive plans rather than pension plans because they do not have annual funding requirements. Profit-sharing plans provide economic incentives for employees because firm profits are distributed directly to employees. In a deferred profit-sharing planProfit sharing plan in which the employer puts part of its profits in trust for the benefit of employees., a firm puts part of its profits in trust for the benefit of employees. Typically, the share of profit allocated is related to salary; that is, the share each year is the percentage determined by the employee’s salary divided by total salaries for all participants in the plan. Per EGTRRA 2001, the maximum amount of contribution is 25 percent of the total payroll of all employees.

Table 21.4 "The Slone-Jones Dental Office: Standard Profit Sharing Plan (2009)", featuring again the Slone-Jones Dental Office, shows an allocation of profit sharing should the employer decide to contribute $30,000 to the profit-sharing plan. The allocation is based on the percentage of each employee’s pay from total payroll allowed (see Column 4 in Table 21.4 "The Slone-Jones Dental Office: Standard Profit Sharing Plan (2009)"). The maximum profits to be shared in 2009 cannot be greater than an allocation of $49,000 for top employees.Internal Revenue Service (IRS), “IRS Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009). If the maximum compensation allowed is $245,000 and the maximum contribution is $49,000, in essence the contribution to the account of an employee making $245,000 or more would not be more than 20 percent.

Table 21.4 The Slone-Jones Dental Office: Standard Profit Sharing Plan (2009)

(1) (2) (3) (4) (5)
Employees Current Age Salary Maximum Allowed Compensation Percentage of Pay from Total Adjusted Payroll (3)/330,000 Allocation of $30,000 Profits (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)Special type of profit sharing plan where all investments are in employer’s common stock. is a special form of profit-sharing plan. The unique feature of an ESOP is that all investments are in the employer’s common stock. Proponents of ESOPs claim that this ownership participation increases employee morale and productivity. Critics regard it as a tie-in of human and economic capital in a single firm, which may lead to complete losses when the firm is in trouble. An illustration of the hardship that can occur when employees invest in their company is Enron, a case we noted earlier.

An ESOP represents the ultimate in investment concentration because all contributions are invested in one security. This is distinctly different from the investment diversification found in the typical pension or profit-sharing plan. To alleviate the ESOP investment risk for older employees, employers are required to allow at least three diversified investment portfolios for persons over age fifty-five who also have at least ten years of participation in the plan. Each diversified portfolio contains several issues of nonemployer securities, such as common stocks or bonds. One option might even be a low-risk investment, such as bank certificates of deposit. This allows use of an incentive-type qualified retirement plan without unnecessarily jeopardizing the future retiree’s benefits.

401(k) Plans

Another qualified defined contribution plan is the 401(k) planDefined contribution plan that allows an employee to defer before-tax compensation toward a retirement account, which may be matched or supplemented by employer contributions., which allows employees to defer compensation for retirement before taxes. Refer to the example of deferral in Table 21.5 "The Slone-Jones Dental Office: ADP Tests for 401(k) Plan (2009)". As you can see, contributions to a 401(k) plan are limited per the description in Figure 21.2 "Retirement Plans by Type, Limits as of 2009" and Tables 21.6 and 21.7. The total contribution amount to a 401(k) plan, by both employee and employer, cannot exceed $49,000 or 100 percent of the employee’s income. In 2009, the deferral by the employee cannot exceed $16,500, unless the employee is over age fifty.Internal Revenue Service (IRS), “IRS Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009).

Table 21.5 The Slone-Jones Dental Office: ADP Tests for 401(k) Plan (2009)

(1) (2) (3) (4) (5)
Employees Current Age Salary Allowable Compensation Voluntary 401(k) Contribution Contribution as a Percentage of Compensation (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: Average Jack’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’s contribution. 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.

Table 21.6 Limits for 401(k), 403(b) [also Roth 401(k) and 403(b)], and 457 Plans

Taxable Year Salary Reduction Limit
2005 $14,000
2006 $15,000
2007 $15,500
2008 $15,500
2009 $16,500

Table 21.7 Additional Limits for Employees over 50 Years of Age for 401(k), 403(b) [also Roth 401(k) and 403(b)], and 457 Plans

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 Indexed to inflation

To receive the tax credits for 401(k), employers have to pass the average deferral percentage (ADP) test, unless they either (1) match 100 percent of the employee contribution up to 3 percent of compensation and 50 percent of the employee contribution between 3 percent and 5 percent of compensation or (2) make a nonelective (nonmatching) contribution for all eligible nonhighly-compensated employees equal to at least 3 percent of compensation. These employers’ contributions are considered a safe harbor. The ADP test is shown in Table 21.5 "The Slone-Jones Dental Office: ADP Tests for 401(k) Plan (2009)" for a hypothetical elective deferral of the employees of the Slone-Jones Dental Office.

As you can see, the ADP has two parts:

  • Average the deferral percentages of the nonhighly-compensated employees. Multiply this figure by 1.25. Is the result greater than the average for the highly compensated employees? If it is, the employer passed the test. If it is not, proceed to the next test.
  • Take the average of the deferral percentages of nonhighly-compensated employees. Double this percentage or add two percentage points, whichever is less. Is the result greater than the average for the highly compensated employees?

If the answer is no, the employer did not pass the ADP test and the highly compensated employees have to pay taxes on the amounts they cannot defer. Most employers give incentives to employees to voluntarily defer greater amounts.

As noted, strict requirements are put on withdrawals, such as allowing them only for hardships (that is, heavy and immediate financial needs), disability, death, retirement, termination of employment, or reaching age fifty-nine and a half. As in all other qualified retirement plans, a 10 percent penalty tax applies to withdrawals made by employees before age fifty-nine and a half. The penalty undoubtedly discourages contributions from employees who want easier access to their savings. Most employees would rather take loans.

Other Qualified Plans

Tax-deferred programs for employees include individual retirement accounts (IRAs); employer-sponsored Internal Revenue Code (IRC) Section 401(k) savings/profit-sharing plans, discussed above; IRC Section 403(b) tax-sheltered annuity (TSA) plans for employees of educational and certain other tax-exempt organizations; and IRC Section 457 plans for state and local government employees. The TSA is a retirement plan of tax-exempt organizations and educational organizations of state or local governments.

403(b) and 457 Plans

Employees of tax-exempt groups, such as hospitals or public schools, can elect to defer a portion of their salaries for retirement in what are called 403(b) plansAllows employees of tax-exempt entities to defer compensation toward retirement accounts, similar to 401(k) plans.. They are similar to 401(k) plans. Section 457 plansAllows employees of state and local governments and nonproft, noneducational institutions to defer compensation toward retirement accounts, similar to 401(k) plans; the money must be held separately from employer assets in a trust, custodial account, or annuity contract., offered to employees of state and local governments and nonprofit, noneducational institutions, were created in 1978. They are similar to 401(k) and 403(b) plans because the money in the plan must be held separately from employer assets, in a trust, custodial account, or annuity contract. The 457 plan may be offered in conjunction with another defined-contribution plan such as a 401(k) or 403(b) or a defined benefit pension plan. EGTRRA 2001 changed the 457’s unique features and made it more comparable to the 401(k) and 403(b). Employees of governmental educational institutions can defer compensation in both 403(b) and 457 plans up to the maximum of each. Tables 21.6 and 21.7 show the new maximums for the plans under EGTRRA 2001.

Self-employed workers can make tax-deferred contributions through a Keogh plan or a simplified employee plan (SEP). Small employers also can establish a SEP or a savings incentive match plan for employees of small employers (SIMPLE).

Keogh Plans

Keogh plansAllow tax-deferred retirement contributions toward retirement savings for self-employed persons. (also known as HR-10 plans) are for people who earn self-employment income. Contributions can be made based on either full- or part-time employment. Even if the employee is a retirement plan participant with an organization that has one or more qualified defined benefit or defined contribution plans, the employee can establish a Keogh plan based on self-employment earned income. For example, the employee may work full-time for wages or salary but part-time as a consultant or accountant in the evenings and on weekends. Saving part of net income from self-employment is what Keogh is all about. Proprietors, partners, and employees can be covered in the same plan. The Keogh plan may be designed as either a regular defined benefit or money purchase plan with the same contribution limits.

Simplified Employee Pension Plans

A Simplified Employee Pension (SEP)Allows employers to make deductible contributions to employee individual retirement accounts (IRAs) at higher limits than the traditional IRA. is similar to an employer-sponsored individual retirement account (IRA). With a SEP, the employer makes a deductible contribution to the IRA, but the contribution limit is much higher than the annual deduction limit of the typical IRA (explained in the next section). The SEP contribution is limited to the lesser of $49,000 or 25 percent of the employee’s compensation in 2009.Internal Revenue Service (IRS), “IRS Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009). Coverage requirements ensure that a broad cross section of employees is included in the SEP. Employers are not locked into an annual contribution amount, but when contributions are made, they must be allocated in a way that does not discriminate in favor of highly compensated employees. The main advantage of the SEP is low administrative cost.

SEPs allow employers to establish and make contributions to IRAs. The two critical differences between SEP-IRAs and other IRAs are that SEP contributions are generally made by employers, not employees, and that the limits of SEP are substantially larger.

SIMPLE Plans

Savings Incentive Match Plan for Employees (SIMPLE)Allow employees of small businesses who meet income eligibility to make retirement savings contributions through payroll deductions that can be supplemented by employer contributions. plans are for employers with one hundred employees or less. This plan was authorized by the Small Business Job Protection Act of 1996. Small businesses comprise over 38 percent of the nation’s private work force. The maximum contributions 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 Announces Pension Plan Limitations for 2009,” IR-2008-118, October 16, 2008, http://www.irs.gov/newsroom/article/0,,id=187833,00.html (accessed April 17, 2009). through convenient payroll deductions. Employers offer matching contributions equal to employee contributions (up to 3 percent of employee wages) or fixed contributions equal to 2 percent of employee wages. This plan, like SEP, eliminates many of the administrative costs associated with larger retirement plans. The employees who can participate are those who earned $5,000 or more during the preceding calendar year. This plan cannot be established with other qualified plans. As in all other defined contribution plans, the employee may make the initial choice of financial institution to receive contributions.

Table 21.8 SIMPLE Plan Limits

Taxable Year Salary Reduction Limit
2005 $10,000
2006 $10,000
2007 $10,500
2008 $10,500
2009 $11,500

Table 21.9 SIMPLE Plan Limits for Employees Age Fifty or Older

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 Indexed to inflation

Individual Retirement Accounts (IRAs)

Traditional IRA and Roth IRA

When discussing other retirement plans, we include traditional IRAIndividual retirement account that allows individuals to defer taxes on account contributions and earnings on contributions until the account is withdrawn, subject to annual income and contribution limits; also the vehicle for rolling over employers’ sponsored retirement accounts in order to avoid penalties and tax issues. and Roth IRAIndividual retirement account funded with after-tax dollars, but earnings on the account are never taxed, even when drawn upon at retirement, subject to annual income and contribution limits. despite the fact that these programs are not provided by the employer. But they do require some level of income for participation. An employee cannot make contributions to an IRA without some level of compensation. An employee who is not part of an employer’s program can defer compensation by establishing an individual retirement account (IRA) or Roth IRA. This is also the vehicle for rolling over employers’ sponsored retirement accounts in order to avoid penalties and tax issues. An employee who participates in the employer’s retirement plans but earns a low income can open an IRA or a Roth IRA. A traditional IRA allows the employee to defer taxes on the contributions and the earning on the contributions until the accounts are withdrawn. A Roth IRA is funded with after-tax dollars, but the earnings on the account are never taxed, even after the employee retires and begins drawing from the account. The Roth IRA is considered a wonderful program from a taxation planning point of view, especially during low earning years when the tax rate is very low. The maximum allowed contributions to the traditional IRA and Roth IRA are featured in Table 21.10 "Traditional IRA and Roth IRA Limits" and Table 21.11 "IRA and Roth IRA Limits for People Age Fifty and Older".

Table 21.10 Traditional IRA and Roth IRA Limits

Taxable Year Maximum Deductible Amount
2002–2004 $3,000
2005 $4,000
2006–2007 $4,000
2008 $5,000
2009 $5,000
2010 Indexed to inflation

Table 21.11 IRA and Roth IRA Limits for People Age Fifty and Older

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 to Inflation

Who is eligible to make tax-deferred IRA contributions? An employee who does not participate in an employer-sponsored retirement plan in a particular year can make contributions up to the amount shown in Tables 21.10 and 21.11 (or 100 percent of the employee’s earned income if he or she is making less than that shown in Tables 21.10 and 21.11). If the employee participates in an employer-sponsored retirement plan (that is, an employer makes contributions or provides credits on the employee’s behalf), the maximum amount of tax-deferred IRA contribution depends on income earned from work, but not from investments, Social Security, and other nonemployment sources. The maximum contributions for the following income levels in 2009 are the following:Internal Revenue Service (IRS), “2009 IRA Contribution and Deduction Limits—Effect of Modified AGI on Deduction if You Are Covered by a Retirement Plan at Work,” January 13, 2009, http://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 the several tax-deferred, qualified programs is the deferral of income taxes until the employee withdraws the funds from the annuity (or other tax-deferred plan such as a mutual fund). Ideally, withdrawal takes place in retirement, many years in the future. If the employee had not made the qualified contributions, a significant portion would have gone to government treasuries in the years they were earned. When contributions are made to qualified plans, the money that would otherwise have gone to pay income taxes instead earns investment returns, along with the remainder of the employee’s contributions.

A 10 percent federal penalty tax applies to premature withdrawals (those made prior to age fifty-nine and a half). The penalty does not apply to the following:

The Roth IRA is a program for retirement without tax implication upon distribution, but the contributions are made with after-tax income. The Roth IRA was instituted on January 1, 1998, as a result of the Taxpayer Relief Act of 1997. It provides no tax deduction for contributions, which is not a great incentive to save, but instead it provides a benefit that is not available for any other form of retirement savings. If certain earning requirements are met, all earnings are tax-free when withdrawn. Other benefits included under the Roth IRA are avoiding the early distribution penalty on certain withdrawals and avoiding the need to take minimum distributions after age seventy and a half. Roth IRA is not a pretax contribution type of retirement savings account, but it is the only plan that allows earnings to accumulate without tax implication ever. A regular IRA provides a pretax saving, but the earnings are taxed when they are withdrawn.

Eligibility for the Roth IRA is available even if the employee participates in a retirement plan maintained by the employer. The contribution limits are shown in Tables 21.10 and 21.11. There are earning requirements: (1) for the maximum contribution, the income limits are less than $105,000 for single individuals and less than $166,000 for married individuals filing joint returns; (2) the amount that can be contributed is reduced gradually and then completely eliminated when adjusted gross income is $120,000 or more (single) and $176,000 or more (married, filing jointly).Internal Revenue Service (IRS), “2009 Contribution and Deduction Limits—Amount of Roth IRA Contributions That You Can Make for 2009,” February 16, 2009, http://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 modified adjusted gross income is $100,000 or less, and (b) the employee is single or files jointly with a spouse.Internal Revenue Service (IRS), “Individual Retirement Arrangements (IRAs),” Publication 590 (2008), http://www.irs.gov/publications/p590/ch01.html#en_US_publink10006253 (accessed April 17, 2009). Taxes will have to be paid in the year of the conversion.

The Pension Protection Act of 2006 allows IRA owners who are age seventy and a half and over to make tax-free distributions of up to $100,000 directly to tax-exempt charities. Otherwise, if no distribution has been taken, the owner is required to take minimal distribution and pay taxes on that amount as noted above.

The brief description presented here is introductory, and you are advised to consult the many sources for each pension plan on the 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) and Roth 403(b)After-tax contribution plans created from EGTRRA 2001 that work like the Roth IRA subject to a five-year waiting period and attainment of age fifty-nine and a half for distributions; have no income limits and no coordination limits.—a new after-tax contribution feature that is part of the EGTRRA 2001 (with a delayed effective date). The same limits that apply to regular 401(k) and 403(b) plans apply to both Roth 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 and Contributions,” February 18, 2009, http://www.irs.gov/retirement/article/0,,id=96461,00.html (accessed April 17, 2009). Both Roth 401(k) and Roth 403(b) work like a Roth IRA. The deferral is on an after-tax basis and the account is never taxed if it is held for five years. Distributions are allowed after age fifty-nine and a half and after five years in the program. There are no income limits and no coordination limits between a Roth IRA and a Roth 403(b) or Roth IRA and Roth 401(k). ERISA 401(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.For frequently asked questions regarding Roth 401(k) and Roth 403(b), visit the IRS Web site at http://www.irs.gov/retirement/article/0,,id=152956,00.html#1 (accessed April 17, 2009).

The 2006 act also permanently extended the Roth 401(k) and 403(b) features that were introduced in 2006 and were scheduled to sunset in 2010. Under these provisions, employees are allowed to make after-tax contributions to those accounts. Like the Roth IRA, there is never tax on the earnings for the Roth contributions. This is subject to keeping the money in the account for five years or at least until the account holder reaches age fifty-nine and a half.

Retirement Savings and the Recession

The prevalence of defined contribution plans, while not preferred by many Americans compared to the security of defined benefit plans, has at least come to be accepted as the way of the world. Individuals understand that the extent to which they are able to accumulate funds for retirement is largely a matter of their own design. A study by the Employee Benefit Research Institute (EBRI) indicates that 67 percent of workers considered defined contribution plans their primary retirement vehicle in 2006, over twice the percentage reported twenty years prior. Conversely, about 31 percent of workers had defined benefit plans as their primary retirement option in 2006 compared to almost 57 percent in 1988. In times of economic prosperity, retirement savings from defined contribution plans can be a boon to employees. In return for accepting the greater risk associated with individual responsibility for funding retirement, employees are rewarded. On the other hand, the negative aspects of shouldering more of this risk are brought into play during economic downturns. The 2008–2009 recession is perhaps the first large-scale test of the resiliency of defined contribution retirement plans under significant market pressures.

The S&P 500 lost 37 percent of its value in 2008. This decline just barely trailed the S&P’s worst-ever year of 1937 (during the Great Depression). Many managed funds such as mutual funds, exchange traded funds, and pension funds are made up of investments that are representative of the S&P 500 index’s performance. Consequently, proportionate losses were recorded in many individuals’ retirement funds, particularly those in defined contribution plans. Even before the negative stock returns could be quantified for the year, the director of Congressional Budget Office, Peter Orszag, reported in October 2008 that retirement savings plans had lost $2 trillion over the previous fifteen months alone. Defined benefit plans lost 15 percent of their assets, and defined contribution plans eroded slightly more. According to EBRI, account balances for 401(k) plans fell between 7.2 and 11.2 percent. Public pension plans (like the 403[b] and Section 457 plans discussed in this chapter) have also been hit hard, losing $300 billion between the second quarter of 2007 and the first quarter of 2008. Investments in equities, like those in the S&P 500, are primarily to blame for these widespread losses and are due to the overall depreciation in stock prices. Also of note are institutional investments by fund managers in mortgage-backed securities (MBSs) that defaulted (as detailed in the box “Problem Investments and the Credit Crisis” in Chapter 7 "Insurance Operations"), which in turn devalued portfolios designed for retirement savings.

Those with defined benefit plans may be somewhat comforted by the fact that these plans are insured by the Pension Benefit Guaranty Corporation (PBGC), as discussed in this chapter. Defined benefit recipients will at least get something in the event of private pension fund insolvency. Defined contribution plan participants, however, are largely left to fend for themselves. As a direct consequence of the recession, these employees have seen their account balances shrink and their employers who contributed funds go out of business. EBRI reports that 401(k) account balances in excess of $200,000 have lost 25 percent of their value. This most affects workers between the ages of thirty-six and forty-five who have long tenures with their employers. Much of the growth they have directly contributed to and actively managed over years or decades has been erased in short order—and these employees have less time until retirement to rebuild their accounts than do younger workers. EBRI posits several scenarios under which diminished account balances could be replenished in the future. At a 5 percent return-on-equity rate, for example, workers aged thirty-six to forty-five who incurred moderate losses would need close to two years to restore accounts to their 2008 end-of-year positions. Workers in this age range with the most severe losses would need five years.

Burdens of the recession affecting other areas of workers’ lives have also had carryover effects on retirement plans. Individuals struggling to make ends meet are turning to savings, including withdrawals from retirement accounts. Prudential Retirement reports that hardship withdrawals from defined contribution plans increased at a rate of 45 percent throughout 2007 and most of 2008. The short-term benefit of using such funds today produces a long-term shortfall in the form of a future needs funding gap, but for many Americans, this is the only option left. The American Association for Retired Persons (AARP) reports that 20 percent of baby boomers had stopped making voluntary contributions altogether as a consequence of the recession. On the other side of this issue, many employers too announced they were suspending (at least temporarily) matching contributions to employees’ 401(k) plans. Such employers include companies like Coca-Cola Bottling, Motorola, UPS, General Motors, and (ironically enough) the AARP. The end result of all these problems is that more and more U.S. workers are choosing to delay 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 older were working full-time; by 2007, this had increased to 30 percent. By 2016, it is not inconceivable to speculate that 80 percent of persons fifty-five and older will remain in the work force. As further proof, an AARP poll indicates that 65 percent of workers over age forty-five believe they will need to work for a longer period of time if the economic trend is not soon reversed. When employees do retire, they have little confidence that retirement income will be sufficient to maintain their standards of living, as suggested by the 69 percent of respondents who anticipate cutting back on spending during retirement. Continuing to work beyond one’s normal retirement age buys more time to accumulate income for nonworking years and increases the benefit amounts from Social Security and individual retirement options. Working longer may mean putting plans and dreams on hold, but for many Americans looking forward to enjoying any retirement at all, it is the most practical solution. If there’s any good news, it’s that workers today are in the best position to afford this luxury, with life expectancies (and quality of life) of the population substantially improved over previous generations (as discussed in Chapter 17 "Life Cycle Financial Risks").

Employees unaccustomed to making long-term investment decisions have understandably found the shift to defined contribution plans jarring. There is some evidence that employers could do a better job of informing workers about the realities of their responsibilities. EBRI found that one in four workers in the fifty-six to sixty-five age range had more than 90 percent of their 401(k) account balances in equities at year-end 2007; two in five had more than 70 percent in equities. This degree of risk is alarming to see for individuals so close to retirement. Rather than dazzling their workers with the array and complexity of investment options available to defined contribution plan participants, employers could instead emphasize sound, basic principles of financial planning. How many employees are guided by the notion that investments should become more conservative over time to preserve accumulated earnings and reduce risk? For example, subtracting one’s age from one hundred is a general rule of thumb that could be used to give a rough estimate as to the proportion of retirement assets that should be invested in stocks (with the remainder in lower-risk investments). The financial planning community also stresses the importance of diversification not just to balance risk between bonds and equities, but across different investment sources to ensure that one’s savings will not be spoiled because it was concentrated in only a few funds that performed badly. A family needs analysis, incorporating projected future income requirements against earnings from Social Security, personal savings, investments, and employer plans (like the hypothetical cases in Chapter 23 "Cases in Holistic Risk Management" and Section 17.6 "Appendix: How Much Life Insurance to Buy?"), is another component of responsible retirement planning.

Sources: Nancy Trejos, “Retirement Savings Lose $2 Trillion in 15 Months,” Washington Post, October 8, 2008, http://www.washingtonpost.com/wp-dyn/content/article/2008/10/07/AR2008100703358.html?sid=ST2008100702063&s_pos=, accessed March 10, 2009; “New Research from EBRI: Defined Contribution Retirement Plans Increasingly Seen as Primary Type,” Reuters, February 9, 2009, http://www.reuters.com/article/pressRelease/idUS166119+09-Feb-2009+PRN20090209, accessed March 10, 2009; Jack VanDerhei, “The Impact of the Recent Financial Crisis on 401(k) Account Balances,” Employee Benefit Research Institute (EBRI), February 2009, http://ebri.org/publications/ib/index.cfm?fa=ibDisp&content_id=4192, accessed March 10, 2009; Jim Connolly, “Pru Panelists: Recovery May Be Slow,” National Underwriter Life/Health Edition, January 7, 2009, http://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 Public Radio), March 11, 2009, http://www.npr.org/templates/story/story.php?storyId=101751588, accessed March 13, 2009; Chris Farrell, “Why You’ll Work Through Your 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’s Plunge: 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 qualified defined benefit plans and defined contribution plans:

  • Defined benefit plans require the greatest degree of employer commitment by guaranteeing specified retirement benefits for employees.

    • Defined benefit plans use a benefit formula based on a flat dollar amount, flat percentage of pay, amount unit benefit, or percentage unit benefit.
    • The cash balance plan sets up hypothetical individual retirement accounts for employees and credits participants annually with plan contributions and guarantees minimum interest credit (similar to defined contribution plans, making it a hybrid plan).
    • Defined benefit plans may be integrated with Social Security, they provide cost-of-living adjustments, and all are insured by the PBGC.
    • Salary levels, normal retirement age, employee ages, mortality assumptions, and more influence employer funding obligations, as actuarially determined.

  • Defined contribution plans require less employer commitment by guaranteeing only contribution amounts toward employees’ retirement accounts

    • Money purchase plan—most common, establishes rate of annual employer contributions such that the benefit at retirement varies with the contribution amount, length of participation, investment earnings, and retirement age
    • Profit-sharing plans—distribute a portion of company profits among participants in relation to salary
    • 401(k) plans—allow employees to defer compensation for retirement before taxes, but employers must pass ADP test to receive tax credits

  • Other qualified plans allowing tax-deferred contributions include 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 and nonproft, noneducational institutions
    • Keogh plans—for the self-employed
    • SEP—individual retirement accounts (IRAs) that employers can contribute toward on a tax-deductible basis
    • SIMPLE—for employees of small businesses
  • Contributions toward qualified plans and benefits are subject to annual IRS limits, and tax penalties are imposed for taking early distributions

  • Individual Retirement Accounts (IRAs)

    • Traditional IRA—allows individuals to defer taxes on account contributions and earnings on contributions until account is withdrawn, subject to annual income and contribution limits; also the vehicle for rolling over employers’ sponsored retirement accounts in order to avoid penalties and tax issues
    • Roth IRA—funded with after-tax dollars, but earnings on the account 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 plans created from EGTRRA 2001 that work like the Roth IRA subject to a five-year waiting period and attainment of age fifty-nine and a half for distributions; have no income limits and no coordination limits

Discussion Questions

  1. As an employee with a defined benefit pension plan, which would you prefer: a flat amount benefit formula that specifies $1,000 per month, or a percentage unit benefit formula that figures your benefit to be 1.5 percent per year times your average annual salary for your highest three consecutive years of employment? Explain your answer.
  2. As an employer, would you prefer a defined contribution pension plan or a defined benefit plan? Explain your answer.

  3. What are the primary differences between a defined benefit plan and a defined contribution plan? Create a matrix and include discussion about:

    1. Who bears the risk of investment?
    2. What are the actuarial complexities?
    3. What is fixed, contributions or benefits?
    4. Are there separate accounts?
    5. Is the plan insured?
    6. Is the plan better for older or for younger employees?
  4. What is a cash balance plan? What is a cash balance conversion and what employees does it favor?
  5. What are the different types of deferred compensation plans available to employers?
  6. Some employers have deferred profit-sharing plans instead of defined benefit or defined contribution money purchase plans. Why?
  7. As an employee, would you prefer a deferred or an immediate (cash at the end of the year) profit-sharing plan? If your income doubled, would your choice change? Explain your answer.
  8. Compare the traditional IRA with the Roth IRA.
  9. What conditions need to be met for an employer to receive tax credits for a 401(k) plan?
  10. What type of pension benefit plan best meet the needs of small employers? What are its advantages over other types of plans?