Q1. review case study #1 Understanding Your Employee Benefits: Investing in your Retirement found on page 123 of your textbook. Please post your answers to the two questions found at the end of the case study page 124.

Q2. Using the free "Retirement 101" link from the International Foundation of Employee Benefit website answer the following questions.

www.ifebp.org/retirement101

1. Find the squirrel video link towards the bottom of the page. Which squirrel (Nutley or Chester) would you like to be related to retirement savings? Why?

2. Identify what two retirement plans are explained on this site.

3. Select the "Defined Contribution Plan" section what defined contribution plan?Identify three plans that are described.

4. Do employers have to provide a defined contribution plan to its employees?

5. Identify three benefits of a defined contribution plan.

6. How do you reduce taxes by contribution to a define contribution plan?

7. How is a defined contribution plan different from a defined benefit plan?

8. What does the acronym "SPD" mean related to a retirement plan. What would you use it for?

9. Under the "How much should I save for my retirement?" section and the "How much money will I need when I retire?" section choose one of the worksheets provided by the link. How would you use this as a future human resource professional?

10. After reviewing the site identify one tool or section that you could share to a future employee who had questions about retirement savings. How would you use it and how could it help answer the employee's questions. Be specific.

92 Part Two Retirement, Health Care, and Life Insurance 2. Differences between qualified plans 2. Reconsidering the Vesting Schedule and nonqualified plans. at Syntax Software 3. Features of defined benefit plans and Endnotes defined contribution plans. Learning Objectives In this chapter, you will gain an under- 4. Specific types of defined contribution plans. standing of: 5. Features of various hybrid plans. 1. How employer-sponsored retirement plans are defined. Of course, most people work to fund basic needs (food) and wants (vacations). While needs and wants may change over time, we will always have them, even in retirement. Therefore, it is nec- essary to build financial resources throughout our employment to fund retirement. The U.S. federal government refers to savings for retirement as a three-legged stool, supported by personal savings, government benefits, and employer-sponsored retirement plans. We study two of the three legs in this book: Social Security retire- ment benefits (Chapter 7) and employer-sponsored retirement plans in this chapter. Benefits professionals play an important role in designing and administering retirement plans and working with other HR professionals and line managers who help employees understand their options. DEFINING AND EXPLORING RETIREMENT PLANS We learned in Chapter 3 that retirement plans function by providing: retirement income to employees, or [result] in a deferral of income by employ- ees for periods extending to the termination of covered employment or beyond, regardless of the method of calculating the contributions made in the plan, the method of calculating benefits under the plan, or the method of distributing benefits from the plan. We elaborate on this definition throughout the chapter by reviewing three main categories of employer-sponsored retirement plans and specific practices within each category. Before embarking on that discussion, let's explore the origins and prevalence of employer-sponsored retirement benefits followed by understanding the essential distinction between qualified and nonqualified retirement plans. For putting those discussions into context, let's give brief definitions of defined benefitChapter 4 Employer-Sponsored Retirement Plans 93 plans and defined contribution plans. A defined benefit plan guarantees the retire- ment benefits. This benefit usually is expressed in terms of an annual sum equal to a percentage of a participant's preretirement pay multiplied by the number of years he or she has worked for the employer. Defined benefit plans are sometimes referred to as pension plans. Under a defined contribution plan, employees make annual contributions to their individual investment accounts, based on a formula contained in the plan document. Employers may choose to make matching contri- butions to employees' accounts. The amount a participant receives in retirement depends on the performance of the selected financial investment. Origins of Employer-Sponsored Retirement Benefits According to the Employee Benefit Research Institute, the first plan in the United States was established in 1759 to benefit widows and children of Presbyterian ministers. Then, in the private sector, the American Express Company established a formal pension in 1875. Plans were adopted primarily in the railroad, banking, and public utility industries and eventually became increasingly popular in the private sector. It is believed that more and more companies adopted retirement plans to attract and retain employees. But, there were limits to which companies chose to retain employees. Approximately 30 years of service were needed to qualify for retirement benefits, and the mandatory retirement age was 65 in most states during the early 20th century. According to economics professor Joanna Short, "Because of the lengthy service requirement and mandatory retirement provision, firms viewed pensions as a way to reduce labor turnover and as a more humane way to remove older, less productive employees." The most significant growth occurred after favorable tax treatment was established through the passage of the Revenue Act of 1921 and the Revenue Act of 1928. During World War II, government-imposed wage controls led companies to adopt discretionary employee benefits plans, which were excluded from those wage increase restrictions. Finally, as discussed in Chapter 3, the National Labor Relations Act of 1935 instituted retirement plans as a mandatory subject of bargaining between unions and management. This requirement further contributed substantially to the growth of retirement plans in the unionized private sector. Trends in Retirement Plan Coverage and Costs According to the U.S. Bureau of Labor Statistics, nearly 55 percent of workers employed in the private sector participated in at least one company-sponsored retirement plan in 1992-1993." Since then, the participation rate has declined slightly, to approximately 51 percent in 2020.' However, there has been a noticeable decrease in participation rates for defined benefit plans, over the last 30 years. In 1992-1993, 32 percent of private-sector employees participated in defined benefit plans, and slightly more (35 percent) participated in defined contribution plans. In 2020, only 11 percent participated in defined benefit plans, but there was an increase to 47 percent participation in defined contribution plans.' These trends can be explained by a variety of factors. We focus on two important ones here: industry characteristics and union status.94 Part Two Retirement, Health Care, and Life Insurance Industry Characteristics We can observe differences in retirement plan participation between goods-produc- ing industries and service-providing industries where most goods-producing tries offer higher pay and retirement plans. Automobile manufacturing and home building are examples of specific goods-producing industries. Food service and retail are examples of service-producing industries. Many goods-producing compa- nies operate in product markets where there is relatively little competition from other companies, enabling them to offer generous retirement plans. Competition on product costs are lower, such as is the case for coal mining. This phenomenon can be attributed to factors such as higher barriers to enter into the product market. Government regulation and extremely expensive heavy or robotic equipment rep- resent entry barriers. The U.S. defense industry and the public utilities industry have high entry barriers and virtually no threats from foreign competitors. In addition, goods-producing businesses are typically capital intensive. Capital refers to buildings (e.g., factories and, warehouses) and heavy equipment (e.g., hoists used to raise steel in the shipbuilding process). Capital-intensive businesses require highly capable employees who have the aptitude to learn how to use complex physical equipment such as casting machines and robotics. Workers usu- ally receive on-the-job training, sometimes including employer-sponsored techni- cal instruction. In addition, some employers may require specialized training or an advanced degree to qualify for those jobs. Service industries such as retail and food service are not capital intensive, and most have the reputation of paying low wages and offering less generous benefits, including retirement plans. For example, there are a substantial number of fast- food companies that compete for market share and need to manage costs in order to protect profit margins. Also, the operation of service industries depends almost exclusively on employees who need only relatively common skills. Most retail sales workers receive on-the-job training, which usually lasts a few days to a few months. Union Status Union and management negotiations usually center on pay raises and employee ben- efits. There is greater power to negotiate terms of employment as a collective rather than individually, particularly for low-skilled jobs. We can observe higher pay and more generous retirement and health-care benefits. Union leaders also fought hard for these improvements to maintain the memberships' loyalty and support. Unions generally secured high wages for their members through the early 1980s, when com- petition from foreign companies offered quality products at similar or lower prices. Even still, unions have managed to maintain lucrative benefits, though more attention to costs has pressured some companies to freeze or terminate pension plans. QUALIFIED VS. NONQUALIFIED PLANS The Internal Revenue Code (IRC) and ERISA's Title I and Title II provisions set 13 minimum standards to determine whether retirement plans are qualifiedChapter 4 Employer-Sponsored Retirement Plans 95 EXHIBIT 4.1 Characteristics Participation requirements. of Qualified . Coverage requirements. Retirement . Vesting rules Plans . Accrual rules. Nondiscrimination rules: Testing. . Top-heavy provisions. . Minimum funding standards. . Social Security integration. Contribution and benefit limits. Plan distribution rules. Qualified survivor annuities. . Qualified domestic relations orders. . Plan termination rules and procedures. or nonqualified. Exhibit 4.1 lists ERISA's minimum standards. Employers establish qualified plans when all of the ERISA minimum standards are met. Failure to meet at least one minimum standard results in a plan becoming nonqualified. What is the main advantage of offering qualified plans? Qualified plans provide both employees and employers with immediate tax benefits. In most cases, monetary contributions to qualified plans reduce the amount of an employee's or company's annual earnings that are subject to taxation. Companies establish qualified plans for nonexecutive employees. What about executives? Because most executives earn substantially more than other employees and relative to IRC contribution limits, for example, companies base executive retirement benefits on nonqualified deferred compensation plans (NQDC). We discuss NQDCs in Chapter 12 and the criteria that distinguish between exec- utive and nonexecutive employees. In this chapter, reference is made from time to time to two employee groups, defined in the IRC, who we consider as meeting executive status: key employees and highly compensated employees. Participation Requirements As reviewed in Chapter 3, employees must be allowed to participate in employer- sponsored plans after they have reached age 21 and have completed one year of service (based on 1,000 work hours). In addition, the Setting Every Community Up for Retirement Enhancement (SECURE) Act requires that long-term part-time employees be granted participation in employer-sponsored plans. More will be said about this later in the chapter. Coverage Requirements Coverage requirements limit the freedom of employers to exclude employees. Qualified plans do not disproportionately favor highly compensated employees." Another important group is key employees. Again, as we discuss in Chapter 12 on executive benefits, these groups help distinguish between nonexecutive employees and executive employees. Also in Chapter 12, we provide a full definition of each group and the criteria for determining membership in each one.96 Part Two Retirement, Health Care, and Life Insurance companies demonstrate whether plans meet the coverage requirement b maintaining a nondiscriminatory ratio of nonhighly compensated employ highly compensated employees based on one of the following two tests. . Percentage test. Qualified plans benefit at least 70 percent of employees who are not highly compensated employees in the plan. . Ratio test. Qualified plans cover a percentage of nonhighly compensated employees that is at least 70 percent of the percentage of highly compensated employees covered by the plan. Average benefit test. Qualified plans benefit a "nondiscriminatory classification" . of employees and possess an "average benefit percentage" for nonhighly com- pensated employees that is, at a minimum, 70 percent of the average benefit percentage for highly compensated employees. 10 U.S. Department of Treasury regulations impose an additional participation standard for defined benefit plans. These plans require coverage of at least 50 employees, or 40 percent of the workforce must benefit from the plan. Vesting Rules Vesting refers to an employee's nonforfeitable rights to retirement benefits. 2 In defined benefit employees vest in a specific annual amount, as defined under the terms of the plan, each year after retirement. In defined contribution plans, employees vest in net employer contributions. Net employer contributions equal gross employer contributions plus investment gains or minus investment losses. Title I of ERISA requires that companies follow an allowed schedule for vesting rights: cliff vesting or six-year graduated vesting. Cliff vesting schedules must grant employees 100 percent vesting after no more than three years from beginning participation in the retirement plan. This schedule is known as cliff vesting because leaving one's job prior to becoming vested is tantamount to falling off a cliff-an employee loses all the accrued employer contributions if they leave before starting the third year of participation in the plan. Alternatively, companies may use a graduated vesting schedule. The six-year graduated schedule allows workers to become 20 percent vested after two years and to vest at a rate of 20 percent each year thereafter until they are 100 percent vested after six years from beginning participation in the retirement plan. Exhibit 4.2 shows an example of the six-year graduated schedule. For example, let's assume that an employer has EXHIBIT 4.2 Sample of a Years of Vesting Service Six-Year Nonforfeitable Percentage Graduated 20% Vesting OUT D WN 40% Schedule 60% under ERISA 80% 100%Chapter 4 Employer-Sponsored Retirement Plans 97 adopted the six-year graduated vesting schedule. Also assume that this employer has contributed $15,000 to an employee's retirement account since he began his employment two years ago. According to the graduated vesting schedule, this employee has earned a 20 percent nonforfeitable right to the employer's contribution-that is, $3,000 = (20 percent x $15,000). Plans may have faster vest- ing schedules, which reach 100 percent vesting in fewer than six years. Accrual Rules Qualified plans are subject to minimum accrual rules based on the IRC and ERISA, 13 Accrual rules specify the rate at which participants accumulate (or earn) benefits. Defined benefit and defined contribution plans use different accrual rules, which are discussed in subsequent sections of this chapter. Nondiscrimination Rules: Testing Nondiscrimination rules prohibit employers from favoring highly compensated employees in making contributions or benefits, availability of benefits, rights, or plan features." Also, employers may not amend retirement plans so that highly compensated employees are favored. The nondiscrimination requirement may be fulfilled in one of two ways: safe harbors or a facts-and-circumstances testing. Safe harbors refer to compliance guidelines in a law or regulation. Retirement plans that meet safe harbor conditions automatically fulfill the nondiscrimination requirement based on particular design features. Failure to reach safe harbors requires passing at least one of two facts-and-circumstances tests (not discussed in this book). It is important to note that the safe harbors and facts-and-circumstances tests differ between defined benefit and defined contribution plans. Safe harbors are reviewed in this chapter. Top-Heavy Provisions A top-heavy plan provides non-key employees with a minimum benefit if it is a defined benefit plan or a minimum contribution if it is a defined contribution plan: . A defined benefit plan is top-heavy if the present value of the accrued benefits (PVAB)* under the plan for the key employees exceeds 60 percent of the PVAB under the plan for all employees. . A defined contribution plan is top-heavy if the total of the accounts of the key employees under the plan exceeds 60 percent of the total of the accounts of all employees under the plan. . A top-heavy plan must also provide a special vesting schedule: . 3-year 100 percent vesting schedule, or . 6-year graduated vesting schedule. *Present value is the value today of an amount of money in the future. The accrued benefit is the amount that a participant has earned under the plan's terms at a specified time. For example, $1,000 today is the same as $1,100 one year from today, assuming a 10 percent annual interest rate.100 Part Two Retirement, Health Care, and Life Insurance The IRC recognizes both formulas as appropriate calculation methods employer-sponsored plans. Flat Benefit Formulas Flat benefit formulas designate a flat dollar amount per employee flat amount formula) or a dollar amount based on an employee's compensation flat percentage formula). Annual benefits are usually expressed as a percentage of final average wage or salary based on the last three or four years of service. Let's assume that in 2022, when Robert plans to retire, his final average salary in the three-year period preceding retirement was $100,000 (based annual salaries of $99,000. $100,000, and $101,000). Also assume that the plan's designated percentage is 60 percent. Robert's annual retirement income equals $60,000; that is, $100,000 final average salary x 60 percent. Flat benefit formulas often lead to resentment among employees because length of service is not a consideration. Longer-service employees expect to receive a higher percentage of final average salary during retirement than do employees who retire with substantially less service. There are two possible explanations for these expectations. First, longer-service employees believe they have earned the right to receive a higher percentage, arguing that more years enabled higher productivity than did employees with substantially fewer years Second, longer-service employees feel that the company owes them a larger percentage in recognition of loyalty and commitment to the company over a longer period. Unit Benefit Formulas Unlike flat benefit formulas, unit benefit formulas take into account length of ser- vice. Typically, employers decide to contribute a specified dollar amount or percent- age for each service year worked. Annual benefits are usually based on age, years of service, and final average wages or salary. Retirement plans based on unit benefit formulas specify annual retirement benefits as a percentage of final average salary. Exhibit 4.3 illustrates these percentages for one retirement plan based on age and years of service. Looking at this exhibit, let's assume that Mary retires at age 59 with 25 years of service and a final average salary of $52,500. Mary multiplies $52,500 by the annual percentage of 43.43 percent. Her annual benefit is thus $22,800.75, that is, ($52,500 x 43.43 percent). Nondiscrimination Rules: Testing Defined benefit plans must meet several uniformity criteria. Uniformity refers to consistent treatment based on factors such as a benefits formula. Exhibit 4.4 describes the uniformity requirements issued by the U.S. Treasury Department. Accrual Rules Accumulated benefit obligation refers to the present value of benefits based on designated date. Actuaries determine a defined benefit plan's accumulated benefit obligation by making assumptions about the return on investment of assets andChapter 4 Employer-Sponsored Retirement Plans 101 EXHIBIT 4.3 Annual Age Retirement Years of Benefits Based Service 62 60+ 59 58 57 56 55 on a Unit UT 8.35 Benefit 10.02 Formula 7 11.69 13.36 11.76 10.96 10.15 9.35 60 00 12.56 15.03 14.13 13.23 12.32 11.42 10.52 10 16.70 15.70 14.70 13.69 12.69 1 1.69 11 18.60 17.48 16.37 15.25 14.14 13.02 12 20.50 19.27 18.04 16.81 15.58 14.35 22.40 21.06 19.71 18.37 17.02 15.68 24.30 22.84 21.38 19.93 18.47 17.01 26.20 24.63 23.06 21.48 19.91 18.34 28.10 26.41 24.73 23.04 21.36 19.67 30.00 28.20 26.40 24.60 22.80 21.00 31.90 29.99 28.07 26.16 24.24 22.33 33.80 31.77 29.74 27.72 25.69 23.66 35.70 33.56 31.42 29.27 27.13 24.99 37.80 35.53 33.26 31.00 28.73 26.46 39.90 37.51 35.11 32.72 30.32 27.93 42.00 39.48 36.96 34.44 31.93 29.40 44.10 41.45 38.81 36.16 33.52 30.87 46.20 43.43 40.66 37.88 35.11 32.34 48.30 45.40 42.50 39.61 36.71 33.81 50.40 47.38 44.35 41.33 38.30 35.28 52.50 49.35 46.20 43.05 39.90 36.75 29 54.60 51.32 48.05 44.77 41.50 38.22 30 56.70 53.30 49.90 46.49 43.09 39.69 31 59.00 55.46 51.92 48.38 44.84 41.30 32 61.30 57.62 53.94 50.27 46.59 42.91 33 63.60 59.78 55.97 52.15 48.34 44.52 65.90 61.95 57.99 54.04 40.08 46.13 34 68.20 68.20 68.20 68.20 68.20 68.20 35 36 70.50 70.50 70.50 70.50 70.50 70.50 72.80 72.80 72.80 72.80 72.80 72.80 37 75.10 75.00 75.00 75.00 75.00 75.00 38 77.40 75.00 75.00 75.00 75.00 75.00 39 79.70 75.00 75.00 75.00 75.00 75.00 40 75.00 75.00 75.00 1 80.00 75.00 75.00 41+% 102 Part Two Retirement, Health Care, and Life Insurance EXHIBIT 4.4 Uniformity Requirements for Defined Benefit Plans Source: Treas. Regs. $1.401(a)(4)-3(b)(2) . Uniform Normal Retirement Benefit The same benefit formula must apply to all employees in the plan. The formula must provide all employees with an annual benefit payable in the same form, commencing at the same uniform normal elirement age. The annual benefit must be the same percentage of average annual compensation al the same dollar amount for all employees in the plan who will have the same number of years Service at normal retirement age. The annual benefit must equal the employee's accrued benefit at normal retirement age and must be the normal retirement benefit under the plan. Uniform Postnormal Retirement Benefits With respect to an employee with a given number of years of service at any age after normal retirement age, the annual benefit commencing at the employee's age must be the same percentage of average annual compensation or the same dollar amount that would be payable commencing at normal retirement age to an employee who had that same number of years of service at normal retirement age. Uniform Subsidies Each subsidized optional form of benefit under the plan must be available to essentially all employees in the plan. In determining whether a subsidized optional form of benefit is available, the same criteria apply that are used for determining whether an optional form of benefit is currently available to a group of employees in the plan. An optional form of benefit is considered subsidized if the normalized optional form of benefit is larger than the normalized normal retirement benefit under the plan. Uniform Vesting and Service Crediting All employees in the plan must be subject to the same vesting schedule and the same definition of years of service for all purposes under the plan. For the purposes of crediting service, only service with the employer (or a predecessor employer) may be taken into account. No Employee Contributions The plan is not a contributory defined benefit plan. Special rules apply to contributory defined benefit plans. Period of Accrual Each employee's benefit must be accrued over the same years of service that are taken into account in applying the benefit formula under the plan to that employee. Any year in which the employee benefits under the plan is included as a year of service in which a benefit accrues. characteristics of the participants and their beneficiaries, including expected length of service and life expectancyes. The IRS specifies criteria to judge whether an employer's defined benefit plan meets its accumulated benefit obligation. These criteria discourage employers from engaging in a practice known as backloading. Backloading occurs wheneve benefits accrue at a substantially higher rate closer to an employee's eligibility earn retirement benefits. Fulfillment of at least one of these criteria ensures thatChapter 4 Employer-Sponsored Retirement Plans 103 benefits accrue regularly throughout participation in a defined benefit plan: the three percent rule, the 1331/3 percent rule, or the fractional rule. The Three Percent Rule Under the three percent rule, a participant's accrued benefit cannot be less than 3 percent of the normal retirement benefit, assuming the participant began participation at the earliest possible age and remained employed without interruption until age 65 or until the plan's designated normal retirement age. For instance, Margaret recently retired at age 62 from Company A. She joined the company 41 years earlier at age 21 and imme- diately began participation in the defined benefit plan. Company A's defined benefit plan awards an annual benefit equal to 70 percent of the four-year average highest salary. Margaret's four-year average annual salary was $50,000, yielding an annual retirement benefit of $35,000; that is, ($50,000 x 70 percent). Under the three percent rule, Margaret's accrued benefit must be no less than $1,050 ($35,000 x 3 percent). The 1331/3 Percent Rule Under the 1331/3 percent rule, the annual accrual rate cannot exceed 13313 percent of the accrual rate for any prior year. For example, a company's retirement plan specifies the following annual accrual rates: 1.5 percent of compensation for each year of service up to 20, and 1.75 percent of compensation for each year of service in excess of 20. This plan satisfies the 1331/3 percent rule because the 1.75 percent annual accrual rate is less than 13313 percent of the prior annual 1.5 percent accrual rate: 116 percent; that is, [(1.75 percent/1.5 percent) x 100 percent]. The Fractional Rule The fractional rule applies to participants who terminate their employment prior to reaching normal retirement age. This rule stipulates that benefit accrual upon termination be proportional to the normal retirement benefits. Said another way, this method compares an employee's plan participation to the total years of par- ticipation upon reaching the normal retirement age. For example, let's assume that the annual annuity at the normal retirement age is $20,000. Let's also assume that service years at the normal retirement age would have been 30 years, but terminated her employment at 20 service years. Based on the fractional rule, the annual annuity is $13,333; that is, [$20,000 x (20 years/30 years)]. Paying an annual benefit equaling less than $13,333 would violate the fractional rule. Top-Heavy Provisions Each non-key employee must receive an accrued benefit of a designated percentage multiplied by the employee's average compensation. The percentage is the lesser of 2 percent times the participant's number of years of service with the employer, or 20 percent. For instance, an employee with four years of service and an average annual compensation of $75,000 would be entitled to a minimum benefit of $6,000; (i.e., 4 years x 0.02 percent x $75,000). This amount is less than $15,000, which equals 20 percent of $75,000.104 Part Two Retirement, Health Care, and Life Insurance Minimum Funding Standards SA imposes strict funding requirements on qualified plans. under defined ben polls, employers make an annual contribution that is sufficiently large to ensureleft Promised benefits will be available to retirees. Actuaries periodically review sethat ads of information to determine a sufficient funding level: life expectancyes al ployees and their designated beneficiaries, projected compensation levels, and , arelihood of employees terminating their employment before they have earned bene fits. ERISA imposes reporting of actuarial information to the Internal Revenue Serve (IRS), which, in turn, submits these data to the U.S. Department of Labor. The Depafe ment of Labor reviews the data to ensure compliance with ERISA regulations. Benefit Limits The IRC sets a maximum annual benefit for defined benefit plans that is equal to the lesser of 230,000 in 2021, or 100 percent of the highest average compensation for three consecutive years.2 The annual earnings limit on which the annual retirement benefit may be calculated was 290,000 in 2021. These limits are indexed for inflation in $5,000 increments.22 Plan Termination Rules and Procedures The Pension Benefit Guaranty Corporation (PBGC) program recognizes three type of plan terminations: distress terminations, involuntary terminations, and standar terminations. Exhibit 4.5 contains a description of these termination types an the PBGC-mandated procedures for conducting them. EXHIBIT 4.5 Types of Pension Plan Termination Source: Pension Benefit Guarantee Corporation, Termination Fact Sheet. Accessed December 23, 2020, http://pbgc.gov/about/factsheets/page/termination.htm process. The (PBGC) recognizes three types of plan termination, with specific requirements for the termination Distress Termination A company in financial distress may voluntarily terminate a pension plan if: . The plan administrator has issued a Notice of Intent to Terminate to affected parties, including the PBGC, at least 60 days, and no more than 90 days, in advance of the proposed termination date. The plan administrator has issued a subsequent termination notice to PBGC, which includes data concerning the number of participants and the plan's assets and liabilities. The PBGC has determined that the plan sponsor and each of its corporate affiliates have satisfied a least one of the following financial distress tests-though not necessarily the same test: . A petition has been filed seeking liquidation in bankruptcy; . A petition has been filed seeking reorganization in bankruptcy, and the bankruptcy court (or an appropriate state court) has determined that the company will not be able to reorganize with the plan intact and approves the plan termination; is terminated; or . It has been demonstrated that the sponsor or affiliate cannot continue in business unless the plan . It has been demonstrated that the costs of providing pension coverage have become unreason- ably burdensome solely as a result of a decline in the number of employees covered by the planChapter 4 Employer-Sponsored Retirement Plans 105 EXHIBIT 4.5 (Continued) Involuntary Termination The law provides that the PBGC may terminate a pension plan, even if a company has not filed to terminate a plan on its own initiative, if: The plan has not met the minimum funding requirements. The plan cannot pay current benefits when due. company. A lump sum payment has been made to a participant who is a substantial owner of the sponsoring . The loss to the PBGC is expected to increase unreasonably if the plan is not terminated. The PBGC must terminate a plan if assets are unavailable to pay benefits currently due. Standard Termination A plan may terminate only if plan assets are sufficient to satisfy all plan benefits and if the plan administrator has taken the following steps: Issued a Notice of Intent to Terminate to affected parties other than the PBGC at least 60 days, and no more than 90 days, before the proposed termination date; it also must inform plan participants that the PBGC's guarantee of their benefits will cease upon distribution of plan assets. Informed plan participants of the identity of the private insurer from whom an annuity is being pur- chased or the names of insurers from whom bids will be sought no later than 45 days before the distribution of plan assets, Sent each plan participant a notice that includes the benefits that the participant has earned and data the plan used to calculate the value of the benefits. Submitted a termination notice to the PBGC that includes certified data on the plan's assets and lia- bilities as of the proposed date of distribution. . Distributed plan assets to cover all benefit liabilities under the plan. Plans must provide the PBGC with the names of any missing participants and either money to pay their benefits or the names of the insurers holding their annuities. Before sending money to the PBGC, the plan administrator must conduct a diligent search that includes using a commercial locator service. If assets cannot cover all benefit liabilities, the plan administrator must notify the PBGC and stop the termination process. If the plan administrator does not follow proper procedures, the PBGC may issue a Notice of Noncompliance that nullifies the proposed termination. Annuity insurer selections are fiduciary decisions and must comply with fiduciary provisions of Title I of ERISA, which is enforced by the Department of Labor. Termination insurance protects against the loss of vested pension benefits when plans fail. Employers are assessed charges by the PBGC to cover possible plan termi- nations. Insurance premiums are set by Congress for employers according to the num- ber of covered employees and to whether a pension plan covers employees of just one company (single-employer plans) or a collective bargaining agreement maintains a pension plan to which more than one employer contributes (multiemployer plans). In addition, the PBGC ensures a basic level of annual benefits to participants in the event that a plan terminates with insufficient assets to pay its obligations. The maximum PBGC-guaranteed annual benefit is adjusted every year." For plans ended in 2019, the maximum annual benefit was approximately $67,000 for those who retire at age 65. The amount is higher for those who retire later and lower106 Part Two Retirement, Health Care, and Life Insurance those who retire earlier or elect survivor benefits. The maximum ben count is lower for benefits commencing at ages below 0or because you fit liforces receive more monthly pension checks over an expected longer remainily mespan. Following this logic, the maximum amount is higher for benefits ging menicing at ages above 65. Similarly, pension benefit amounts are lower wu Vivor benefits because the payout will probably extend for a longer period that if benefits terminated upon the participant's death. DEFINED CONTRIBUTION PLANS Under defined contribution plans, companies set up an account for each employee who chooses to participate. Employees enter into a salary reduction agreement. Salary reduction agreements permit an employer to defer a specified amount of pay, often expressed as a percentage of pay, into the employee's account each pay period. Alternatively, the Pension Protection Act (discussed in Chapter 3) permits employers to automatically enroll newly hired employees in the defined contribu- tion plan and setting regular contributions through payroll deduction. We discuss automatic enrollment later in this chapter. The employer may have a matching contribution policy. Employers invest these funds on behalf of the employee, choosing from a variety of investment options such as company stock, diversified stock market funds, or federal government bond funds. Employees may be given a choice of investment options. What is the main difference between defined benefit plans and defined contribution plans? Defined contribution plans specify rules for the amount of annual contributions, while defined benefit plans specify the annual retirement benefit. Unlike defined benefit plans, these plans do not guarantee particular benefit amounts based on three factors that are discussed in the next section. Participants bear the risk of possible investment gain or loss. Benefit amounts depend upon several factors, including the contribution amounts along with employer matching contributions if offered, the performance of investments, and forfeitures transferred to participant accounts. Companies may choose to offer one or more specific types of defined contribution plans, which we review later in the chapter. Individual Accounts Defined contribution plans provide accounts for each employee into which contri- butions are made, investment losses are debited, and gains are credited. As noted previously, there are three possible contribution sources. First, employee contributions are usually expressed as a percentage of the employee's wage or salary. Second, forfeitures come from the unvested employer contribution amounts (and invest- ment gains, if any) of former employees' accounts. The third source is employer contributions. If employers choose to make contributions to individual accounts, they do so, but the employee makes contributions first. Under these circumstances, employer contributions are referred to as matching contributions. Matching con butions are most often expressed as a percentage of the employee's annual compensation, and they may choose to make a full or partial match.Chapter 4 Employer-Sponsored Retirement Plans 107 Companies that offer matching contributions do so for numerous reasons, including recruitment and retention of the most qualified individuals. Also, companies choose the formulas for making contributions and setting maximum contributions: limits. Here are three common approaches for determining matching . Full match: The employer fully matches an employee's contribution to the 401(k) plan account up to an amount set by law. For illustrative purposes, an employee earning $50,000 annually contributes $2,000 to their 401(k). Then, the company's matching contribution equals $2,000. . Fixed dollar match: The employer deposits $1 for every $1 the employee contributes up to a specified limit, for instance, 5 percent of pay. One employee contributes 3 percent of their $100,000 pay, equaling $3,000 (3 percent x $100,000). The employer contributes the same amount. Another employee contributes 10 percent of their $100,000 pay, equaling $10,000 (10 percent x $100,000). In this case, the company deposits $5,000 (5 percent x $100,000) because the plan specifies a 5 percent matching contribution maximum. . Variable dollar match: The employer's contribution decreases as an employee's contribution increases. For example, an employer might deposit $1 for every $1 on the first 3 percent of pay contributed by the employee, and 50 cents per dollar on the next 3 percent of pay. An employee who earns $100,000 annually contributes 6 percent to the 401(k) plan, equaling $6,000 (6 percent x $100,000). The employer contributes a total of $4,500 [($1 x (3 percent x $100,000)) + ($0.50 x (3 percent x $100,000))]. Automatic Enrollment Automatic enrollment is a feature of some defined contribution plans. As soon as eligibility requirements are met (not to be less favorable than ERISA participation rules), employees become covered under a plan but have the right to decline cov- erage at any time. A minimum default employee contribution and default invest- ment vehicle are set, but employees may choose to contribute a different percentage and change investments. In 2021, companies could deduct as little as 3 percent of an employee's pay up to 10 percent. There are three automatic enrollment plans: . Automatic enrollment provision. Workers are automatically enrolled in the retirement plan once they meet eligibility requirements unless they explicitly opt out. . Automatic escalation. Employee contributions are automatically increased at a predetermined rate over time, raising the contribution rate as a share of earn- ings. Employees may choose to contribute a different percentage. The deduc- tion percentage may increase each year by up to 1 percent until reaching the 15 percent cap. . Default contributions. The plan specifies the initial level of employee contribu- tion. Employees may elect to contribute a percentage of earnings different from the default rate.% 108 Part Two Retirement, Health Care, and Life Insurance Investment of Contributions PRISA requires that a fiduciary be named. According to the U.S. Department Labor, fiduciaries have important responsibilities and are subject to standards of conduct because they act on behalf of participants in a retirement plan and the beneficiaries. These responsibilities include: Acting solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them. . Carrying out their duties prudently. . Following the plan documents (unless inconsistent with ERISA). . Diversifying plan investments. . Paying only reasonable plan expenses. The duty to act prudently is one of a fiduciary's central responsibilities under ERISA. It requires expertise in a variety of areas, such as investments. Lacking that expertise, a fiduciary will want to hire someone with professional knowledge to carry out the investment and other functions. Prudence focuses on the process for making fiduciary decisions. Therefore, it is wise to document decisions and the basis for those decisions. 24 Employee Participation in Investments Most companies may allow plan participants to make choices about the invest- ment of funds in their individual accounts, including the following: . Company stock. Employees receive equity in the company that sponsors the defined contribution plan. Defined contribution plans cannot be based exclu sively on the company's stock. . Common stock fund. This is a professionally managed fund invested in the common stock of a variety of companies. The performance of stock can be highly variable. It is difficult to predict whether a stock will increase in value over time and, if so, by how much. At the same time, it is difficult to predict whether a stock will decline in value over time and, if so, by how much. Fixed-interest securities. These securities include bonds and other nonfederal instruments that pay a fixed interest rate over a predetermined period. The gain in investment is relatively low, but there is no risk for loss. Diversified investments. These are professionally managed funds that are invested in more than one type of equity (stock) such as based on company size or indus- try, or debt (bond) instrument. A diversified investment approach balances the extreme risk of gain or loss by including investments that do not fluctuate widely. . Money market fund. This is a professionally managed mutual fund that invests in short-term Treasury bills, certificates of deposit, or corporate bonds. The fund managers sell shares to investors, who receive regular payments of interest. . Lifecycle fund (or target date fund). Target date typically refers to expected retirement date. This is a balanced fund generally of stocks and bonds designedChapter 4 Employer-Sponsored Retirement Plans 109 to become more conservative as the investor approaches retirement by moving from equity funds to fixed-income mutual funds. When retirement is far in the distant future, taking risks in the stock market generally (but, not always) pay off over time because stocks generally increase in value over the long term. When closer to retirement, relying on fewer stocks lessens the risk of substan- tial loss when individuals will need to withdraw money soon." Most individuals have never made financial investments and the aforementioned descriptions of investment options will likely be unfamiliar. It is important that employers provide resources to help employees understand investment alternatives. In Chapter 9, we discuss financial education benefits to promote this objective. The number of investment choices varies by company. Typically, large companies offer an average of 16 investment choices, and there is a trend toward fewer choices. This trend is the result of three factors. First, administrative costs decline with the number of funds. Second, most employees choose to invest their contributions in a single invest- ment fund rather than in multiple funds. Third, investment companies recently began offering lifecycle funds, which employees find appealing as they are investing in a fund that roughly corresponds to their expected retirement year, as previously noted. Accrual Rules The accrued benefit equals the balance in an individual's account. Companies may not reduce contribution amounts based on age. Also, they may not set max- imum age limits for discontinuing contributions. Top-Heavy Provisions Companies must make minimum contributions to non-key-employee accounts equal to the lesser of 3 percent of annual compensation or the highest contribu- tion credited to key-employee accounts. Minimum Funding Standard The minimum funding standard for defined contribution plans is less complex than for defined benefit plans. This standard is met when contributions to the individual accounts reach the minimum amounts as specified by the plan." Contribution Limits An annual addition refers to the annual maximum allowable contribution to a participant's account in a defined contribution plan. The annual addition includes employer contributions, employee contributions, and forfeitures allocated to the participant's account."In 2021, annual additions were limited to the lesser of $58,000 or 100 percent of the participant's compensation." The amount of an employer's annual deductible contribution to a participant's account depends on the type of defined contribution plan."In 2021, the maximum contribution to a profit-sharing plan was the lesser of 25 percent of compensation or $58,000. Section 401(k), 403(b), and 457 plans had contribution limits of $19,500 in 2021. The limit is indexed for inflation in $500 increments.110 Part Two Retirement, Health Care, and Life Insurance Communicating Benefit Amount and the SECURE Act whydescribed earlier, the defined contribution benefit amount is the account balance an individual begins to withdraw money from it. In addition, the SECURE act requires defined contribution plans to provide "lifetime income illustration Participants at least annually. These illustrations help participants to und Stand how defined contribution balances may translate into regular monthly pay ments in retirement. Additional information and assumptions factor into the determination of life. time income illustrations. These factors include the date of retirement and when to start receiving payments, the age and life expectancy of the participant at retirement, whether the participant is married, the investment return or interest rate of investments, and the availability of commercial annuity contracts, which we described earlier. TYPES OF DEFINED CONTRIBUTION PLANS Defined contribution refers to a broad classification of different retirement plans that specify who is eligible to make contributions and the formula for making contributions. Beyond that are particular defined contribution practices, the choice of which depends partly on the type of organization. We review the fol- lowing defined contribution plans: . 401(k) plans . Roth 401(k) plans profit-sharing plans stock bonus plans employee stock ownership plans . savings incentive match plans for employees (SIMPLEs) . 403(b) tax-deferred annuities 457 plans . pooled employer plans 401(k) Plans 401(k) plans are named after the section of the Internal Revenue Code that cre- ated them. These plans, also known as cash or deferred arrangements (CODAs), permit employees to defer part of their compensation to an individual account set up in the qualified defined contribution plan. Only private-sector or tax-exempt employers are eligible to sponsor 401(k) plans. Section 401(k) plans offer three noteworthy tax benefits. First, employees do not pay income taxes on their contributions to the plan until they withdraw funds. Second, employers deduct their contributions to the plan from taxable income. Third, any investment gains are not taxed until participants receive payments.Chapter 4 Employer-Sponsored Retirement Plans 111 Roth 401(k) Plans The IRC established Roth 401(k) plans in 2006. These plans differ from 401(k) plans in two ways. First, an employee pays income tax on their contributions. Second, upon retirement, employee withdrawals are not taxed. Roth 401(k) plans are becoming an increasingly popular offering to help employees man- age the uncertainty of possible changes in future income tax rates. For exam- ple, it is not possible to know years in advance what income tax rates will be when an individual retires. The rates could be equal to, lower than, or greater than current income tax rates. Higher future income tax rates would require non-Roth 401(k) participants to withdraw larger amounts to meet retirees' needs. Higher withdrawal rates would lower the value of a 401(k) plan more quickly, as well as reduce the number of years in which it will provide income. Profit-Sharing Plans Companies set up profit-sharing plans to distribute a portion of profits to employees. Companies start by establishing a profit-sharing pool-that is, the money earmarked for distribution. Maximum annual contributions are limited to the lesser of 25 percent of employee compensation or the annual addition limit, $58,000 in 2021.31 Employer Contributions Companies determine the pool of profit-sharing money by application of a for- mula every year or based on the discretion of their boards of directors. One of three common formulas establishes employer contributions. A fixed first-dollar- of-profits formula uses a specific percentage of either pretax or after-tax annual profits (alternatively, gross sales or some other basis), contingent upon the suc- cessful attainment of a company goal. For instance, a company might establish that the profit-sharing fund will equal 1 percent of corporate profits. Second, a graduated first-dollar-of-profits formula uses a different percentage based on level of attained profits. For example, a company may choose to share 2 percent of the first $10 million of profits and 3 percent of the profits in excess of that level. Third, profitability threshold formulas fund profit-sharing pools only if profits exceed a predetermined minimum level but have a maximum payout level. Companies establish minimums to guarantee a return to shareholders before they distribute profits to employees and maximums because they attri- bute any profits beyond this level to factors other than employee productivity or creativity, such as technological innovation. For instance, a company may choose to share the increment of profits between 2 and 4 percent. There would be no payout below 2 percent or above 4 percent of profits. Allocation Formulas After company management selects a funding formula, it must consider how to distribute pool money among employees. Under a qualified defined contribution plan, the chosen allocation formula must not discriminate in favor of highly com- pensated employees. Usually, companies make distributions in one of three ways: equal payments to all employees, proportional payments to employees based on112 Part Two Retirement, Health Care, and Life Insurance ual salary, or proportional payments to employees based on their contribu Profits. Equal payments to all employees reflects a belief that all emplotion would share equally in the company's gains to promote cooperation ampel mployees. However, employee contributions to profits probably vary. Accordings most employers divide the profit-sharing pool among employees on a different basis. Companies may disburse profits based on proportional payments to employeal based on their annual salary. Presumably, higher-paying jobs indicate the greater potential to influence a company's competitive position. Still another approach is to disburse profits as proportional payments to employees based on their contribution to profits. Some companies measure employee contributions to profits based on job performance. However, this approach is often not feasible because it is difficult to directly isolate each employee's contributions to profits. Stock Bonus Plans A stock bonus plan is a kind of profit-sharing plan paid in employer stock instead of cash. Participants of stock bonus plans possess the right to vote as shareholders. Voting rights differ based on whether company stock is traded in public stock exchanges. 32 In the case of publicly traded stock, plan participants may vote on all issues. Employee Stock Option Plans (ESOPS) Employee stock option plans (ESOPs) provide shares of company stock to employees. These plans may be thought of as essentially stock bonus plans that use borrowed funds to purchase stock. ESOPs are either nonleveraged or leveraged plans.3 In the case of nonleveraged ESOPs, the company contributes stock or cash to buy stock. The stock is then allocated to the accounts of participants. Nonleveraged plans are stock bonus plans. In the case of leveraged ESOPs, the plan administrator borrows money from a financial institution to purchase company stock. Over time, the company makes principal and interest payments to the ESOP to repay the loan. Savings Incentive Match Plans for Employees (SIMPLEs) Congress enacted a law in 1996 that established savings incentive match plans for employees (SIMPLEs) for employees working in small companies. SIMPLE plan: Small companies that meet the following criteria are eligible to establish a . The company employs 100 or fewer people. . Each employee's previous year earnings was at least $5,000. . The company does not maintain another retirement plan. Companies may establish SIMPLEs as either individual retirement accounts (IRAS) or as 401(k) plans. We briefly consider the SIMPLE 401(k) plan. Employees, employers, or both may make contributions. The employee contribution limit is lower than in regular 401(k) plans. In 2021, employees may contribute up the lesser of 100 percent of compensation or $13,500. Employers may choose to make a regular contributionChapter 4 Employer-Sponsored Retirement Plans 113 of 2 percent of annual compensation or a matching contribution. Matching contri- butions cannot exceed more than 3 percent of annual compensation. 403(b) Tax-Deferred Annuity Plans Section 403(b) of the IRC established tax-deferred annuity (TDA) plans. A TDA is available to a broad range of nonprofit organizations such as private and public schools and colleges, public school systems organized by Indian tribal governments, coopera- tive hospital service organizations, and charitable organizations (e.g., the American Red Cross). As with 401(k) plans, contributions come mainly from employers or employees. Employees make contributions through salary reduction agreements with their employers. TDAs, or 403(b) plans, are subject to the same contribution limits as 401(k) plans. TDAs may supplement other employer-sponsored retirement programs, usually defined benefit plans. Private tax-exempt organizations may offer both 401(k) and 403(b) plans, but public organizations are prohibited from offering 401(k) plans. 457 Plans Section 457 plans are nonqualified retirement plans typically for local or state government employees. Until 2002, Section 457 plans were less generous than either 401(k) or 403(b) plans, because maximum annual contributions were sub- stantially lower. Since then, Section 457 plans have the same limits as 401(k) or 403(b) plans. However, unlike 401(k) and 403(b) plans, only employees may con- tribute to Section 457 plans. Pooled Employer Plans and the SECURE Act Pooled employer plans (PEPs) were established under the SECURE Act and apply only to 401(k) plans. PEPs permit unrelated employers to come together to participate in a single retirement plan. Unrelated employers operate in different industries (e.g., plumbing contractor versus software development) or in different geographic regions, which stands in contrast to multiple employer plans (MEPs) on this dimension. PEPs are generally advantageous to small employers. Individually, small employers usually pay higher fees to plan providers (e.g., investment companies such as Fidelity) than larger employers with greater power to negotiate lower fees. Pooling small employers creates higher collective purchasing power to negotiate lower fees. We reviewed both defined benefit and defined contribution plans and the many features of both. We also reviewed several types of defined contribution plans. Exhibit 4.6 summarizes selected differences between defined benefit and defined contribution plans. HYBRID PLANS Hybrid plans combine features of traditional defined benefit and defined contri- bution plans. The following four common hybrid plans will be discussed in turn: (1) cash balance plans and pension equity plans, (2) target benefit plans, (3) money purchase plans, and (4) age-weighted profit-sharing plans.114 Part Two Retirement, Health Care, and Life Insurance EXHIBIT 4.6 Characteristics of Defined Benefit and Defined Contribution Plans U.S. Department of Labor. What You Should Know About Your Retirement Plan. 2006. Accessed january 0, ZOZ1, www.dol.gov/e Defined Contribution Plan Defined Benefit Plan There is no requirement that the Employer Employer funded. Federal rules employer contribute, except in the Contributions set amounts that employers must SIMPLE 401(k) and Safe Harbor 401(k) and/or Matching contribute to plans in an effort to money purchase plans, and SIMPLE IRA Contributions ensure that plans have enough and SEP plans. The employer may money to pay benefits when due. choose to match a portion of the There are penalties for failing to employee's contributions or to contribute meet these requirements. without employee contributions. In some plans, employer contributions may be in the form of employer stock. Employee Many plans require the employee to Contributions Generally, employees do not contribute for an account to be contribute to these plans. established. Managing the The employee often is responsible for Investment Plan officials manage the investment, and the employer is managing the investment of his or her responsible for ensuring that the account, choosing from investment amount it has put in the plan plus options offered by the plan. In some investment earnings will be enough plans, plan officials are responsible for to pay the promised benefit. investing all the plan's assets. Amount of Benefits Paid A promised benefit is based on a The benefit depends on contributions upon Retirement formula in the plan, often using a made by the employee and/or the combination of the employee's employer, performance of the account's age, years worked for the investments, and fees charged to the employer, and/or salary. account. Type of Retirement Traditionally, these plans pay the The retiree may transfer the account retiree monthly annuity payments Benefit that continue for life. Plans may balance into an individual retirement Payments offer other payment options. account (IRA) from which the retiree withdraws money, or may receive it as a lump sum payment. Some plans also offer Guarantee of The federal government, through monthly payments through an annuity. Benefits the Pension Benefit Guaranty No federal guarantee of benefits. Corporation (PBGC), guarantees some amount of benefits. Leaving the If an employee leaves after Company before vesting in a benefit but before the The employee may transfer the account Retirement Age plan's retirement age, the benefit balance to an individual retirement account generally stays with the plan until (IRA) or, in some cases, another employer the employee files a claim for it at plan, where it can continue to grow based retirement. Some defined benefit on investment earnings. The employee plans offer early retirement also may take the balance out of the plan, but will owe taxes and possibly penalties, options. thus reducing retirement income. Plans may cash out small accounts.Chapter 4 Employer-Sponsored Retirement Plans 115 Many employers have set aside traditional defined benefit plans for hybrid plans. Numerous a