Types
Of Pension Plan
Defined
Benefit Plans
In
a defined benefit plan, the employer agrees
to provide the employee a nominal benefit amount
at retirement based on a specified formula.
The formula is usually one of three general
types: a flat-benefit formula, a career-average
formula, or a final-pay formula.
- Flat-Benefit
Formulas These
formulas pay a flat dollar amount for each
year of service recognized under the plan.
- Career-Average
Formulas There are two types of career-average
formulas. Under the first type, participants
earn a percentage of the pay recognized
for plan purposes in each year they are
plan participants. The second type of career-average
formula averages the participant's yearly
earnings over the period of plan participation.
At retirement, the benefit equals a percentage
of the career-average pay, multiplied by
the participant's number of years of service.
- Final-Pay
Formulas
These plans base benefits on average earnings
during a specified number of years at the
end of a participant's career; this is presumably
the time when earnings are highest. The
benefit equals a percentage of the participant's
final average earnings, multiplied by the
number of years of service. This formula
provides preretirement inflation protection
to the participant but can represent a higher
cost to the employer.
Flat-benefit
formulas are common in collectively bargained
plans or plans covering hourly paid employees.
Career-average and final-pay formulas are most
common in plans covering nonunion employees.
Under pay-related formulas, an employer has
some discretion in defining pay for plan purposes
provided the definition does not discriminate
in favor of highly compensated employees, subject
to the statutory and regulatory definition of
compensation used in testing for nondiscrimination.
Under ERISA's minimum standards, there is also
some leeway in determining what employment period
will be recognized in the benefit formula. The
benefit may reflect only the plan participation
period or may be based on the entire employment
period.
Defined
Contribution Plans
In
a defined contribution plan, the employer makes
provision for contributions to an account established
for each participating employee. The final retirement
benefit reflects the total of employer contributions,
any employee contributions, and investment gains
or losses. Sometimes the accumulated amount
includes forfeitures resulting from employer
contributions forfeited by employees who leave
before becoming vested. As a result, the level
of future retirement benefits cannot be calculated
exactly in advance. Employer contributions to
defined contribution plans are often based on
a specific formula such as a percentage of participant
salary or of company profits.
The
plans may be designed to include pretax or after-tax
employee contributions, which may be voluntary
or mandatory. There are several types of defined
contribution plans:
-
In a money purchase plan, employer contributions
are mandatory and are usually stated as
a percentage of employee salary.
- In
a profit-sharing plan, total contributions
to be distributed are often derived from
a portion of company profits.
- Stock
bonus plans are similar to profit-sharing
plans but usually make contributions and
benefit payments in the form of company
stock.
-
A target benefit plan is a cross between
a defined benefit plan and a money purchase
plan-with a targeted benefit used to determine
the level of contributions but with contributions
allocated to accounts as in a money purchase
plan.
- A
thrift, or savings, plan is essentially
an employee savings account, often with
employer matching contributions.
-
In a 401(k) arrangement, an employee can
elect to contribute, on a pretax basis,
a portion of current compensation to an
individual account, thus deferring current
income tax on the contribution and the investment
income earned.
-
In an employee stock ownership plan (ESOP),
employer contributions to employee accounts
must be primarily in company stock.
In
December 2004, the Treasury Department and IRS
issued proposed temporary regulations designed
to shut down abusive tax shelter schemes involving
ESOP-based pension schemes.
Section
409(p) of the tax code generally prohibits accruals
or allocations under an employee stock ownership
plan (ESOP) that holds stock of an S corporation,
where the ownership interest in the ESOP or
in rights to acquire the corporation are so
concentrated among 10% owners that they hold
50% or more of the interests in the corporation.
The
regulations replaced proposed temporary regulations
that were issued in 2003 and addressed a wide
variety of issues under section 409(p), including
the key definitions of a prohibited accrual
or allocation, a disqualified person and a non-allocation
year.
“These
regulations support our efforts to shut down
abusive schemes, in this case those skirting
pension laws," IRS Commissioner Mark W. Everson
commented at the time.
The
regulations came into effect for plan years
beginning on or after Jan. 1, 2005, subject
to several special effective date rules.
BACK
TO TOP
