Retirement programs: assembling the best possible plan.
Defined contribution plans contain provisions that enable employers to determine the amount that must be contributed to a pension plan each year, usually requiring employers to contribute a percentage of company income or employee salaries to a pension fund. Once the defined contribution is paid, the employer has no additional liability to provide pension benefits; therefore, the employees accept the risk of the plan's investment performance. Thus, if the plan performs exceptionally well, employees share in the gains in the form of increased pension benefits distributed in the future from the assets accumulated in the trust fund. On the other hand, if the plan performs poorly, employees share in the losses by receiving smaller pension benefits. Defined benefit plans are backed by the Pension Benefit Guaranty Corporation (PBGC), under the authority of the Employee Retirement and Income Security Act (ERISA) of 1974. The PBGC insures pension benefits up to a level of $2,352.27 per person per month, for a worker retiring at age 65. Defined benefit plans specify the benefits to be received by employees and the employers contribution is based on estimates of the cost of providing these benefits. Benefits are usually defined in terms of a formula that incorporates factors such as employee age, years of service, salary levels and any other factors specified in the employment agreement. In contrast to defined contribution plans, in defined benefit plans the employer accepts the investment risk of the plan. The employee does not own an accumulated fund but is promised a contractual pension based on a formula. Many variables must be estimated in order to determine the periodic pension contribution from the employer; these estimates are referred to as actuarial assumptions. If the investment performance of the plan exceeds the actuarially determined pension obligation, the employer may reduce future contributions, but if the performance is poor, then the burden is on the employer who must make additional contributions to ensure that the plan will be able to fund future benefits. If pension plans satisfy certain criteria contained in the Federal income tax laws, substantial tax benefits are available. A qualified plan--one meeting the tax law criteria--has features that allow employees to avoid paying taxes on benefits until they are actually received. Employers are allowed a tax deduction at the time contributions are made to the fund. Earnings on fund assets are not taxed until distributed to beneficiaries.
Most large pension plans are either fully or partially funded, which means that the resources of the plan from which future benefits are to be paid have been transferred to a trustee or fiscal agent. The employer, or sponsoring company, usually makes a cash contribution to the trustee, who is responsible for investing the money and for the management of the fund assets. The trustee pays beneficiaries as retirement or separation occurs and is required to prepare financial statements that are available for employee-participants and other interested parties.
The majority of new qualified retirement plans established today by middle-sized companies are defined contribution plans. The Investment Company Institute Research Department recently published statistics showing that over 75% of middle-sized retirement plans were defined contribution plans.
The Internal Revenue Service (IRS) issued 370 defined benefit plan determination letters covering 857,000 employees, averaging more than 2,300 employees per plan, between October, 1990, and October, 1991. During the same period, they issued 11,853 defined contribution plan determination letters covering approximately 1.6 million employees, averaging only 135 employees per plan. This is a clear indication of the preference of middle-sized companies for defined contribution plans.
Defined Contribution Plans
The defined contribution plan is usually prefered by both employers and employees. The flexible funding requirements of these plans are the main reason for their strong appeal to middle-market employers. Such plans do not commit the company to a fixed outlay each year as discretionary contributions are permitted. From the employee's perspective, it is easier to understand the benefits of defined contribution plans and therefore they tend to prefer them to defined benefit plans.
Among middle-sized organizations one of the most popular defined contribution plans is the 401(k) plan. Under these plans, companies usually match some percentage of employees' pre-tax contributions. However, a matching contribution is not required and many companies offer a discretionary match only. These plans have been in place in middle-sized companies for many years; consequently, the number and asset size of such plans have increased substantially. Even so, the great majority (98%) of the total small pension plan market consists of pension plans with $5 million or less in assets.
In recent years employees have started taking a more active interest in their individual accounts. Many employees actually direct the investment of their account balances among different investment funds. When a company offers this popular option to its employees it is important to also provide competent investment advice as well as accurate and timely account statements to all employees.
While most new qualified retirement plans established by middle-sized companies are defined contribution plans, it is important to recognize that there can be certain problems associated with these plans. As a general rule, these problems fall into three broad categories: administrative, communication and compliance. Administrative Pitfalls
Employers are often advised that the 401 (k) plan is both easy and inexpensive to administer because of its "turnkey" feature. However, these plans are often more complex than companies are led to believe. A recent survey shows that almost half of all middle-sized companies spend over 20% of their time managing their plans. And the more features and options the plan offers, the more difficult and time-consuming it will be to administer. If a company is considering implementing a 401 (k) plan, it is important to explore the following issues:
* Administrative costs over the first two years: Total operating costs, including commissions, should be known before the plan is initiated. Any costs involved in either the termination of the plan or a change in investments should be quoted and the method and frequency of billing should be stated.
* Tax issues: Some of the more important questions to be answered relate to nondiscrimination testing (a test devised by the IRS to ensure that a qualified plan does not discriminate, either in contributions or benefits, in favor of highly compensated employees); deductibility of employer and employee contributions; employees' ability to fund IRAs; and the consequences of having more than one plan.
* Examples of informational reports: The administrator of the plan should provide management with draft reports before employees are issued with statements. The administrator should discuss with management the results of these reports so that management can have the chance to detect any early signs of trouble, to discuss future planning opportunities, and to evaluate the administrator's performance.
The 1974 ERISA law states, in part, that the plan's administrator is required to "Discharge his duties...solely in the interest of the participants and beneficiaries and...with the care, skill, prudence and diligence...that a prudent man...would use."
It is vital to the success of a 401 (k) plan to have clear and concise channels of communication with employees. In order to ensure good communication at all times, a company should:
* Provide an opportunity for the investment firm to present an annual performance update to all employees. Employees who are fully informed with regard to their retirement plan usually have more confidence in the plan and consequently there is greater participation in the plan, both in the number of participants and in the amount of the contribution.
* Provide clear and concise statements to employees. An attempt should be made to minimize confusion caused by statements cluttered with irrelevant information.
* Provide an opportunity for those employees not presently contributing to a company's plan to meet with representatives from the investment firm or from the company. Employees often do not participate in a plan because they do not understand the plan.
Compliance Requirements Pitfalls
Both the IRS and the Department of Labor (DOL) will frequently contact the firm requiring information regarding the retirement plan. All such inquiries should be answered promptly as procrastination can prove to be costly and time-consuming in resolving the resulting problems. Most compliance violations are caused by filing Form 5500s incorrectly. Improper or incomplete responses to IRS and DOL inquires can only lead to further complications. Federal law often requires that the IRS and DOL exchange information, so it is important that information supplied should be accurate. In order to avoid compliance violations, the following actions are recommended:
* File complete 5500s on time. If necessary, apply for an extension by or before the deadline date. The employer must provide the pension plan employee, within 30 days of the request, with an annual report which summarizes the information contained in Form 5500. The detailed form includes an accountant's report, a list of investments and a report showing whether there is enough money in the fund to pay the benefits promised by the plan.
* Comply with all plan audit requirements. Rules concerning plan audits can be confusing, so it is important to fully understand the type of audit required and the appropriate dates for any audits.
* Respond to any IRS questions regarding 5500s within the usual 30-day period allowed. These inquiries are usually made through form letters and are relatively uncomplicated. Justifying a late response, however, is not as simple. Conclusion
A company's retirement plan is often one of the important factors in attracting and retaining good employees. A successful retirement plan is the result of continuing work and planning on the part of the company. It involves a great deal of effort to implement a plan and keep it running smoothly. An unsuccessful plan can cause many problems for the company and erode employee moral. It is important that a company should be fully aware of the possible pitfalls involved in these plans as these problems can generally be easily avoided. More and more companies are opting out of defined benefit plans in favor of defined contribution plans. Over 90% of the top 500 companies in the country now offer defined contribution plans, such as the 401 (k). These plans are required by law to offer a choice of at least three investment options, with the employee having the right to choose how the money should be divided among them. All earnings remain tax-free until withdrawn.
While employers are not liable for the performance of a 401 (k) plan, they are responsible for providing diversified investment options and good quality investment advisers or quality Guaranteed Income Contract (GIC) insurers. It is the duty of the employer to establish a structure within which the employee can make sound investment decisions.
Today's workers change jobs more often, usually before they would be fully vested in a company pension plan, so the trend toward defined contribution plans, such as the tax-deferred 401 (k), or self-directed IRAs and Keogh plans is welcome news. These retirement plans are not guaranteed by the PBGC, but they are thought to be as safe because the employee controls the amount of money saved and how this money is invested. Defined contribution plans offer solid advantages to middle-sized companies and statistics indicate that the trend in middle-sized companies is toward this type of plan.
Jeanne Sylvestre, PhD, is an associate professor at the University of South Alabama.
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|Publication:||The National Public Accountant|
|Date:||Feb 1, 1994|
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