Corporate and Private Pension Plans in the United States

Table of Contents

List of Tables

List of Abbreviations

A) Introduction
I. Brief History of Pension Plans in the United States
II. Relevance of Pension Plans for the American Population
1) Tax Advantages for Employers
2) Income Security for Employees
3) Supplemental of Social Security System
4) Prevalence of Corporate Pension Plans
(a) Sponsoring and Participation Level by Work Group
(b) Sponsoring and Participation Level by Plan Type
(c) Pension and Annuity Income Levels
5) Relevance of Individual Retirement Arrangements
6) Influence on Financial Markets
7) Further Areas of Pension Coverage
(a) Self-employed Individuals
(b) Unions as Co-founder of Pension Plan Trusts
i Multiemployer Plans
ii Multiple Employer Plans
iii Single Employer Plans
(c) Governmental Employees

B) Regulatory Environment of Retirement Plans
I. Employee Retirement Income Security Act of
II. Trusts
1) Pension Trust Triangle
2) Tax Exemption of Trusts
3) Prudent Man Rule
4) Funding
5) Legal Force and Creditor Protection
6) ERISA vs. State Law
III. Systematic Segmentation
IV. Tax Regulations for Qualified Retirement Plans
1) An Overview of the Current Tax System
2) Tax Treatment of Transactions
(a) Contributions
i Employee Contributions
ii Employer Contributions
(b) Distributions
i Averaging Method for Lump Sum Distributions
ii Tax Deferrals on Net Unrealized Appreciation in Employer Securities
iii Tax Free Rollover Distributions
(c) Tax Credits for IRA Contributions
(d) Regular Taxation of Distributions
i Lump Sum
ii Annuities
iii Exlusion Rule
(e) Asset Accumulation
(f) Early Distributions
(g) Loans

C) Qualified Plans
I. General Set of Standards for Qualified Plans
II. Defined Benefit Plans
III. Defined Contribution Plans
1) 401(k) Plans
(a) Contributions
i Pre-Tax Elective Deferral
ii Matching Contributions
iii Non-Elective Deferrals
iv After-Tax Contributions
v Catch-up Contributions
vi Limitation on Contributions
2) Thrift and Savings Plans
(a) Contributions
(b) Distributions
3) Profit-Sharing Plans
(a) Contributions
(b) Differences to a 401(k) Plan
4) Money Purchase Pension Plans
5) Stock Bonus Plans
(a) Contributions
(b) Distributions
6) Employee Stock Ownership Plans
7) Safe Harbor 401(k) Plans
IV. Individual Tax-Favored Plans
1) Traditional IRAs
(a) Plan Qualifications
(b) Contributions
(c) Distributions
(d) Rollovers
2) Roth IRAs
(a) Contributions
(b) Distributions
(c) Rollovers
3) Savings Incentive Match Plan for Employees (SIMPLE)
(a) Special Requirements
(b) Participation
(c) Contributions
(d) SIMPLE IRA
(e) SIMPLE 401(k)
(f) Distributions
4) Simplified Employee Pensions
(a) Participation
(b) Contributions
(c) Distributions

D) Facts and Trends of Retirement Plan Participation
I. The Shift in the Plan Type Landscape
1) Current Participation Profiles
2) Historical Devolution
II. Reasons and Implications for Employers
1) Long-term Liabilities
2) Funding Volatility
3) Company Maturity Risk
4) High Costs and Regulations
5) Weakening Unionizing
II. Advantages and Implications for Employees
1) Elimination of Employment Risk
2) Elimination of Employer Risk
3) Remaining Risks
(a) Accumulation Risk
(b) Longevity Risk
(c) Investment Risk
(d) Leakage in Plan and Financial Knowledge
III. Pension Shortfall
IV. Financial Crisis
1) Impact on Fund Assets
2) Reactions of Plan Participants

E) Resume

Appendix

Bibliography

Glossary

List of Tables

Table 1: Employer Spending on Benefits as Percentage of Total Benefit Spending, 1960 –

Table 2: Source of Income in Percent for Population Age 65 and Over,

Table 3: Sponsorship Level and Participation Rate in Pension Plans among All Worker Groups in

Table 4: Access, Participation and Take- up Rates in Pension Plans for all Private Industry Workers in

Table 5: Ownership of IRAs and 401(k)-Type Plans by Workers Ages 21 – 64, in Percent of Workers Ages 21 -

Table 6: Total Assets held in Private Pension Funds for the Years 2006 to

Table 7: 401(k) Plan Asset Allocation 2007, Rounded Data

Table 9: Example of a Plan’s Vesting and Accrual Schedule

Table 10: Accrual and Vesting of Benefits According to the IRS

Table 11: Basic Types of Contributions to a 401(k) Plan

Table 12: IRA Deduction Limits of MAGI by Filing Status

Table 13: Allocation of Pension Plans by Number for the Year 2006; Rounded Data

Table 14: Allocation of Pension Plans by Number of Active Participants for the Year

Table 15: Participation by Plan Type, 1979 to

Table 16: Participants with Participant-Direction in 401(k) and Non 401(k) Plans, 1988 –

Table 17: Return Rates of Defined Benefit and 401(k) Plans 2003 –

Table 18: Misinformation of Employees about their own Pension Plan Coverage

Table 19: Projected Retirement Income Replacement Compared to Projected Retirement Needs

Table 20: Retirement Income Replacement Sources

Table 21: Projected Retirement Income Replacement Compared to Projected Needs

Table 22: Required Replacement Ratios Broken Down by Social Security and Other Sources

Table 23: Median Replacement Rates for Participants Turning 65 between 2035 and 2039, by Income Quartile

Table 24: Major Stock Market Performance, 1993 -

Table 25: Change in Average Account Balance of 401(k) Participants, by Age and Tenure, Jan. 1, 2000 through Jan. 20,

Table 26: Change in Average Account Balances of 401(k) Participants, by Age and Tenure, Jan. 1, 2000 through Jan. 20,

Table 27: Asset Allocation Distribution of 401(k) Participant Account Balances to Equity, by Age: Year-End 2007 and

Table 28: Defined Contribution Plan Participant Activities in 2008.

List of Abbreviations

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Word of Thanks

I thank my parents, Sevim and Ali Ihsan Saglik, for their (not merely) financial support of my study, and special thanks to my Brother Ahmet who has been saving me for more than a decade from excessive fits of raving madness due to computer problems.

Foreword

Within the two last centuries the U.S. retirement system developed from employer-sponsored defined benefit plans for the few to the so-called three-legged stool: Social Security, employer-sponsored pensions, and private savings. This system provides today a successful basis of income security. Poverty among elderly has fallen significantly over the last several decades and millions of Americans enjoy well-funded pensions from both sources public and private retirement income. However, as with many other industry countries, the pay-as-you-go funded Social Security is projected to struggle with its financing due structural changes in the labor market, longer life spans and the huge number of baby boomers who have been retiring nowadays. The role of private pensions is therefore being associated with increasing importance for the American society. The private pension system already accounts for a significant portion of income, provides numerous plan types according to the wishes of all parties, and is considered the biggest financer of the U.S. capital market. Despite these impressive credentials the private pension system experienced a massive shift in pension plan coverage which changed the overall structure of retirement planning and which is expected to strongly affect the income situation of future U.S. retirees.

This thesis gives first an understanding of the relevance of corporate and private pension plans for the U.S. work force. Then, the thesis examines the regulatory environment of qualified pension plans and the tax treatment of transactions on the employer and employee side. Further, the multitudinous pension plan qualification standards are disclosed and explained in detail. The main part of this thesis navigates the reader through the basic plan types in the private sector including employer-sponsored plans and individual retirement arrangements. Afterwards, the thesis deals critically with the opportunities and risks as a result of the structural shift in the retirement plan landscape from defined benefit to defined contribution plans in general, and to 401(k) plans in particular. This chapter is followed by an outlook on pension shortfalls for future retirees according to recent studies of governmental and private institutions. The impact of the current financial crisis on plan funds and the reactions of plan participants thereon are captured in the last chapter.

It should be noted that this thesis focuses solely on qualified plans, and within that plans basically on defined contribution plans. A deeper examination of further main plan types such as defined benefit or hybrid plans would go far beyond the scope of that thesis. However, for reasons of a comprehensive understanding of the U.S. retirement system and for purposes of comparison, defined benefit plans are taken into consideration whenever required.

A short hint to the use of personal and possessive pronouns: This thesis uses solely the male form ‘he’ or ‘him’ which, however, does automatically include the female ‘she’ or ‘her’.

A) Introduction

I. Brief History of Pension Plans in the United States

The history and widespread adoption of corporate and private pension plans in the United States roots in a combination of economic, political, social and demographic developments. With the steady growth of the industrial sector in the second half of the 19th century the mainly agricultural and handcraft focused structure of economy changed rapidly. The increasing urbanization and mobilisation, the changed living circumstances and further economic and social changes led to a loss in reliance on traditional old age support by the younger generations. A spreading poverty among older Americans was the result of insufficient or not existing retirement planning. Unemployment rate of job seeking men over age 65 increased from 26.8 percent in the year 1890 to 31.2 percent in 1900 and 54 percent in 1930.^[1] Growing concerns of employers and the government to support elderly employees led to the establishment of institutional regulations for retirement planning. Some of the earlier corporate retirement schemes were founded by the private railroad companies. A high level of unionization and low cost pressure due to low competition were the forces behind. These early pension schemes gave the employee the choice to make voluntary employee contributions. Until 1920, corporate pension schemes were provided by transportation companies, banks, mine, coal or oil companies, and a few big corporations. Usually employers distributed the pension benefits out of firm profits and just in rare cases financing of pension benefits was made through pension trusts or purchase of insurance. Legislations with tax incentives followed in 1921 and 1926. Pension trusts became exempt from taxes and employer contributions were declared business expenses, and actual receive of pension benefit distributions became taxable income for the retiree. This strongly stimulated adoption of corporate pension plans which provided then benefits for about ten percent of all employees. In 1942, with the Revenue Act and amendments thereto in the Internal Revenue Code in 1954, tax privileges were made dependent from certain non-discrimination provisions, and a limitation of employer expenses for pension benefits was introduced. With growing unionization, pension plans became essential parts of collective bargaining.^[2]

The Taft-Hartley Act (or Labor Management Relations Act) of 1947 permitted labor representatives to manage bargained pension, and funds had to be held in a trust. Allocation of the steadily growing funds shifted from life insurance investments and fixed-interest securities to the capital market, especially to the stock exchange market. Further governmental regulation provided employees with more rights to gather pension plan information.

A milestone in the history of pension plan regulation was the passage of the Employee Retirement Income Security Act of 1974 (ERISA). This act was a consolidation of any further existing employee benefit programs and added various changes thereto. Main purpose of ERISA was to give pension plans status of a legal body, separated from employer or other sponsors.^[3] Before ERISA, federal regulation focused merely on preventing discrimination in favour of highly compensated, officers and managers and on limitation of federal revenue losses through excessive plan contributions. Federal law lacked in many areas, for example in providing vesting rules, in dealing with actuarial sound estimates of a plan, in benefit accrual reporting, in protecting plan participants against mismanagement of plan assets or in enforcing rights for participants to juridical claim their accrued benefits and file a suit in case of mismanagement of plan assets.^[4] Furthermore, employee participation in plan management and severe requirements for trust administration were set up. The years were marked by several pension and tax reform acts. The complexity of the pension system got inflated with time going by and peaked now in a scope four times larger than, for example, the entire German tax law provisions. This keeps the administrative costs of pension plans on a high level which led to shut down of smaller pension benefit trusts and to decreasing plan adoptions of smaller businesses.^[5]

The recent significant pension reform, the Pension Protection Act of 2006 (PPA 2006), was enforced due to concerns of legislators that Americans do not save enough for retirement. The PPA 2006 made many of the enacted provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) permanent and changed the Treasury rate applicable to actuarial estimates of defined benefit plan funding.^[6] However, the most substantial renewal is considered to be the adoption of automatic enrollment of employees in an employer sponsored 401(k) plan. That means that employees are automatically rolled into the employer’s 401(k) plan unless they opt out. Though, some employer pension plans have had automatically enrollment long before the PPA 2006, however the PPA 2006 pre-empts state law and employer regardless of the residential state can enrol their employees now without the employees’ written authorization.^[7] Additionally, the employer has to invest the automatic enrollment contributions in a Qualified Default Investment Alternative (QDIA) since the employee is not making the election. A QDIA is an investment vehicle which is in general professionally managed, e.g. by asset allocation based on the participant’s age, life expectancy and changing needs over time (those provisions are offered for example in life-cycle, balanced or targeted retirement funds).^[8] Furthermore employer can choose to offer a default investment option which allows the employee to invest in a professional diversified portfolio. Congress hopes that advantages conducive thereto will result in higher commitment of pension plan participating among the labor force and also will improve non-discrimination testing since more non-highly compensated employees participate automatically in the plan.

II. Relevance of Pension Plans for the American Population

1) Tax Advantages for Employers

Employers may have numerous reasons for providing their employees with different types of benefits, the ability to take generous tax advantages is considered to be the main explanation for U.S. Companies. Contributions to retirement plans are usually deductible business expenses for the company which lead to lower tax rates. The estimated tax expenditures^[9] for the year 2009 for all employment-based benefits are estimated at $347.9 billion, with tax favored pension and retirement contributions accounting for $220.6 billion.^[10]

The employer can improve its competitive advantage toward other employers if its pension plan includes generous provisions (e.g. high matching contributions). Top benefit companies enjoy high attractiveness among employees. Employer benefits tie employees to their employers and are a way to keep fluctuations of the company at low levels. Finally, employers might convince elderly and less productive workers to enter retirement instead of working beyond normal retirement age and occupying therefore a position which might be more suitable for a younger worker.

2) Income Security for Employees

Employment-based benefit programs provide some measure of income security and access to medical care to active, unemployed and disabled workers, retirees, and their beneficiaries. The regulatory environment of those programs is provided by ERISA which defines the different types of employee benefit plans.^[11] Benefit programs can be divided in voluntary employment based benefits and mandatory employment based benefits. The variety of voluntary benefits is numerous. Besides retirement income benefits, the employee or retiree can benefit from health, dental, vision or life insurance, Medicare B and further programs. The list of mandatory employment-based benefits comprises for example Social Security retirement, Social Security disability, Medicare part A, workers’ compensation and unemployment insurance. Among all voluntary choices retirement income benefits present the main pillar of employment-based benefits. Health insurance programs as the second pillar of voluntarily employer sponsored benefits, covered 62.2 percent (162.5 million persons) of the civilian population under age 65 in 2007.^[12]

Even though employer spending on health insurance increased steadily, retirement benefits are still the main source of employment-based benefits.^[13]

Abbildung in dieser Leseprobe nicht enthalten

Table 1: Employer Spending on Benefits as Percentage of Total Benefit Spending, 1960 – 2007.^[14]

The aggregated amount of benefits received from employer-benefit systems in 2007 was $2,993.9 billion dollar. The share of OASDI benefits out of total retirement benefits was 45.9 percent.^[15]

3) Supplemental of Social Security System

The Social Security Act of 1935 was introduced to provide and protect retirement income. In 1956 it was widened to income protection for disabled workers their dependents and developed to its current form of Old-Age, Survivors, and Disability Insurance (OASDI) with adding health insurance for the elderly and disabled. The Social Security system is a combination of a pay-as-you-go and a capital based system. Under the pay-as-you-go system current revenues are immediately distributed to beneficiaries. Capital based means that any surplus is invested in trust funds.^[16] In 2008 OASDI covered 161.6 million employees and self-employed individuals, with 49.1 million persons such as the elderly, disabled and their dependents and survivors receiving benefits.^[17] The Social Security system however, does not comprise the entire population of the United States but it is interconnected to the labor market. Benefits depend on age, number of years of work, and the average income. The Social Security system is funded by the Federal Insurance Contribution Act tax (FICA). FICA is a payroll tax imposed on both the employer and the employee to the half and in full to self employed individuals. The current overall contribution rate is 12.4% plus an additional 2.9% Medicare tax. Employees and employers share to the Social Security is 6.2% of gross compensation up to $106,800 (Social Security Wage Base). However, a limitation base on Medicare does not exist.^[18] Eligible for OASDI benefits is every individual who was employed for a minimum time period and who earned a certain level of income. The normal retirement age has been increased from 65 to 66, initially applicable to individuals born in 1943, and will gradually increase up to age 67 for people born in 1960 or later. Reduced early retirement benefits continue to be distributable at age 62.^[19] In fact, the average retirement age is 62.6.^[20] Benefits from Social Security are tax exempt up to certain income limits.^[21]

The mean total income in the year 2007 for population above age 65 was according to EBRI $27,118. The overall retirement income^[22] was $15,440 with income from OASDI of $10,395.^[23]

The source of retirement income for population above age 65 consisted in 2007 by 38.6 percent of OASDI and by 18.6 percent of pension and annuities. The rest was filled by earnings, income assets, and other sources.^[24]

Abbildung in dieser Leseprobe nicht enthalten

Table 2: Source of Income in Percent for Population Age 65 and Over, 2007.^[25]

90.2 percent of the population received OASDI benefits and about 33 percent received pension and annuities from employment-based retirement plans.^[26] The public pension spending of the U.S. was six percent in 2005.^[27]

The mainly pay-as-you-go funded social security system faces, like many OECD countries, the challenges of a steadily increasing old age population, higher life expectancy and last not but least the retiring baby-boomer generation. The trend is a shift in the ratio of Old-Age and Survivors Insurance (OASDI) covered workers to OASDI beneficiaries from 16.5 in 1950 to 3.7 in 1970 to 3.2 in 2008 with intermediate assumptions of a further shrinking of the OASI-ratio to 2.2 in 2030 and 2.0 in 2085.^[28]

4) Prevalence of Corporate Pension Plans

(a) Sponsoring and Participation Level by Work Group

The number of pension trusts rocketed in the second half of the 20th century. While the amount of trusts at the end of the 1930s was about 700, nowadays there are about one million trusts to manage the assets for future retirees. The number of pension plan covered employees was about 4 million in 1940, 9.8 million in 1950, 18.7 million in 1960, and 26.1 million in 1970.^[29] Today 158.1 million American workers, ages 21 – 64, worked for an employer or union who sponsored a retirement plan with a participation rate of 41.5 percent. 110.1 million workers from the private sector had a sponsoring rate of 52.7 percent and participation rate was 42 percent, whereas the sponsorship of public employees were significantly higher with 83.3 percent of public workers who had access to a retirement plan and a 75.4 percent participation rate.

Table 3: Sponsorship Level and Participation Rate in Pension Plans among All Worker Groups in 2007.^[30]

Abbildung in dieser Leseprobe nicht enthalten

When making a cross-section, facts can be summarized as follows:

- Access and participation among full time, full year, and wage and salary workers is higher than among part time workers.
- Workers over age 50 are likely to participate in a pension plan almost three times more than employees in their twenties.
- Being white and having a higher educational level can be associated with a higher probability of participation.
- Higher income is proportional to plan participation. Merely one quarter of the salary group with annual earnings from $15,000 - $20,000 participated in a pension plan compared with more than 70 percent of employees with annual earnings of more than $50,000.
- Small differences exist in the participation rate between male and female workers to the extent that participation rate of female workers is slightly higher than for male workers.
- Employer size is also an important factor in employment based retirement plan participation. Just 15.4 percent of workers at employers with ten or less employees participated in pension plans compared with a participation rate of 58 percent at employers with more than 1,000 employees.^[31]

(b) Sponsoring and Participation Level by Plan Type

Regarding to the U.S. Bureau of Labor, in 2007 access and participation subdivided in plan types, defined benefit and defined contribution, was as follows:

Table 4: Access, Participation and Take- up Rates in Pension Plans for all Private Industry Workers in 2007.^[32]

Abbildung in dieser Leseprobe nicht enthalten

- The access rate to a defined benefit plan in the private industry was 62 percent with a participation rate of 43 percent.
- Defined benefit plans were offered only to 22 percent of private sector workers and almost every worker (20 percent) participated therein.
- 51 percent participated in both plans.
- The take-up rate^[33] in defined benefit plans was higher than in defined contribution plans.
- The only work group who had a greater participation in defined benefit plans than in defined contribution plans were union workers.
- Participation rate for union workers in 2007 was more than triple the average of all private industry workers and participation almost twice as much in both plans than for their non-union colleagues.
- Among occupational groups, a 77 percent rate of participation was the highest for management, business, and financial employees and a rate of 25 percent was the lowest for service workers. ^[34]

(c) Pension and Annuity Income Levels

Regarding to the latest analyses by EBRI of retirement annuity and employment-based income (which includes income from defined benefit and defined contribution plans), the current pension and annuity distributions among population can be summarized as follows:

- 42.6 percent of men age 65 and over received pension and/or annuity income with a mean annual amount of $18,293 (median $12,000) compared to women from whom only 27.9 percent age 65 and over received an annual pension income of $11,895 (median $7,920). However this gender gap is closing since more young women today tend to spend more time in work force than today’s elderly woman did. The same is with the level of pension income which is likely to make up with those of men.^[35]
- In general, more workers with a graduate-level receive pension/annuity income than workers with a high school diploma only and hereby receive more than twice as much.
- Workers of the public sector are likely to receive more than double as much than workers from the private sector.^[36]
- The median annual pension/annuity income of population above age 50 in the lowest quintile was $2,628, in contrast to workers in the highest income quintile $31,320.^[37]

5) Relevance of Individual Retirement Arrangements

Besides the various employer-sponsored retirement saving plans, there are many individual sponsored tax-favored saving vehicles, namely individual retirement account (IRA) or individual retirement annuity. The majority of workers own an individual retirement account. Further forms of individual retirement accounts exist in form of SEP-, SAR SEP-, SIMPLE- and Roth-IRAs. ERISA authorized the establishment of individual retirement arrangements^[38] to encourage people in retirement planning and to provide an opportunity to those not participating in tax-favored retirement programs. Especially, self-employed individuals and small companies enjoy the advantages of individual retirement arrangements.

The Investment Company Institute estimates the number of households holding any type of IRA in 2008 at 47.3 million, or 40.5 percent of all U.S. households. IRAs represented a share of retirement assets of $4.7 trillion out of 10.9 trillion of private retirement assets.^[39]

Regarding to EBRI, 23 percent of workers ages 21 - 64 owned an IRA at the end of 2005, and kept up with the increasing trend in 401(k)-type plan participation.^[40]

Abbildung in dieser Leseprobe nicht enthalten

Table 5: Ownership of IRAs and 401(k)-Type Plans by Workers Ages 21 – 64, in Percent of Workers Ages 21 - 64.^[41]

6) Influence on Financial Markets

The influence of pension plans on financial market is enormous. The employer transfers contributions to external trusts which manage the pension assets and invest the money in domestic and international financial. The U.S. financial markets have been heavily subsidized by the huge volumes of U.S. pension plan assets. That makes it easier for firms to raise capital or defend the company from hostile acquisition, the firms depend less on banks and other credit institutions. The meaning of pension funds for the capital market is undeniably of high relevance.

The U.S. investment company Watson Wyatt Worldwide estimates in its ‘Global Pension Assets Study’ the overall U.S. public pension assets in 2007 at $15,026 billion or at 109 percent of the U.S. Gross Domestic Product (GDP). For comparison, Germany’s assets are estimated at $364 billion or at 11 percent of its GDP.^[42] An analysis of the Organisation for Economic Co-operation and Development (OECD) puts the worth of pension assets in 2007 for the U.S. at $10.2 trillion, which equals 76.7 percent of their GDP.^[43] Here, Germany’s share is assessed at 4.1 percent of its GDP. The U.S. figure keeps pace with the average of the other OECD countries which was 74.5 percent of their GDP.

According to the Federal Reserve Board, total private plan assets amounted to following percentages of the U.S. GDP^[44]:

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Table 6: Total Assets held in Private Pension Funds for the Years 2006 to 2008.^[45]

The types of pension vehicles are barely restricted and funds manager can invest the assets into the entire variety of financial market instruments. That includes time deposits, money market papers, U.S. government securities, credit market instruments, corporate and foreign bonds, mortgages, bonds and equities, and mutual shares.^[46]

Regarding to the database of EBRI and the Investment Company Institute (ICI) asset allocation of 401(k) plans in 2007 was as follows:

Abbildung in dieser Leseprobe nicht enthalten

Table 7: 401(k) Plan Asset Allocation 2007, Rounded Data.^[47]

7) Further Areas of Pension Coverage

(a) Self-employed Individuals

Pension schemes in the U.S. do not merely cover employees. Tax and employee benefit regulations cover every individual employed by an employer.^[48] A pension plan can therefore cover executives, directors, individuals having a share at the company and self-employed individuals who maintain any business relationship to the employer.^[49] The type of plan is called KEOGH- or 401(k)-solo plan.

(b) Unions as Co-founder of Pension Plan Trusts

It is not merely a privilege to employers to establish a pension trust. Also unions have legal permission to establish one or more pension plans.^[50] Unions or labor organizations has therefore to negotiate with employers or employer organizations to set up a pension plan. In case of qualified pension plans creation of a pension trust requires always the cooperation of at least one employer.^[51]

i Multiemployer Plans

The Labor Management Relations Act of 1947 (known as the Taft-Hartley Act) specified the provisions of a multiemployer pension plan. Labor organisations negotiate with employers or employer organisations to reach a labor-management agreement that covers workers under a multiemployer pension plan. Then, trust funds are established by contributions from employers.^[52] Multiemployer plans are defined benefit plans and wide spread in the U.S. They are favoured by small size employers, mostly in the same geographic area, and industry sectors which are remarked by high employee volatility.^[53] These sectors include construction, trucking, garment manufacturing, and grocery stores. Ten percent of defined benefits plans are multiemployer plans and cover 25 percent of all participants in such plans.^[54] A specific characteristic of a multiemployer plan is the portability of pension benefit credits. The plan assets are fully portable if the employee quits service with his employer and moves to another employer as long as each member (employer) is covered under a collective bargaining agreement that requires plan contributions.^[55]

ii Multiple Employer Plans

A seldom type of plans is the multiple employer plans. Those plans involve employers who have just some kind of connection towards each other or possess an affiliated group status (e.g. farmer’s cooperatives, business franchises) and are usually maintained by religious, charitable and educational institutions. Like a multiemployer pension trust it provides benefits to employees by more than one employer but does not involve a collective bargaining agreement.^[56] As contributions are usually made by employers only, multiple employer pension plans are defined benefit plans.^[57]

iii Single Employer Plans

A single employer plan is the most common type of private plans and is controlled by one employer. Often it is provided through associations such as the Chamber of Commerce or the National Association of Automobile Dealers. These associations for example, offer usually a Master Prototype Plan under which employers create their own benefits packages and then implement the plan as single employer agreement with the sponsoring financial services company which manages the pooled assets of the participating employers.^[58]

(c) Governmental Employees

For governmental, state or public employees like teachers, police, administrators or civil servants the government or state provides own pension funds. They differ from pension plans in the private industry mainly by their defined benefit character. The risk of benefit payments is carried by the employer, de facto by the tax payers.

The overall volume of U.S. federal pension plans and state and local pension plans in 2007 was, with respect to the renowned pension magazine Pensions and Investments, $5,193 billion, compared with $3,938 billion of assets in corporate and private-sector industry funds.^[59]

Some of the biggest public pension funds in the U.S. are, for example, the California Public Employees Retirement System (CALPERS) with assets as of December 2007 in amount of $254,627 billion, the Federal Retirement Thrift with assets in amount of $223,338 billion, the California State Teachers Retirement System (CalSTRS) with assets in amount of $176,270 billion, and the New York State Common Retirement Fund with $164,363 billion of assets.^[60]

B) Regulatory Environment of Retirement Plans

I. Employee Retirement Income Security Act of 1974

Regulating law of pension plans is the Employee Retirement Income Security Act (ERISA) of 1974 which can be regarded as the equivalent to the German ‘Betriebsrentengesetz’. ERISA does not solely comprise employee pension benefit plans it also regulates other employment-based benefits of the employer for its employees.^[61] The employer is free to combine pension plans with welfare plans in one single plan. The main term for both types of plans is employee benefit plan.^[62] The term corporate pension benefits has therefore a wider range than the German term ‘betriebliche Altersversorgung’. In the narrow sense, corporate pension plans are similar to the German corporate pension law since they provide old age income, benefits for disability and dependents In a wider sense, corporate pension benefits cover other risks and benefits of the employees which are not covered in German employer-sponsored plans (e.g., medical benefits).

ERISA covers the two basic categories of pension plans which are defined benefit plans and defined contribution plans, and is divided into four parts:

illustration not visible in this excerpt^[63]

ERISA guarantees protection of employer established and maintained pension plans, regulates in details vesting and funding provisions and gives employees recoverable rights of disbursements of their vested pension benefits. An insolvency guarantee was established in the form of the Pension Benefit Guaranty Corporation (PBGC) which acts as an independent governmental agency to encourage the continuation and maintenance of defined benefit pension plans, provide timely and uninterrupted payment of pension benefits in case of plan termination, and is funded by pension insurance premiums of employers (ranging from $9 to $34 per participant in the plan)^[64], from plan sponsors at the lowest level necessary to carry out its operations.^[65] The maximum benefit distributable to a vested participant age 65 is $54,000 for the year 2009.^[66]

II. Trusts

1) Pension Trust Triangle

The variety of pension plans in the U.S. is enormous. Plan benefits are often designed to accommodate demands and wishes of every single employee. However, a common basis of all pension plans is the method of funding. Establishing a pension plan means generally funding through pension trusts. Pension trusts are juridical autonomous establishments such as banks or similar institutions which are permitted to manage the funds.^[67] In case of an individual retirement account contributions can be accumulated in a qualified trust or also in a custodial account, managed by a bank, trust company, or other qualified financial institution; or it may even be deposited with a life insurer under a flexible premium individual retirement annuity (investment funds that guarantee a specific interest rate).^[68]

Involved parties are always the settler (employer, individual), the trustee or fiduciary (trust organization) and the beneficiary (employee, individual), that is why a pension plan constellation is referred to as ‘Pension Trust Triangle’.

For employment-based pension plans the settler is usually the employer, who establishes a pension plan for his employees. In case of an individual retirement plan which is independent from any co-operation with an employer, the settler is the individual. The trustee is a bank or any similar institution which satisfies the regulatory definitions of the Secretary. Contributions are made by the employer on behalf of the employees, the employee, or, in case of an individual retirement plan, by the individual. Benefits are distributed by the trustee to the beneficiary.

2) Tax Exemption of Trusts

Qualified pension trusts are tax-exempt trusts.^[69] Therefore, investment earnings can grow tax free and are subject to taxation not prior to distribution. Prudent Man Rule

3) Prudent Man Rule

In fulfilling their responsibilities the trustee has to act in the exclusive interest of the plan participants in accordance with the governing plan documents, and has to diversify the plan assets in a way that minimizes risk of large losses, and he has to act with the care, skill, prudence and diligence under the circumstances a prudent man would do if in the same capacity. This rule is referred to as ERISA’s ‘prudent man’ rule. The trustee has the exclusive authority and discretion to manage and control the assets or the plan.^[70]

4) Funding

Funding of the plan assets is made through external capital drain by the employer. Assets in a qualified pension plan must be kept separate from the employer’s general assets and the employer has no access to the funds. The trust has the legal title^[71] of the trust assets. Pension book reserves of the company for pension promises are made in very rare cases, e.g. if the plan is maintained outside the U.S. for non-resident aliens.^[72]

5) Legal Force and Creditor Protection

The U.S. pension trust is a full legal body and benefits are subject to legal force.^[73] If the qualified plan should be established in form of annuity contracts with a life insurance company, the beneficiary can claim his benefits directly from the company.^[74]

Additionally, qualified retirement plan assets enjoy protection from creditors. The Bankruptcy abuse Prevention and Consumer Protection Act of 2005 (also known as the 2005 Bankruptcy Act) extended the protection areas of tax-qualified retirement plans and IRAs. If the employer goes bankrupt its creditors cannot enforce the trust assets of qualified pension trusts of an employer. Those assets are not property of the employer since they were established to provide exclusive benefit for employees or their beneficiaries.^[75] In the case that the participant files for bankruptcy first, his assets in the plan are considered part of bankruptcy estate but the Act protects this assets from creditors.^[76]

6) ERISA vs. State Law

Trust law is superimposed by ERISA. If trust law calls the beneficiaries participants, beneficiaries in the sense of ERISA are any persons who are designated by the participant (e.g., the employee), or by the terms of the plan who are entitled to receive benefits under the pension plan.^[77] For example, if trust law uses the term beneficiary, ERISA uses the term participant.

III. Systematic Segmentation

For an initial overview, a systematic segmentation of pension plans is necessary. Main focus thereby is on the difference between qualified and non - qualified pension plans. A qualified plan is a pension plan which satisfies all requirements of IRC Section 401(a).^[78] A non-qualified plan therefore, does not satisfy these requirements and cannot claim the full tax advantages.

Furthermore, pension plans can be divided into:

- defined benefit and defined contribution plans,
- single employer and multiemployer plans,
- contributory and non-contributory plans.

Within these groups of plans further differences exist. However, a more detailed segmentation is often not easy due to high flexibility of plans, and finally it is not implicitly necessary.^[79]

IV. Tax Regulations for Qualified Retirement Plans

1) An Overview of the Current Tax System

The United States federal income tax is embedded in the Internal Revenue Code enacted in Title 26 of the United States Code and imposes a progressive tax on the taxable income of individuals, partnerships, companies, corporations, trusts, decedents’ estates, and certain bankruptcy estates. The following table is the basic scheme for income tax computation:

illustration not visible in this excerpt

The amount includable in wages does not comprise employer contributions to employer-sponsored retirement plans and compensation (e.g. elective deferrals of the employee). In the case of contributions to an IRA, the deductible contributions are part of the adjustments and have to be deducted from the total income. Finally, a saver’s credit can be applied for taxpayers who contributed to qualified retirement plans.^[80]

The U.S. tax law knows six tax brackets, 10, 15, 25, 28, and 35 percent, each bracket for a certain range of income. The taxpayer’s tax liability is calculated by applying the marginal tax rate to the income plus the marginal tax rate multiplied by the upper limit of the prior tax bracket. For example, a single earner with income of $30,000 would be in the 15 percent tax bracket. The prior tax bracket is the ten percent tax bracket up to an income limit of $8,350. The individual has to pay 10 percent of $8,350 plus 15 percent times $21,650 ($30,000 – $8,350).^[81]

2) Tax Treatment of Transactions

The key mechanism in encouraging both employers and employees for establishing and maintaining qualified retirement plans is a preferential tax treatment. Pension plans serve as tax shelters and include following major advantages:

- Plan earnings are not taxed,
- Employer contributions are deductible when made,
- Employees are not currently taxed on amounts which the employer contributes on their behalf, and
- Favorable tax treatment may be obtained for certain kinds of distributions.

(a) Contributions

i Employee Contributions

Typically, compensation is taxed when distributed to the employee. If the employer contributes part of the employee’s compensation on behalf of the employee to a retirement plan, the tax on the contributed amount is deferred and not taxed until the plan distributes the accumulated pre-tax contributions.^[82] This includes elective employee contributions, employer matching contributions, employer non-elective contributions and the employee’s catch-up contributions into a qualified retirement plan. Though, elective deferrals and catch-up contributions are exempt from income tax, they are still considered wages for purposes of Social Security and Medicare taxes (FICA) as well as unemployment taxes (FUTA), and thus, are fully taxed for those purposes.^[83] The employer’s non-elective and matching contributions are exempt from FICA and FUTA taxes both at the time of contribution and distribution.^[84]

After-tax contributions to an employer-sponsored plan are also an option when they are designated employee contributions (e.g. in 401(k) plans).^[85] That amount is called basis in the plan and is tax-free at distribution.

In case of an IRA, contributions are originally made from taxed income and can be deducted in the annual tax return up to certain limits if they are considered qualified contributions.^[86] Contributions made to a SEP IRA or a SIMPLE IRA are not treated as deductible amounts, instead they are treated as deferred compensation (such as 401(k) contributions) and are from the ground up not included in the employee’s gross income.^[87]

Roth IRAs are subject to reverse tax favored treatment. Here, the deferred amounts are regularly made on an after-tax basis. Investment returns remain tax free in the accumulation period. At distribution, the entire amount is also tax exempt.

ii Employer Contributions

The employer may deduct contributions to an amount necessary to fund a qualified pension plan and any contributions made for the employees. Limitations on the deductible amounts vary in the case of pension and annuity plans and in the case of profit-sharing and stock bonus plans.

Contributions to defined benefit plans are limited on the amounts to either satisfy the pension trust’s minimum funding standards with respect to Section 412(a), or on the amounts necessary to fund, in a level manner, the current and past service costs over the remaining future service of each employee or, the normal costs of the plan, plus the amount necessary to amortize unfunded past service costs (and interest thereon) in equal annual payments over a ten-year period.^[88] In short, the trust must be in condition to cover all future benefit liabilities with its current assets. At the same time any overfunding of trust is restricted by law (otherwise it would have a detrimental effect to fiscal revenues).^[89]

Contributions to a profit-sharing or stock bonus plan (matching or non-elective contributions) may not exceed a percentage, currently 25 percent, of the aggregate compensation otherwise paid to the covered employees.^[90] An exemption exists for SIMPLE 401(k) plans. Unlike traditional 401(k) plans the limitation does not only refer to 25 percent of the aggregate compensation, rather it refers to contributions that are required to be made under Section 401(k)(11), e.g. non-elective contributions.^[91]

(b) Distributions

Certain types of distributions may receive favored tax treatment. This includes lump-sum distributions, distributions from employer securities, and rollovers.

i Averaging Method for Lump Sum Distributions

A lump sum distribution is a distribution of the entire account balance within a short period and is normally taxed as ordinary income. Under certain conditions, however, the participant can claim favoured tax treatment in form of the ten-year averaging. Eligible is an individual born before 1936, which have not used ten-year averaging on any distribution since 1986, and who participated in the plan for at least five years.^[92] Additionally, the entire balance has to be paid out within one taxable year to be qualified for that favoured tax treatment. A partial rollover and partial lump sum of the plan’s balance would disqualify for a favoured tax treatment of the payments.

For example, a ten-year averaging means that the participant pays in one year the amount of tax on his lump sum distribution as if it were the only income which he would receive over a ten-year period. Computation is as follows: (1) the tentative tax is one-tenth of the taxable amount of the distribution and multiplied by ten and (2) the tentative tax is subject to the 1986 schedule for single persons.

For example, a distribution of $50,000 under the ten-year-averaging rule would be subject to a tax due of $5,970. Under the normal federal tax application the tax liability would be $19,800.^[93] Additionally, for pre-1936 born participants an additional special tax treatment applies for accumulated capital gains prior to 1974. Hereby, the participant can elect to apply a 20 percent capital gain tax to earnings before 1974 and to elect for the rest of the taxable distribution the ten-year average option. The special tax computed under the average method is added to the regular tax. This may result in a smaller tax than one would pay by including the taxable amount of the distribution as ordinary income in figuring his regular tax.^[94]

ii Tax Deferrals on Net Unrealized Appreciation in Employer Securities

The employee or beneficiary may receive a distribution in form of employer securities. In this case the tax on net unrealized appreciation (NUA) in the value of the securities can be deferred.^[95] The net unrealized appreciation is the net increase in the securities' value for the time period they were hold in the trust. This tax deferral applies to distributions of the employer corporation stocks, bonds, registered debentures, and debentures with interest coupons attached. If the NUA is received as part of a lump sum, it is tax free until the securities are sold or exchanged where the NUA then is taxed as long term capital gain.^[96]

iii Tax Free Rollover Distributions

A common tax favored distribution form is a rollover which allows individuals who leave the employer to take the plan interests in a lump sum, and move it to an eligible retirement plan. An eligible retirement plan includes an individual retirement account, an individual retirement annuity or a qualified employer-sponsored plan.^[97] Rollovers are not taxed in accordance with IRC Section 402(c) if they meet certain requirements to be an eligible rollover.^[98] Additionally, transfer must be made within 60 days of receipt date^[99] - a mechanism to keep participants away from the temptation to use the assets for current spending and to avoid a break in the accumulation period. A further variety of a rollover is a direct rollover, namely trustee-to-trustee transfer. Hereby, the interest is directly transferred from the trustee or old plan to the new trustee or the new eligible retirement plan. Trustee-to-trustee transfers are from the ground up not taxed.^[100] The only difference to a rollover is that in a rollover distribution first, the interests are distributed to the participant who has then to contribute the sum within the required period into a new plan. A direct transfer does not distribute the interests to the participant. The maximum amount that could be rolled over tax free is the portion that would be includible in gross income if the rollover exclusion rules were disregarded (i.e., any pre-tax contributions in the plan).^[101] Mainly, an eligible rollover distribution does not include the portion of any distribution that is excludible form gross income under Section 72 as a return of the employee’s investment in the contract.^[102] A return of the employee’s after-tax contribution is not subject to taxation since it was contributed on an after-tax basis. Therefore, a rollover from employee’s basis can just be made into a defined contribution plan with separate accounts for the after-tax amounts, or to an individual retirement account or annuity.^[103]

(c) Tax Credits for IRA Contributions

With the enacting PPA 2006 the saver’s credit was made permanent to give lower and middle income taxpayers a small bonus for their contributions to qualified retirement plans. This includes elective deferrals as well as contributions to IRAs and Roth IRAs. Since it is a tax credit it reduces the tax liability dollar per dollar. For example, if the taxpayer’s income tax due is $10,000 and the applicable tax credit is $1,000, his net tax liability is $9,000.

Married taxpayers who are filing jointly are each entitled to the credit. For obtaining the saver’s credit up to $2,000, the taxpayer has to meet certain requirements.^[104] The amount of the saver’s credit is calculated by taking the applicable percentage times the amount of qualified retirement saving contributions. The applicable percentage depends on the filing status and AGI range and drops from 50 percent, to 20 percent, to ten percent, and is completely phased out when income exceeds a certain AGI amount.^[105]

(d) Regular Taxation of Distributions

Pension plans offer retiring participants, besides a lump sum distribution, the choice of an annuity. Distributions in form of an annuity and a lump sum where the recipient does not qualify for the averaging method are each subject to ordinary income tax in accordance with IRC Section 72 (relating to annuities) in the year in which so distributed.^[106] Before taking a closer look at the tax peculiarities, both contribution types are explained further.

i Lump Sum

Lump sum distributions are commonly offered in defined contribution plans, payable within one year, for payment at retirement (minimum age 59½), death, disability or separation from service, or after a participation period of at least five years.^[107] The taxable amount of the distribution is subject to regular income tax. For example, person A receives a lump sum distribution of the entire account balance in amount of $200,000. The amount is subject to federal income tax in full and he has to pay $70,000 in taxes (35 percent).^[108]

ii Annuities

Whereas the definition of a lump sum distribution is simple since it is a distribution of the entire account balance, a annuities exist in various forms. First, an annuity is a stream of regular payments, usually monthly and basically over the life of the participant (or lives of the participant and spouse, or a designated beneficiary) and is the contrary to a lump. Annuities are basically offered in defined benefit plans, and sometimes can be an option in defined contribution plans. There are two basic types of annuities, the single life (or straight life) annuity which pays benefits until death of the participant and which provides the largest monthly income, and the joint life annuity which pays benefits until death of the designated beneficiary. Within those types different annuity payment forms can be elected. For example, the life annuity certain which provides benefit income for a guaranteed time period. Here, the annuitant receives benefit installments for a certain period, whether or not the annuitant is alive to receive them.^[109] Or the participant can elect the refund annuity where contributions can even be refunded if the participant dies in the accumulation period. Payments are then made to the beneficiary. This type of annuity costs more than a pure annuity.^[110]

iii Exlusion Rule

The basic taxation rule for both types of distribution is that any after-tax contributions are considered not taxable income. For example, if just the employer made only non-taxable contributions to the plan on behalf of the participant and no contribution from the participant was made at any time, the full amount is subject to taxation, an exclusion ratio does not exist. That changes if any amount which was once was contributed on an after-tax basis and which could not be deducted in prior tax returns are included in the plan, namely the basis in the plan.^[111] To avoid double taxation, an exclusion ratio has to be applied. The exclusion ratio allocates the basis (after-tax contributions) between the current and future distributions of an annuity. The amount calculated under the exclusion ratio is not taxable income. The formula for the exclusion ratio is:

- Investment in the contract as of the annuity starting date, divided by

expected returns under the contract as of that date.^[112]

The expected return is the total amount the individual can expect to receive under the annuity contract. Computation is simple in the case of a lump sum or an annuity payable over a fixed period (e.g., in 240 instalments). In case of an annuity whose duration depends for example on the annuitant’s life, it is necessary to use the IRS actuarial tables to determine the life expectancy of the annuitant.^[113]

For example, employee A’s expected return is $300,000. His after-tax contributions in the plan added up to $30,000, the exclusion ratio is ten percent. If the monthly payment from the plan is $2,000, the amount of $200 is not taxable. The exclusion continues until the participant’s investment in the contract (basis) has been fully distributed to him.^[114] After that time, further annuity payments are subject to tax in full.

If the participant deceases, payments to a beneficiary or estate are generally subject to income tax in the same way as payments were to the participant.^[115]

(e) Asset Accumulation

The trust which holds the assets of a pension plan is usually exempt from tax when the plan is qualified.^[116] The type of investment vehicles used by the trust is not a criterion for having the qualified or the non-qualified status. Thus, the trust portfolio has solely to mirror provisions and arrangements of the underlying pension plan. Any investment earnings are not subject to tax until distribution. That leads to tax free accumulation of investment gains and their reinvestment on a gross basis, regardless if contributions are made by the employee or employer.^[117]

(f) Early Distributions

Usually, qualified pension plans may not distribute participant’s interests before retirement. Early distributions are not conform neither with the purpose of ERISA to provide retirement income nor with some of the requirements for tax benefits. Thus, any premature distribution from a qualified plan is imposed with additional tax according to IRC Section 72(t) on distributions made before the date on which the employee reaches age 59½, and is equal to ten percent of the amount of the distribution which is then, includible in gross income (e.g. a hardship distribution to a 401(k) participant).^[118] However, there are exceptions mainly for distributions made:

- To a beneficiary (or the estate of the employee) on or after the death of the employee.
- Attributable to the employee’s being disabled.
- As part of a series of substantially equal periodic payments (annually or less frequently), beginning after separation from service^[119] and made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary.
- To an employee after separation from service after attainment of age 55.^[120]

(g) Loans

Loans are a further exception from a distribution being considered as early distribution. Usually, a loan that does not meet certain requirements is treated as prohibited transaction and subject to income tax and, if the participant has not attained age 59 ½, also to the ten percent excise tax on early distribution.

For being qualified as an ordinary loan several standards have to be met. The plan’s loan regulations must provide loans available to all participants and beneficiaries on a reasonably equivalent basis depending on creditworthiness and financial need; factors which would also be the basis for negotiations in a normal commercial setting. Loans cannot be made in greater amounts for highly compensated employees but a plan can set the maximum individual loan amounts with respect to the vesting percentages of the plan interests. Thus, individuals with larger vested interests would be able to borrow greater amounts of money from the plan. A loan must be made in accordance with the plan’s loan provisions which describe loan types, applying procedure, approval and denial factors, limitations etc. and must have a reasonable interest rate, defined as a rate commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances. A loan must be secured. This might be the participant’s vested benefit, but not to exceed 50 percent of the present value of the vested benefits.^[121]

Further special tax qualification rules have to be satisfied. If the participant has had no other plan loan within the last 12 months period, an ordinary loan cannot exceed the amount of 50 percent of the present value of the vested benefits of the employer, whereas the minimum is $10,000, and the maximum $50,000. If the participant had another plan loan within the last 12 month period, the loan has to be limited to 50 percent of the vested account balance, or $50,000 minus the outstanding loan balance in the preceding 12 month period, whichever is less.^[122]

For example, if the vested account balance of an employee is $30,000, the maximum loan would be $15,000 (50 percent of $30,000).

Alternative example: The participant’s vested account balance is $18,000. He would be permitted to take a loan of $10,000 out of the plan. Though, 50 percent of $16,000 is $8,000, IRC Section 72(p)(A) permits the lesser of $50,000 or the greater of 50 percent of vested benefits or $10,000.

The loan must be repaid within five years (but can be extended to 15 years for home purchase loans) and must be amortizable in substantially level payments at least quarterly.^[123]

It rests on the employer if and for which purposes loans in retirement plans might be available for participants. Law does not restrict the employer to define reasons for taking a loan but many employers just allow them for legal purposes of education expenses for the employee’s spouse or his child, preventing home eviction, un-reimbursed medical expenses, or buying a first-time residence.^[124] Loans are considered a factor to encourage employees to participate in a retirement plan, especially for lower paid employees the option of borrowing against their pension assets might be a crucial incentive when deciding for participation. One drawback of loans is that if the employee quits working or changes the employer, the loan must be repaid immediately. Most plans require full repayment within 60 days of separation from service. If the employee should be unable to do so and the employee has not attained age 59½, the outstanding balance is considered taxable distribution subject to excise taxes.^[125]

C) Qualified Plans

Numerous requirements must be fulfilled by a pension plan or trust for being a qualified plan. U.S. tax law imposes numerous limitations on pension plans to assure that funds are used for the exclusive benefit of employees and not solely for the advantage of the employer. The regulatory environment is provided by Title II ERISA, which is embedded in the Internal Revenue Code Section 401(a) referring to employment-based plans. While Title I of ERISA deals with general and regulatory provisions for pension plans such as participation, vesting, and accrual standards, Title II of ERISA focuses on tax aspects of pension plans and provides requirements for plan qualification. The set of standards in ERISA Title II for qualifying a pension plan is identical to ERISA Title I regarding participation, vesting, and accrual standards. However, with amendments which require higher qualification standards. Most focus is hereby on fulfilling numerous non-discrimination tests. That means that the qualified status always implicates strictly avoiding any privileged benefit and coverage on highly paid employees and insiders of the business.

I. General Set of Standards for Qualified Plans

Despite multitudinous types of qualified plans, following set of standards has to be satisfied mainly for being considered a qualified pension plan:

(1) Liabilities

Liabilities in the plan must be covered by exposed funds whereas the funding has to be made into an external trust. Pension reserves are not permitted in the balance sheet of the company.^[126]

(2) Plan Existence

The plan has to be existent and a written program, and an arrangement which is communicated to the employees. A plan will not be considered qualified until it is communicated to employees.^[127]

(3) Exclusive Benefit Rule

The plan must be formed for the purpose of distributing to the employees or their beneficiaries the corpus^[128] and income of the fund accumulated by the trust.^[129] It must be impossible under the trust to use any part of the corpus or income to be used for, or diverted to, purposes other than for the exclusive benefit of the employees or their beneficiaries unless all liabilities are satisfied.^[130]

(4) Establishment through Employer

The plan must be established by one or more employers.^[131] Even if the plan just requires only employee contributions, it must be established by the employer.^[132] A co-foundation by employee representatives is possible but at least one employer has to be involved in forming a trust.^[133]

(5) Contributions

Contributions must be made by the employer, or employee, or both.^[134]

(6) Non-discrimination Rules

Contributions or benefits cannot be made if they discriminate in favour of highly compensated employees. A highly compensated employee is an employees with compensation for the preceding year in excess of $105,000 (adjusted for inflation), who was an employee in a top-paid group (top 20 percent), or was/is a five-percent owner of the employer.^[135]

A cash of deferred arrangement is subject to further non-discrimination tests to prevent discrimination in favor of highly compensated employees. One is Actual Deferral Percentage (ADP) test. The ADP test compares the deferral rates of highly compensated versus non-highly compensated employees to make sure that the company provides 401(k) plans to the rank-and-file employees and not just to the highly compensated employees.^[136] The other test is the Actual Contribution Percentage (ACP) test which is the exclusive method of satisfying the non-discrimination tests of IRC Section 401(a)(4). This test is principally identical to the ADP test except that is does not focus on employee deferrals instead, it measures employer matching contributions and/or employee after-tax contributions.^[137]

(7) Minimum Vesting Standards

The plan has to provide non-forfeitable rights described in IRC Section 411 (minimum vesting standards).^[138]

Employees’ rights are non-forfeitable in that portion of their accrued benefits derived from their own contributions.^[139] That means that employee contributions are vested immediately once they are allocated to the plan. ERISA provides special vesting schedules for benefits attributable to the employer.

For a better understanding of the concept of vesting, it is important to understand the difference between vesting of benefits and accrual of benefits.

The degree of vesting stands for the extent to which benefits are non-forfeitable. An accrual schedule or formula, on the other hand, stands for the rate at which a (fully) vested benefit increases over time. A participant’s non-forfeitable benefit at any time can be calculated as the amount of accrued benefits times the non-forfeitable percentage at that time.

For example, the company’s defined benefit plan vesting schedule states that the non-forfeitable percentage is 30 percent after one year of service, 50 percent after two years, 80 percent after three years, and 100 percent, or full vesting, after four years of service. The formula provides a retirement annuity measured by $100 x years of service. The amount of accrued and vested benefits for the first four years of participation is as follows:

illustration not visible in this excerpt

Table 8: Example of a Plan’s Vesting and Accrual Schedule.^[140]

A participant who, for example, leaves the employer after three years of service would be entitled to receive $240 annual retirement benefit.

ERISA provides two vesting schedules. One is the three-to-seven-years “graded” vesting where the non-forfeitability of accrued benefits increases as a percentage over time.^[141] The other is the f ive-year “cliff” vesting where The non-forfeitable right of an employee who completed at least five years of service must be 100% of the accrued benefit.^[142]

The three-to-seven-years graded vesting must be at least as great as in following table:

illustration not visible in this excerpt

Table 9: Accrual and Vesting of Benefits According to the IRS.^[143]

The difference between both vesting methods is, that under a “cliff” vesting plan an employee who has not completed five years of service has no vested benefits at all. Benefits here jump from full forfeitable to full non-forfeitable.

However, a participant’s right to the normal retirement benefits must become non-forfeitable upon attainment of normal retirement age.^[144] ERISA defines normal retirement age as the earlier of:

a) the normal retirement age under the plan,^[145] or the later

b) of age 65 or the fifth anniversary of plan participation.^[146]

For example, an employee starts participating in a pension plan at age 61; the plan’s normal retirement age is 64.

a) Which event occurs later? Five year plan participation or attainment of age 65? → Five year plan participation at age 66.

b) Which event occurs earlier? Normal retirement age under the plan or age 66? → 64, the normal retirement age under the plan.

Thus, even if a participant has just a few years of service and would not be fully vested under the vesting schedule, the participant in the example above would become irrevocable entitled to his normal retirement benefits when he leaves the employer under the normal retirement age.^[147]

A non-forfeitable right to the accrued benefits is also applicable at plan termination. The employee’s rights to accrued benefits to such date are non-forfeitable to the extend as they are funded at such date.^[148]

As ERISA introduced non-forfeitability rules, the background was to prevent dismissals of employees for the mere purpose of avoiding retirement benefits. Most corporate pension plans prior to ERISA contained acceleration clauses which led to loss of all benefits attributable to employer contributions if the employee quit the service with the employer prior retirement age.

However, these are minimum vesting schedules. A plan can provide different vesting schedules as long as they are more generous.

One complication in determining years of service emerges if there is any break in service. ERISA defines break in service as “… a calendar year, plan year, or other 12-consecutive-month period designated by the plan … during which the participant has not completed more than 500 hours of service.“^[149] If an employee takes time out, for example to carry for a sick relative or to improve his skateboard and surfing skills on a Australia tour, a break in service is considered if he does not complete at least 501 hours of service with the employer in the plan year. A break of service is then detrimental since the participant can lose the unvested credits in the plan if the length of his break exceeds the greater of:

[...]

^[1] Mc Gill, D. et al., Fundamentals of Pensions, 2005, p. 6.

^[2] Fischer, B. A., Betriebspensionen, 2001, p. 4.

^[3] Fischer, B. A., Betriebspensionen, 2001, p. 5.

^[4] Schieber, S., Evolution and Implications, 2005, p.16.

^[5] Fischer, B. A., Betriebspensionen, 2001, p. 10.

^[6] This Act for example, increased contribution rates, introduced the catch-up provision, and relaxed rollover regulations; See more on interest rate changes at www.pbgc.gov, URL: http://www.pbgc.gov/rates/interest.htmlTreasury

^[7] State laws often prohibited employers from deducting amounts directly from the employees’ pay check unless the employee gave his written permission. That formerly state pre-emption was a barrier to implementing automatic enrollment.

^[8] See Simons, J., Automatic Enrollment, 2007, pp. 1 - 4, URL: http://www.tri-ad.com/pdfs/Auto_Enroll_07.pdf

^[9] Tax expenditures are the forgone revenues due to tax exempt or tax deferred treatment of benefits.

^[10] Employee Benefit Research Institute, Tax Expenditures, 2008, p. 2, URL: http://www.ebri.org/pdf/publications/facts/0208fact.pdf

^[11].The terms ‘employee welfare benefit plan'’ and ‘welfare plan'’ mean any plan …providing…medical, surgical, or hospital care or benefits, or benefits in the event of sickness, accident, disability, death or unemployment, or vacation benefits, apprenticeship or other training programs, or day care centres, scholarship funds, or prepaid legal services...“, ERISA § 3(1).

^[12] Employee Benefit Research Institute, Introduction, 2009, p. 2, URL: http://www.ebri.org/pdf/publications/books/databook/DB.Chapter%2001.pdf

^[13] McDonnell, K., Retirement Spending, 2008, p. 8, URL: http://www.ebri.org/pdf/notespdf/EBRI_Notes_11-2008.pdf

^[14] McDonnell, K., Retirement Spending, 2008, p. 8, URL: http://www.ebri.org/pdf/notespdf/EBRI_Notes_11-2008.pdf

^[15] Employee Benefit Research Center, Finances, 2009, p. 1, URL: .http://www.ebri.org/pdf/publications/books/databook/DB.Chapter%2002.pdf

^[16] Ansahl, Herausforderungen, at www.ansahl.com, URL: http://www.ansahl.com/Altersvorsorge/Rentensysteme/Demographisches-USA.html

^[17] Employee Benefit Research Institute, Introduction, 2009, p. 2, URL: http://www.ebri.org/pdf/publications/books/databook/DB.Chapter%2001.pdf

^[18] Social Security Online , Medicare, 2009, at www.ssa.gov, URL: http://www.socialsecurity.gov/OACT/ProgData/taxRates.html

^[19] Social Security Online , Full, 2009, at www.ssa.gov, URL: http://www.ssa.gov/retire2/retirechart.htm

^[20] Williamson, D., US-Konsumenten, 2009, at www.emagazine.credit-suisse.com, URL http://emagazine.credit-suisse.com/app/article/index.cfm?fuseaction=OpenArticle&aoid=254211&lang=DE

^[21] Social Security Online, Taxes, 2009, at www.ssa.gov, URL http://www.ssa.gov/planners/taxes.htm

^[22] OASDI, private and public pensions, including 401(k) plans and individual retirement accounts.

^[23] Employee Benefit Research Institute, Sources, 2008, p. 4, URL: http://ebri.org/pdf/publications/books/databook/DB.Chapter%2007.pdf

^[24] Employee Benefit Research Institute, Sources, 2008, p. 3, URL: http://ebri.org/pdf/publications/books/databook/DB.Chapter%2007.pdf

^[25] Employee Benefit Research Institute, Sources, 2008, p. 3, URL: http://ebri.org/pdf/publications/books/databook/DB.Chapter%2007.pdf

^[26] Employee Benefit Research Institute, Sources, 2008, p. 4, URL: http://ebri.org/pdf/publications/books/databook/DB.Chapter%2007.pdf

^[27] The average percentage of the OECD Members was 7.2 percent, Germany’s rate was 11.4 percent, see for more information OECD, Pensions at a Glance. 2009, p. 3, URL: http://www.oecd.org/dataoecd/12/60/43098050.pdf

^[28] Employee Benefit Research Institute, Sources of Income, 2008, p.4, URL: http://www.ebri.org/pdf/publications/books/databook/DB.Chapter%2001.pdf

^[29] Fischer, B. A., Bertriebspensionen, 2001, p. 25.

^[30] Copeland, C., Employment-Based, 2008, p. 7, URL: http://www.ebri.org/pdf/briefspdf/EBRI_IB_10-2008.pdf

^[31] Copeland, C., Employment-Based, 2008, p. 7, URL: http://www.ebri.org/pdf/briefspdf/EBRI_IB_10-2008.pdf

^[32] U.S. Bureau of Labor Statistics, Defined-Contribution, 2009, p. 3, URL: http://www.bls.gov/opub/perspectives/issue3.pdf

^[33] The rate between access and actual participation in a plan.

^[34] U.S. Bureau of Labor Statistics, Defined-contribution, pp. 2 – 3, 2009, URL: http://www.bls.gov/opub/perspectives/issue3.pdf

^[35] McDonnell, K., Retirement Annuity, 2008, pp. 1- 3, : http://www.ebri.org/pdf/notespdf/EBRI_Notes_11-2008.pdf

^[36] McDonnell, K., Retirement Annuity, 2008, p. 2 et seq., URL: http://www.ebri.org/pdf/notespdf/EBRI_Notes_11-2008.pdf

^[37] McDonnell, K, Retirement Annuity, 2008, p.5, URL: http://www.ebri.org/pdf/notespdf/EBRI_Notes_11-2008.pdf

^[38] Typically, an individual retirement arrangement is not refered as to a plan. Usually, a plan is employer-based, an individual retirement arrangement is at the discretion of the individual and independent from an employer, explanation by Robert Alexander, Wellington Financial Group Inc., Chantilly VA 20151, URL: http://www.wellington401k.com.

^[39] Investment Company Institute, Research Fundamentals, 2009, pp. 2 - 5, URL: http://ici.org/pdf/09_q1_retmrkt_update.pdf

^[40] Copeland, C., Ownership, 2008, p. 3, URL: http://www.ebri.org/pdf/EBRI_Notes_05-2008.pdf

^[41] Copeland, C., Ownership, 2008, p. 3, URL: http://www.ebri.org/pdf/EBRI_Notes_05-2008.pdf

^[42] Watson Wyatt Worldwide, Global Pension, 2008, p.4, URL: http://www.globalaging.org/pension/world/2008/global%20pension%20assets%20study.pdf

^[43] Organisation for Economic Co-operation and Development, Pension Markets, 2008, p.12, URL: http://www.oecd.org/dataoecd/42/19/41770561.pdf.

^[44] Data from U.S. Department of Commerce, Gross Domestic Product, 2009, at www.bea.gov, URL: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=43&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=2008&LastYear=2009&3Place=N&Update=Update&JavaBox=no#Mid

^[45] Board of Governors of the Federal Reserve System, Funds Accounts, 2009, p. 109, URL: http://www.federalreserve.gov/releases/z1/Current/annuals/a2005-2008.pdf

^[46] Board of Governors of the Federal Reserve System, Funds Accounts, 2009, p. 109, URL: http://www.federalreserve.gov/releases/z1/Current/annuals/a2005-2008.pdf

^[47] VanDerhei, J. et al., Asset Allocation, 2008, p. 20, URL: http://www.ebri.org/pdf/briefspdf/EBRI_IB_12a-2008.pdf

^[48] ERISA § 3(6).

^[49] IRC §§ 401(a)(4) and 414(q).

^[50] ERISA § 3(2).

^[51] IRC § 401(i) .

^[52] ERISA § 3(37)(A).

^[53] Wright, F., Multiple, p. 1- 2, URL: http://www.conversationoncoverage.org/research_conducted/Working_Paper_on_Multiple_Employer_Pension_Plans.pdf

^[54] U.S. Chamber of Commerce, Multiemployer, 2009, at www.uschamber.com, URL: http://www.uschamber.com/issues/index/retirementpension/multiemployerplans.htm

^[55] Weinstein, H./ Wiatrowski, W. J., Multiemployer Pension, p. 19, URL: http://www.bls.gov/opub/cwc/archive/spring1999art4.pdf

^[56] IRC § 413(c).

^[57] Wright, F., Multiple, p. 9, URL: http://www.conversationoncoverage.org/research_conducted/Working_Paper_on_Multiple_Employer_Pension_Plans.pdf

^[58] Wright, F., Multiple, pp. 1 - 2, URL: http://www.conversationoncoverage.org/research_conducted/Working_Paper_on_Multiple_Employer_Pension_Plans.pdf

^[59] Pensions & Investments, Public Funds, 2008, at www.pionline.com, URL: http://www.pionline.com/article/20080901/CHART/23723038/-1/WWTOPFUNDS

^[60] In comparison, the German pension fund ‘Bayrische Versorgungskammer’ had 2007 year-end assets of $58,621, see Pensions & Investments, Largest Pension, 2008, at www.pionline.com, URL: http://www.pionline.com/article/20080901/CHART2/23723097/-1/WWTOPFUNDS

^[61] ERISA § 3(1) defines welfare benefits as “…medical, surgical or hospital care of benefits, or benefits in the event of sickness, accident, disability, death or unemployment, or vacation benefits, apprenticeship or other training programs, or day care centres, scholarship funds, or prepaid legal services or (B) any benefit described in section 189(c) of this title…”

^[62] ERISA § 3(3).

^[63] Conison, J., Employee Benefits, 2003, p. 16 et seq.

^[64] Pension Benefit Guaranty Corporation, Premium, 2009, p. 2, URL: http://www.pbgc.gov/docs/2009_comprehensive_booklet.pdf#page=3

^[65] Definition at www.investopedia.com, URL: http://www.investopedia.com/terms/p/pbgc.asp

^[66] For more information on insured benefits see www.pbgc.gov, URL: http://www.pbgc.gov/media/news-archive/news-releases/2008/pr09-03.html

^[67] ERISA § 403(a).

^[68] IRC § 401(f).

^[69] IRC § 501.

^[70] ERISA § 1103(a).

^[71] Equal to the German term ‚Rechtsinhaber’.

^[72] ERISA § § 4(b)(4) and (5): Pension book reserves can be made for pension plans maintained outside of the United States for non-resident aliens or if such a plan is an excess benefit plan.

^[73] ERISA § 502(a)(1): “A civil action may be brought…by a participant or beneficiary…to enforce his rights under the terms of the plan.” ERISA § 502(d)(1): “An employee benefit plan may sue or be sued under this subchapter as an entity.”

^[74] The plan is under a life insurance comparable with a German ‘Direktversicherung’, see Fischer, B. A., Betriebspensionen, 2001, p. 146.

^[75] IRC § 401(a).

^[76] See Gary, R./ Nagele, J., Protecting Your Pension, 2007, pp. 229 - 234.

^[77] ERISA § 3(7) and (8).

^[78] More detailed definition in following chapters.

^[79] Fischer, B. A., Betriebspensionen, 2001, p. 39.

^[80] See the complete Form 1040 for the year 2008 at www.irs.gov, URL: http://www.irs.gov/pub/irs-pdf/f1040.pdf

^[81] See page 111 for marginal rates and tax brackets for filing status single.

^[82] IRC §§ 402(a) and 403(a)(1).

^[83] IRC §§ 3121(v)(1)(A) and 3306(b)(5)(A).

^[84] IRC § 3306(b)(5)(A).

^[85] IRC § 414(h)(1).

^[86] IRC § 219(a).

^[87] IRC § 219(b)(2),(b)(4).

^[88] IRC § 404(a)(1)(A)(ii), (iii); with the enacting of PPA 2006, increased deduction limits for funding a defined benefit plan with beginning of the year 2006, see Kaster, N. et al., Master Pension, 2009, pp. 164 – 165.

^[89] Both overfunding and underfunding are regularly subject to certain excise taxes. For example, 10 percent penalty tax is imposed on the employer if he makes excess contributions to a pension plan, IRC §§ 401(k)(8) and 4979.

^[90] IRC § 404(a)(3).

^[91] Further examples are employee elective contributions and employer matching contributions, IRC §§ 401(k)(11) and 404(a)(3)(A)(ii).

^[92] Slesnick, T./ Suttle, J.C., Money, 2009, p. 35.

^[93] For more details on this example see Slesnick, T./ Suttle, J.C., Money, 2009, pp. 36 – 37.

^[94] For more details on tax computation see Slesnick, T./ Suttle, J.C., Money, 2009, pp. 38 – 39.

^[95] See Kaster, N. et al., Master Pension, 2009, p. 92.

^[96] See Internal Revenue Service, Publication 575, 2009, p. 15, URL: http://www.irs.gov/pub/irs-pdf/p575.pdf; Tax on long term capital ranges between five and 15 percent, see Perez, W., Capital, 2009, at www.about.com, URL: http://taxes.about.com/od/capitalgains/a/CapitalGainsTax_4.htm

^[97] IRC § 402(c)(8)(b).

^[98] Basically, distribution must not be made as a series of equally periodic payments, IRC § 402(c)(4).

^[99] IRC § 402(c)(3).

^[100] IRC § 402(e)(6).

^[101] IRC § 402(c)(2).

^[102] Treas. Reg. § 1.402(c)-2, A-3(b)(3).

^[103] IRC § 401(a)(31)(C).

^[104] IRC § 25B(c).

^[105] IRC § 25B(c).

^[106] IRC § 402(a)(1).

^[107] IRC § 402(e)(4)(D).

^[108] Note that A would have to pay an additional excise tax of ten percent if he would be under age 59 ½, IRC § 72(t).

^[109] Definition at URL: http://www.allbusiness.com/glossaries/life-annuity-certain/4948429-1.html

^[110] Definition at URL: http://www.allbusiness.com/glossaries/refund-annuity/4960714-1.html

^[111] For example, any after-tax employee contributions or non-deductible IRA contributions.

^[112] IRC § 72(b)(1); Conison, J., Employee Benefits, 2003, p. 151.

^[113] Kaster, N. et al., Master Pension, 2009, pp. 567 – 568.

^[114] IRC § 72(b)(2),(4).

^[115] Mc Gill, D. et al., Fundamentals of Pensions, 2005, p. 174.

^[116] IRC §§ 401(a) and 501(a).

^[117] Fischer, B. A., Betriebspensionen, 2001, p. 77.

^[118] A hardship distribution is a feature of 401(k) plans which allows the participant to withdraw from the plan assets if there is an immediate and heavy financial need and the distribution is necessary to satisfy the participant’s financial need, IRC §401(k)(2)(B)(iv); see also Kaster, N. et al., Master Pension, 2009, p. 1106.

^[119] IRC §§ 72(t)(2)(A)(iv) and 72(t)(3)(B).

^[120] IRC § 72(t)(2)(A).

^[121] Conison, J., Employee Benefits, 2003, p 132.

^[122] Conison, J., Employee Benefits, 2003, p. 133; IRC § 72(p)(2).

^[123] IRC § 72(p)(B).

^[124] IRC § 72(t)(B) - (F).

^[125] www.401khelpcenter.com , Loans, 2009, at URL: http://www.401khelpcenter.com/loans.html

^[126] IRC § 401(a)(2).

^[127] Kaster, N. et al., Master Pension, 2009, p. 112.

^[128] Here, equivalent to the German term ‘Stammkapital’.

^[129] Treas. Reg. § 1.401-1(b)(3)(iii).

^[130] IRC § 401(a)(2); Treas. Reg. § 1.401-1(b)(3)(iv).

^[131] IRC § 401(a) states that a trust must be formed by an employer; see also Treas. Reg. § 1.401-1.

^[132] IRC § 401(a); Treas. Reg. § 1.401-1(a)(2).

^[133] IRC § 401(i).

^[134] IRC § 401(a)(1).

^[135] IRC §§ 401(a)(4) and 414(q) .

^[136] IRC § 401(k)(3)(A)(ii); see also Kaster, N. et al., Master Pension, 2009, pp. 1040 – 1044.

^[137] IRC § 401(m)(2); see also Kaster, N. et al., Master Pension, 2009, p. 1048.

^[138] IRC § 401(a)(7).

^[139] IRC § 411(a)(1).

^[140] Own Tabulations.

^[141] ERISA § 203(a)(2)(B), IRC § 411(a)(2)(B).

^[142] ERISA § 203(a)(2)(A); IRC § 411(a)(2)(A).

^[143] ERISA § 203(a)(2)(B); IRC § 411(a)(2)(B).

^[144] IRC § 411(a)(8).

^[145] IRC § 411(a)(8)(A).

^[146] IRC § 411(a)(8)(B).

^[147] Conison, J, Employee Benefits, 2003, p. 81.

^[148] IRC § 411(3).

^[149] ERISA § 203(b)(3)(A).