DEATH AND DISABILITY BENEFITS

Qualified plans are intended primarily to provide retirement benefits or, in the case of profit-sharing and similar plans, deferred-compensation benefits. However, the regulations indicate that a plan may provide for the payment of incidental death benefits through insurance or otherwise, and also that the plan may provide for the payment of a pension due to disability. Moreover, a qualified plan must in certain circumstances provide a survivorship pension to the participant's spouse.

Currently under Code Section 401(a)(11), two types of survivorship benefits are required: the qualified joint and survivor annuity and the qualified preretirement survivor annuity. All pension plans must provide these, but profit-sharing plans need not provide them if the participant's vested account balance is payable as a death benefit to the spouse. ESOPs and stock bonus plans generally do not have to provide spousal survivorship benefits.

Qualified Joint and Survivor Annuity
The qualified joint and survivor annuity is a postretirement death benefit for the spouse. Plans subject to this requirement must provide, as an automatic form of benefit, an annuity for the life of the participant with a survivor annuity for the life of the participant's spouse. The survivor annuity must be not less than 50 percent of nor greater than the annuity payable during the joint lives of participant and spouse. The spouse annuity must be continued even if the spouse remarries. The joint and survivor annuity must be at least the actuarial equivalent of the plan's normal form of benefit or any optional form of benefit offered under the plan.

The qualified joint and survivor form must be offered automatically to a married participant at retirement. The participant may elect to receive another form of benefit if the plan so provides; however, the spouse must consent in writing to the election and the consent form must be notarized or witnessed by a plan representative. An election to waive the joint and survivor form must be made during a 90-day period ending on the annuity starting date. A waiver of the joint and survivor annuity can be revoked—the participant can change the election during the 90-day period. The plan administrator must provide the participant with a notice of the election period and an explanation of the consequences of the election within a reasonable period before the annuity starting date.

Preretirement Survivor Annuity
Code Section 401(a)(11) mandates a preretirement death benefit for the spouse of a vested plan participant. The survivor annuity payable if the participant dies before retirement is the amount that would have been paid under a qualified joint and survivor annuity, computed as if the participant had either (1) retired on the day before his or her death or (2) separated from service on the date of death and survived to the plan's earliest retirement age, then retired with an immediate joint and survivor annuity. For a defined-contribution plan, a qualified preretirement survivor annuity is an annuity for the life of the surviving spouse actuarially equivalent to at least 50 percent of the participant's vested account balance as of the date of death.

As with the qualified joint and survivor annuity, a participant can elect to receive an alternative form of preretirement survivorship benefit, including a benefit that does not provide for the spouse. However, written consent by the spouse is required for such an election. The right to make such an election must be communicated to all participants with a vested benefit who have attained age 32, and the participant can elect to waive the preretirement survivor annuity at any time after age 35.

Subsidizing Survivor Annuities
A plan can provide that a participant who receives either the qualified joint and survivor annuity or the preretirement survivor annuity will receive an annuity payment lower than the amount that would be paid under a straight-life annuity; the reduction reflects the extra cost to the plan of the survivorship feature. For example, the normal form of benefit might be a straight-life annuity of $1,000 per month, but the joint and survivor annuity might pay only $800 per month while both spouses survived, then $400 per month to the survivor. However, a plan is permitted to subsidize all or part of the cost of the survivorship feature. If the survivorship feature is fully subsidized, the plan does not have to allow the participant to elect an alternative form of benefit.

Incidental Death Benefits
A qualified plan may provide a death benefit over and above the survivorship benefits required by law. In a defined-contribution plan, probably the most common form of death benefit is a provision that the participant's vested account balance will be paid to the participant's designated beneficiary in the event of the participant's death before retirement or termination of service. Defined-benefit plans, unless they use insurance as discussed later, usually do not provide an additional death benefit; in such cases, the survivors receive no death benefit except for whatever survivor annuity the plan provides.

To provide any substantial preretirement death benefit, it is usually necessary for the plan to purchase life insurance. This provides the plan with significant funds at a participant's death; it is particularly important in the early years of a participant's employment, when the participant's accrued benefit is still relatively small. An insured preretirement death benefit can be provided in either a defined-benefit or defined-contribution plan. Contributions to the plan by the employer may be used to pay life insurance premiums, as long as the amount qualifies under the tests for incidental benefits.

In general, the IRS considers that nonretirement benefits such as life, medical, or disability insurance in a qualified plan will be incidental and therefore permissible, as long as the cost of providing these benefits is less than 25 percent of the cost of providing all the benefits under the plan. In applying this approach to life insurance benefits, the 25 percent rule is applied to the portion of any life insurance premium that is used to provide current life insurance protection. Any portion of the premium used to increase the cash value of the policy is considered a contribution to the plan fund available to pay retirement benefits and is not considered in the 25 percent limitation.

The IRS has ruled, using its general 25 percent test, that if a qualified plan provides death benefits using ordinary life insurance (life insurance with a cash value), the death benefit will be considered incidental if either (1) less than 50 percent of the total cumulative employer contribution credited to each participant's account has been used to purchase ordinary life insurance or (2) the face amount of the policies does not exceed 100 times the anticipated monthly normal retirement benefit or the accumulated reserve under the life insurance policy, whichever is greater. In practice, defined-benefit plans using ordinary life insurance are usually designed to take advantage of the 100-times rule, while defined-contribution plans, including profit-sharing plans, that use ordinary life contracts generally make use of the 50 percent test.

If term insurance contracts are used to provide the death benefit, the 25 percent test will be applied to the entire premium, and the aggregate premiums paid for insurance on each participant should be less than 25 percent of aggregate additions to the employee's account. Term insurance is sometimes used to fund death benefits in defined-contribution plans but rarely in defined-benefit plans.

The discussion so far is somewhat simplified because insurance can be used in qualified plans in many ways, and the IRS has issued many rulings, both revenue rulings and letter rulings, applying the basic 25 percent test to a variety of different fact situations. Thus, there is considerable room for creative design of life insurance-funded death benefits within qualified plans.

If life insurance is provided for a participant through a qualified plan (i.e., by using employer contributions to the plan to pay premiums for the insurance), part or all of the cost of the insurance is currently taxable to the participant. Life insurance provided by the plan is not considered part of a Section 79 group term plan, and consequently the $50,000 exclusion under Section 79 does not apply.

If cash value life insurance is used and if all of the death proceeds are payable to the participant's estate or beneficiary, the term cost, or cost of the "pure amount at risk," is taxable income to the employee. The term cost is the difference between the face amount of insurance and the cash surrender value of the policy at the end of the policy year. In other words, the cost of the policy's cash value is not currently taxable to the employee because the cash value is considered part of the plan fund to be used to provide the retirement benefit.

Planning Considerations
It is relatively uncommon for a qualified plan to provide medical, disability or term life insurance to participants because the tax treatment provides no advantage to the employee in so doing. It is more common, however, to use cash-value life insurance as funding for the plan because the cost to the employee using the PS 58 table or the insurance company's term rates may prove to be a relatively favorable way to provide life insurance.

The decision whether to include life insurance in a qualified plan relates to the employee benefit design objective of efficiency. The employer must first decide whether and to what extent it will provide death benefits to employees. Death benefits can be provided for employees under group term plans and other plans as well as providing them as an incidental benefit in qualified plans. The death benefit should be designed to produce the lowest employer and employee cost for the benefit level desired. A death benefit should be included in the qualified plan only to the extent it is consistent with this objective.

Disability Benefits from Qualified Plans
A qualified plan may provide as an incidental benefit a pension payable upon disability. The plan must provide a specific definition of disability. Usually some minimum service or age requirements are imposed to appropriately restrict the class of participants entitled to the disability pension. The disability benefit may be the participant's accrued benefit actuarially reduced because of a commencement date earlier than normal retirement, or the plan may provide some subsidy of the disability benefit to be sure that it is adequate for the participant's needs.

It is becoming increasingly common for companies to cover disability through separate benefit programs, often insured. Such programs tend to be fairer and more efficient than providing disability coverage as an incidental benefit under a qualified plan. In all events, the planner should be sure that there is no duplication of disability coverage between the qualified plan and a separate short-term- or long-term-disability plan of the employer.

Qualified plans that do not provide immediate disability coverage prior to normal retirement age should, however, include some provision for the treatment of the employee's retirement benefit if the employee becomes disabled. Separate long-term-disability programs usually cease paying benefits when the participant reaches age 65 or other normal retirement age. After this age, the company's retirement plan must provide whatever income the participant will receive from the employer. Therefore, from an employee's standpoint, the plan should be designed so that the retirement benefit will be adequate when long-term-disability benefits cease. For example, the plan might provide that a participant who is disabled as defined in the plan will continue to receive service credit for purposes of vesting or benefit accrual, or both. The definition of disability in the plan should be coordinated with the definition in the employer's long-term-disability plan. The plan also should indicate what definition of compensation will be used to determine retirement benefits if the participant becomes disabled before retirement.

BENEFITS AT TERMINATION OF EMPLOYMENT

The vesting provisions of a plan determine the amount of benefit that a participant is entitled to receive upon terminating employment prior to retirement.

In a defined-contribution plan, the termination benefit is the vested portion of the participant's account balance. In defined-contribution plans, particularly profit-sharing plans, the account balance usually is distributed to the participant in full at termination of employment. It is technically possible to defer the distribution to the participant's normal retirement date, but this is rarely done in defined-contribution plans because it causes additional expense to the plan with little or no corresponding benefit to the employer or the plan. However, the plan may give the participant the option to leave the funds on deposit in the plan for withdrawal at a later date, to allow the participant to take advantage of the tax-deferred investment medium afforded by the plan, with a possible loss of favorable income tax treatment on the later plan distribution.

For a defined-benefit plan, the benefit on termination of employment is more complicated. The benefit will be the vested accrued benefit as of the date of termination, determined under the vesting and the accrual rules already described. Use the same example as in the discussion of the fractional accrued-benefit rule, again supposing that an employee terminates employment at age 55 after 20 years of service and the plan's normal retirement age is 65. If the participant is fully vested and the accrued benefit is $8,000 as discussed in the earlier example, an annuity of $8,000 per year will be payable beginning at age 65.

To make sure that terminated participants actually receive deferred vested benefits at retirement, which may be many years after termination, the employer must report all deferred vested benefits of terminated participants to the Social Security Administration, which then can inform retirees of their rights to benefits from plans of former employers. This reporting is done on the Form 5500 series.

In some cases, the deferred vested benefit may be such a small amount that keeping track of it until the participant's retirement is merely a nuisance for both employer and employee. The employer can cash-out a distribution—that is, pay cash to the employee in lieu of the deferred vested benefit—without the employee's consent, so long as the entire benefit is distributed and the employer portion of the benefit so distributed does not exceed $5,000. The involuntary cashout must be within one year of termination of participation in the plan; the plan must have a provision permitting the employee to repay the cashout to the plan if the employee was not fully vested at the time of termination, in case the employee should resume participation in the plan. A cashout of a benefit that exceeds the $5,000 limit can be made, but only with the consent of the employee.

SEPARATE ACCOUNTS FUNDING AND NEW MONEY

The investment of qualified plan funds under an insurance contract can involve certain disadvantages relating to the commingling of the employer's pension funds with those of other employers or with other funds of the insurance company. Separate accounts funding and the new money technique are methods by which two of these disadvantages can be mitigated.

Separate Accounts
Separate accounts funding was developed to avoid commingling pension assets with all of the general assets of the insurance company because an insurance company's general assets have traditionally been invested in long-term, low-return investment vehicles, sometimes subject to legal restrictions on investments. With separate accounts funding, the insurance company makes available one or more special accounts, separate from its general asset accounts, solely for investment of pension money. Such separate accounts may have a specified investment philosophy; for example, one type of account might be invested in common stocks, another in bonds, another in real estate mortgages, another in money market instruments, and so forth. The qualified plan sponsor is then given the option to invest various portions of the plan fund in one or more of the separate accounts. The funds so designated are commingled with similar funds of other qualified plans, as in a common or collective trust fund. If an individual plan fund is large enough, an insurer may also offer the employer an individual separate account only for that employer with whatever mix of assets the employer designates.

New Money
Because many of the insurance contracts available for qualified plan funding involve the mingling of an employer's pension contributions with money invested in previous years, the investment return credited on a given year's contributions is not necessarily equal to the return that could have been earned if the amounts contributed had been newly invested that year. This can present a problem under contracts giving employers discretion as to how much to contribute to the fund during a given year, as is generally true under DA and IPG contracts. Where the composite return provided under the insurance contract is greater than that available for new investments, the employer will tend to maximize contributions, while contributions will be minimized when new outside investments can obtain a higher rate of return than under the contract. To alleviate such problems, insurers have developed methods to credit each block of qualified plan contributions with the rate of return at which the funds were actually invested. There are a number of ways of accomplishing this; such techniques are referred to as new money, investment year, or investment generation methods.

New money methods must not only credit plan contributions for a given year with the current investment rate for that year, but must also take account of the fact that contributions from past years are constantly being reinvested at current rates. Thus, a plan contribution made in Year 1 is credited with the new money rate for Year 1. For Year 2, the Year 1 contribution is credited not with the Year 2 rate, but with a composite of the Year 1 rate and the Year 2 rate, to reflect the fact that a portion (but only a portion) of the Year 1 money will be reinvested in Year 2.

Two broad methods of accounting for these changes are the declining-index method and the fixed-index method. Under the declining-index method, the amount of money associated with a particular year gradually declines as the amount originally invested in that year is reinvested in later years. Thus, under the declining-index method, the amount invested in Year 1 in the previous example would decline in Year 2 to reflect the fact that part of it was reinvested in Year 2. Under the fixed-index method, the amount associated with the initial investment year remains the same, and the rate of return credited to that amount is adjusted to reflect reinvestments without changing the original principal amount. The two methods generally produce the same results.

THE ACCRUED BENEFIT

Under the vesting rules for qualified plans, many employees will be entitled to a benefit from their qualified plan if they terminate employment before retirement. Also, if an employer terminates a plan before all employees have retired, plan participants generally receive the benefits they have earned at that point. Therefore, the plan must provide a means of determining the amount of benefit payable to employees with a given termination date. To do this, the qualified plan benefit is treated as having been earned over the employee's entire period of employment. The amount of benefit earned as of a given date is referred to as the accrued benefit at that date.

Every qualified plan must include a means for determining the participant's accrued benefit. Furthermore, to prevent discrimination, Code Section 411(b) and extensive IRS regulations under Code Section 401(a)(4) require that benefits accrue at minimum specified rates. The purpose of the Section 411(b) benefit accrual rules is to prevent the plan from having an excessive amount of what is known as backloading. An extreme example of a backloaded plan would be one that had a normal retirement age of 65 with a provision that no employee who terminated employment prior to age 63 would receive any benefit under this plan. In effect, all of the benefits under this plan would accrue during the two years between ages 63 and 65. This much backloading is not permitted under current rules. Obviously, the purpose of the accrual rules is to prevent employers from favoring highly compensated employees who are the ones most likely to continue employment to later ages. Incidentally, the benefit accrual rules do not prohibit frontloading—rapid benefit accrual during a participant's earlier years of employment. However, few employers would have any reason for designing a frontloaded plan.

Benefit Accrual Rules
In a defined-contribution plan, a participant's accrued benefit is simply equal to the balance in that participant's account under the plan. The account balance includes employer and employee contributions, forfeitures from accounts of other employees, and investment earnings on the account, less any distributions from the account. If a defined-contribution plan has a nondiscriminatory contribution formula, there normally is no problem of backloading. Consequently, there are no specific rates of accrual required for defined-contribution plans.

For defined-benefit plans, however, benefits must accrue at a rate specified in Code Section 411(b). The plan's accrual rate must be at least as fast as one of three alternative minimum rules:

1. Three Percent Rule. Under this rule, the benefit accrued by a participant during each year of participation must be at least 3 percent of the maximum benefit that a hypothetical participant can accrue by entering at the plan's earliest entry age and participating until normal retirement.
2. 133⅓ Percent Rule. Under this rule, the rate of benefits accrued in any given plan year cannot be more than 133⅓ percent of the rate of benefit accrual during any prior year.
3. Fractional Rule. Under this rule, the benefit the employee has accrued at the date of termination must be proportionate to the normal retirement benefit. The following requirement must be satisfied:

The tendency is for most plans to provide a termination benefit based on the fractional rule, because it is simpler to design and explain to participants.

Fully insured plans—plans that are funded exclusively by the purchase of insurance contracts providing level annual premium payments to retirement and providing benefits guaranteed by an insurance company—are not specifically subject to the preceding three accrual rules if the accrued benefit meets the following tests:

• The accrued benefit is not less than the cash surrender value of the participant's insurance contracts at any time.

• The insurance premiums are paid up, the insurance contracts are not subject to a security interest and there are no policy loans outstanding.

The assumption is that if all these conditions are satisfied, plans funded with insurance contracts will automatically meet or exceed the benefit accrual test. Note that this exception applies only to fully insured plans, not to all plans that use an insurance contract or contracts for funding.

INFLATION PROTECTION

Inflation has been a persistent feature of the U.S. economy, at least since World War II. Although the rate of inflation has gone up and down during that period, many economists believe that some degree of inflation is a permanent structural feature of our economy. A qualified plan, particularly a defined-benefit pension plan, is a theoretically long-range program; benefit levels are often determined for a 25-year-old employee's benefits that will not be paid until 40 years later. Thus, inflation is a serious problem in the design of pension plans.

Although no really satisfactory solution to the problem of inflation in private pension plans has yet been devised, there are some planning approaches that can help with this problem. A distinction can be made between approaches that are applied in the preretirement period while the employee is still at work and in the postretirement period, when the employee is least able to protect against inflation.

Preretirement Inflation
Some types of benefit design are inherently better able to cope with preretirement inflation than others. If the plan benefit depends on employee compensation, the final-average definition of compensation usually does a better job protecting the employee against inflation than the career-average definition because the final-average definition bases benefits on the employee's highest compensation level. Much of the increase in an employee's compensation level over a working career merely reflects inflation. Other reasons for compensation increases are increases in general employee productivity and increases in the individual employee's merit, and both are also appropriately reflected in the retirement benefit. If the plan does not use a final-average formula, the employer should consider periodically reviewing the plan's benefit level in light of inflation and amending the plan to increase benefits as appropriate. It is also possible to include an automatic mechanism in the plan under which future benefit levels for current employees are increased in accordance with some kind of formula based on the inflation rate; however, this is rarely done.

Defined-contribution plans provide some inflation protection not available under defined-benefit plans because the benefit in the defined-contribution plan depends on the value of the investments in each participant's account. In the long run, a reasonably diversified investment portfolio tends to increase in value to keep pace with inflation. This is not necessarily true for short periods; in the 1970s, for example, common stocks often declined even as inflation reached new heights. However, most economists believe that the long-range linkage between asset values and inflation will continue, so defined-contribution plans can be useful in dealing with inflation. Naturally, for this to occur the investment portfolio has to be chosen to emphasize the types of assets—common stocks, for example—that typically show inflation-related growth.

A defined-contribution plan, however, has a disadvantage similar to that of a career-average benefit formula: contributions to the participant's account in the early years are based on then-current compensation, which typically is at a low level compared with later years. This disadvantage tends to reduce the advantage of possible investment-related growth.

Postretirement Inflation
In the postretirement period, one approach to inflation protection in defined benefit plans is indexing of retirement benefits. With an indexed formula, the plan provides that the benefit is to be increased after retirement in accordance with some formula contained in the plan. The design problem here is the choice of a formula that is affordable by the employer and that accurately reflects the impact of inflation on retirees.

One approach is to use the consumer price index (CPI), a price index provided by the government. The CPI is a measure of the relative rise from month to month of a "market basket" of consumer products purchased by a hypothetical average consumer. There is some debate as to whether the CPI accurately reflects the impact of inflation, particularly on retirees, because it may emphasize rising prices of items not normally purchased by retirees or, conversely, may understate the impact of rising prices for items particularly important to retirees. At one time, for example, the CPI had a large component reflecting the cost of new housing, which typically is not a significant item in retirees' budgets.

The government also provides various types of wage indexes indicating the increase in wages in specific portions of the work force. Theoretically, it is possible to index retirement benefits in accordance with a wage index. Based on past experience, this would produce a larger increase in retirement benefits than a price index because wage indexes reflect increases in productivity that have historically outdistanced inflationary price increases. However, in short-term periods, wage indexes can fall behind cost indexes such as the CPI. A theoretical advantage of wage indexing is that retirees will obtain the same protection against inflation as people currently in the work force (but no better). Whatever the merits of this argument, however, wage indexes are rarely used.

A third approach to indexing is to use a formula for increasing benefits that is included in the plan itself and is not dependent on external price or wage indexes. Such a formula makes it easier for the employer to anticipate the cost of the benefit increases. The risk of possibly running ahead of the CPI can be minimized by providing that the formula increase will not exceed an amount determined by reference to the CPI or other chosen economic indexes.

Indexed pension benefits are obviously attractive to participants, but currently they are not extensively used in the private pension system. This is because even a small annual or periodic percentage increase in pension benefits can result in a very large increase in the ultimate cost of the benefit. Private employers, therefore, often avoid indexing because of the possibility of incurring an uncontrollable future liability. However, indexing is quite common in pension programs of federal, state, and local government units. Elected officials often grant indexed pensions to government employees with the implicit expectation that taxpayers in the future (after current officials' terms have expired) will accept tax increases to fund the increased pension costs.

In the private sector, probably the most common mechanism for dealing with postretirement inflation is to increase pension benefits through ad hoc "supplemental payments" to retirees. At one time, there was some concern that a program of supplemental payments might be deemed a separate pension plan involving various federal regulatory complexities. However, to encourage employers to make such supplemental payments, the Labor Department has issued relatively permissive regulations concerning these payments. Under these regulations [Labor Regulations Section 2510.32(g)], a supplemental payment plan will not be treated as a separate pension plan but rather as a welfare plan, which is subject to much simpler regulatory requirements if the amount paid is limited by a formula that effectively restricts it to the cost-of-living increases that have occurred since the retirees' pension payments commenced. The supplemental payments can be made out of the employer's general assets or from a separate trust fund established for them. In addition, there are special provisions [Code Section 415(k)(2)] allowing employees to contribute additional amounts to a defined-benefit plan to provide cost-of-living adjustments to benefits.

DEFINED-CONTRIBUTION FORMULAS

A defined-contribution plan is much simpler than a defined-benefit plan. In a defined-contribution plan, the plan specifies the amount that the employer will contribute to the plan. There are two basic types of contribution formulas for defined-contribution pension plans—the money-purchase formula and the target-benefit formula. For a money-purchase formula, the annual employer contribution is usually a stated percentage of each employee's compensation—for example, 6 percent of compensation. The target-benefit formula uses an actuarial approach, providing larger contribution percentages for older plan entrants.

The following advantages have been identified for defined-contribution plans (including both pension and profit-sharing types) over defined-benefit plans:

• Defined-contribution plans with their individual, periodically reported, and valued employee accounts are easier for the employee to understand and appreciate as a valuable benefit.

• Administration and government regulations are generally simpler for defined-contribution plans. For example, Pension Benefit Guaranty Corporation (PBGA) coverage and reporting requirements do not apply to defined-contribution plans and ongoing actuarial services are not required for defined-contribution plans.

• Defined-contribution plans fit the nature of today's work force, which experiences frequent job-changing, thereby putting a premium on a portable benefit that increases steadily from the first day of employment. Few employees enjoy the luxury of a 40-year career with the same employer, which typically provides the best result for defined-benefit plan participants.

In terms of the number of plans, defined-contribution plans—including profit-sharing and pension plans—constitute about 70 percent of all qualified plans. However, if a comparison is made on the basis of employees covered under qualified plans, the result is the opposite—about 60 percent of such employees are in defined-benefit plans. This indicates, not surprisingly, that defined-benefit plans tend to cover larger groups, although defined-benefit plans are often used for smaller groups as well.

Money-Purchase Formulas
In a money-purchase plan, as in all defined-contribution plans, there is an individual account for each employee. The amount of the benefit at retirement is equal to the employee's account balance at the retirement date or at a valuation date near the time of the retirement date. The plan may provide for payment of the benefit in a lump sum; a variety of payment options, including annuity benefits, may also be made available. The accounts of all employees are usually commingled for investment purposes; each account is kept separate administratively, so that the account increases and decreases in accordance with the investment performance of the fund. Thus, the benefit available at retirement cannot be predicted exactly. Investment risk lies with the employee. If the employee's account is less than anticipated, the employer is not required to make additional contributions.

Target Plans
From a planning point of view, the target plan is a hybrid of the defined-contribution and defined-benefit approaches. Under a target plan, the employer chooses a target level of retirement benefit using a benefit-formula approach similar to that used in designing a defined-benefit plan.

For example, the target level might be some percentage of each participant's final-average compensation. At the plan's inception, an actuarial calculation is made of the level annual contribution amount (for each participant) that would be required to fully fund this benefit at the participant's normal retirement date. These level amounts are then actually contributed by the employer to the plan each year. Unlike a defined-benefit plan, however, there is no change in the level contribution amount if actual investment return or mortality varies from the assumptions used in determining the initial contribution level, unless the plan is actually amended. Therefore, at retirement, the amount actually available may be more or less than anticipated. The plan has individual accounts for each participant, and unlike a defined-benefit plan, each employee's benefit is limited to the amount actually in his or her individual account.

Because a target plan is a defined-contribution plan, it is subject to the Section 415 limits applicable to defined-contribution plans. Under this limit the annual addition to each participant's account cannot exceed the lesser of 25 percent of compensation or $30,000 (dollar figure subject to indexing for inflation; $30,000 in 2000). For some older employees, this limit might prevent making a large enough contribution to fund the target benefit. For example, if an employee enters the plan at age 60 and earns $50,000, the target formula might require a contribution of $15,000 annually, but the actual contribution would be limited to $12,500 (25 percent of $50,000). This disadvantage of a target plan does not apply to a defined-benefit plan, for which the applicable Section 415 limit is not based on the annual contribution.

Target plans are an example of a more general type of benefit/contribution formula design based on what is known as cross-testing. A cross-tested defined-contribution formula is tested for discrimination in favor of the highly compensated by looking at employees' projected benefits at retirement (assuming they continue in employment until retirement age) rather than testing the contribution formula directly. Cross-testing in connection with profit-sharing plans, specifically age-weighted profit-sharing formulas. Currently, employers considering this approach in benefit design are likely to be more interested in age-weighted profit-sharing plans than in target pension plans, because profit-sharing plans have more flexibility in annual contribution levels. Target plans, like all pension plans, require that the employer commit to a fixed annual contribution obligation.

NONTAX FEDERAL REGULATION AFFECTING QUALIFIED PLANS

The tax-law requirements for qualified plans include numerous provisions to prevent discrimination in favor of highly compensated employees. Other federal statutes also have some impact on qualified plan benefit and contribution formulas:

• The Civil Rights Act of 1964 prohibits employers from discriminating on the basis of race, color, religion, sex, or national origin. Sex discrimination, as discussed below, is the only issue under this law that has a significant practical impact on pension benefit design.

• The Age Discrimination in Employment Act (Title 29 USC) prohibits discrimination by employers on the basis of age; the major implications of this provisions are also discussed below.

• The Americans with Disabilities Act (Title 42 USC) prohibits discrimination against disabled employees. This would prohibit special pension provisions applicable only to disabled employees and might also require general pension provisions to be changed to accommodate disabled employees. The law is broadly written and its full implications, including its effect on retirement plans, are not yet entirely apparent.

• The Family and Medical Leave Act of 1993 (Title 29 USC Sees. 2601 et seq.) generally requires employers with 50 or more employees to provide 12 weeks per year of unpaid leave for childbirth, adoption, health condition or care for a sick family member. When the employee returns, all accrued pension and other employee benefits must be restored, but the employer is not required to provide accrual of benefits during the period of the leave.

Sex Discrimination
Of the issues arising under these nontax federal statutes, sex discrimination is the one issue that has the most direct relevance to pension plan design.

Sex discrimination as it relates to qualified plans, annuities, and life insurance is a subject that is not yet completely resolved, but some clear rules for qualified plan design have emerged. The issue arises from the statistical fact that women, as a group, live longer than men. This means that if actuaries make separate calculations for men and women, the same periodic annuity costs more for women than for men of the same age. Or, for a given annuity premium, the periodic annuity amount is lower for women than for men.

The Civil Rights Act of 1964, like its predecessor, the Equal Pay Act of 1963, provides that it is an unlawful employment practice for an employer

to discriminate against any individual with respect to his compensation, terms, conditions or privileges of employment, because of such individual's race, color, religion, sex or national origin [Section 2000e-2(a), Civil Rights Act of 1964].

It is clear that qualified plan benefits are part of an employee's compensation; it was not originally clear, however, what constituted sex discrimination in a qualified plan.

• Must the plan provide the same periodic benefit for both men and women employees?

• Must the plan provide only the same employer contribution to the plan?

Early federal administrative guidelines under the Equal Pay Act of 1963 indicated that an employer satisfied the nondiscrimination requirement if it provided either equal periodic benefits or equal contributions. However, in 1972, the Equal Employment Opportunities Commission (EEOC) issued a revised sex discrimination guideline under the Civil Rights Act of 1964: To avoid sex discrimination in retirement plans, the employer must provide equal periodic benefits to men and women employees in all circumstances. Employers originally resisted this guideline, but recent court cases clearly point in this direction. The first significant case went to the United States Supreme Court, Los Angeles Department of Water and Power v. Manhart, 435 US 702 (1978). That case involved a contributory pension plan of a municipality. The Supreme Court held that the plan could not require women to pay higher contributions than men to receive equal periodic benefits upon retirement. Subsequently, the Supreme Court held in Arizona Governing Committee v. Norris, 103 S.Ct. 3492 (1983), that a municipal retirement plan could not provide sex-based annuity choices at retirement. No employer contributions were involved—only employee contributions.

Although technically the Manhart and Norris cases did not completely establish that the Civil Rights Act requires equal periodic benefits for men and women in an employer-provided retirement plan under all circumstances, the trend of the cases favors an equal-benefit approach and virtually all planners assume this to be the law.

Most qualified plans already avoid obvious sex discrimination problems. Most defined-benefit plans provide the same normal retirement benefit for men and women employees; most defined-contribution plans provide the same employer contribution for men and women employees. Discrimination problems arise when a qualified plan (either defined-benefit or defined-contribution) offers participants a choice of benefits including a retirement annuity. Most plan designers advise using only unisex annuities (those providing the same annuity rate for both men and women) for this purpose. Similarly, if a qualified plan offers life insurance as an incidental benefit, the life insurance cost to the employee must be determined on a unisex basis. However, in determining the annual deposit to a defined benefit plan, the sex of covered employees may be taken into account, because it affects only the employer's costs and not the ultimate benefit that the employee will receive.

The sex discrimination issue is complicated by the fact that the Civil Rights Act does not govern the pricing of insurance products; private insurance companies, therefore, currently are allowed to use sex as a factor in determining life insurance and annuity rates. The argument has been made that when a qualified plan uses a group pension contract for funding, sex-based annuity options should be allowed under the group contract. However, it is the employer, not the insurance company, that provides the pension as part of an employee's compensation. In view of this and the trend of the court cases, insurance companies no longer offer sex-based annuities as part of a group pension contract.

Even if employers remove any conceivable sex discrimination from qualified plan documents, if the plan is designed so that participants can withdraw their benefits at retirement, effective sex discrimination will still be possible so long as sex-based annuities are available from insurance companies. In that situation, men can withdraw their benefits and purchase an annuity from an insurance company providing greater periodic payments than women would be able to purchase for the same amount (or payments greater than those available under the plan if the plan provides a unisex annuity). Because of this and other related problems, the law may at some point reconsider the question whether insurance companies should be allowed to determine annuity and life insurance premiums on the basis of sex.

There is no doubt that sex is a relevant actuarial classification, as is any ascertainable factor affecting life expectancy, which could conceivably include such things as race, religion, or national origin. Insurance companies do not commonly use race or other potentially offensive actuarial factors, regardless of their relevance as predictors of life expectancy. However, they are strongly attached to the use of sex classifications and have vigorously opposed restrictions proposed in Congress.

Both sides of the controversy view the issue as one of fairness. Advocates of sex classification argue that unisex annuity rates are unfair to men, who should be allowed to purchase annuities reflecting their group's life expectancy. Opponents argue that it is unfair to attribute to an individual the characteristics of a group to which that individual belongs, regardless of whether the individual actually possesses those characteristics. Ultimately, Congress may have to determine the appropriate social policy in connection with insurance company practices.

Age Discrimination
The federal Age Discrimination in Employment Act,[3] as amended in 1978, 1986, and 1989, has an impact on qualified plans. The Age Discrimination Act applies to workers and managers of any business that engages in interstate transactions (a very broad category) and employs at least 20 persons during the year. Certain hazardous occupations are excluded as well as executive employees who would be entitled, upon retirement, to an annual pension of $44,000 or more over and above Social Security benefits.

The main provision of the Age Discrimination Act that affects qualified plans is that which prohibits involuntary retirement at any age. A qualified plan must not in any way require mandatory retirement.

In addition, Code Sections 411(b)(1)(H) and 411(b)(2) deal specifically with benefits for older workers. In general, older workers must be treated the same as younger workers with regard to plan contributions (for a defined-contribution plan) and benefit accruals (for a defined-benefit plan). However, for a defined-benefit plan, the benefit formula can provide that benefits are fully accrued not at a specified age but after a specified number of years of service, such as 25. This will cut off further benefit accrual for many older employees, but it is permitted. If a plan provides for normal retirement at 65 with actuarial increases for later retirement, the actuarial increases are credited toward any requirement of benefit accrual that applies. For example, if a plan provides a benefit of $1,000 per month beginning at age 65 or an actuarially adjusted $1,100 per month beginning at age 66, the extra $100 is counted as an additional benefit accrual.

RETIREMENT AGE| Plan Qualification Requirements

A plan's normal retirement age is the age at which a participant can retire and receive the full specified retirement benefit. A defined-benefit plan must specify a normal retirement age in order to fully define the benefit. Defined-contribution plans do not need a normal retirement age for this purpose, but they may have a normal retirement age in order to specify an age at which participants can retire and begin to receive benefits or, as discussed below, an age beyond which no further employer contributions will be made.

Under Code Section 411(a)(8), a plan's normal retirement age can be no greater than the latest of:

• age 65 or

• the fifth anniversary of plan entry if a participant entered within five years of normal retirement age.

Thus, for example, a plan having a normal retirement age of 65 could provide normal retirement at age 67 for a participant entering at age 62.

Although most plans use 65 as the normal retirement age, the plan may specify an earlier normal retirement age. The use of an earlier normal retirement age in a defined-benefit plan requires that funding be accelerated—larger amounts must be contributed to the plan each year to fund each employee's benefit because the benefit will become payable at an earlier date. For plans in which tax sheltering is a primary consideration, such as plans oriented toward key employees in a closely held business, the use of the earliest possible normal retirement age can provide significant additional tax benefits by increasing the deductible plan contributions each year. However, if the normal retirement age is less than the Social Security retirement age, the Section 415 limitations are reduced. This tends to provide some limit on the use of unrealistically low normal retirement ages.

The IRS considers a plan's retirement age to be an actuarial assumption. Therefore, the requirement of "reasonableness" for actuarial assumptions, also puts some limit on the use of unrealistically low normal retirement ages.

Early Retirement
A qualified plan may designate an early retirement age at which an employee may retire and receive an immediate benefit. The early retirement benefit is usually reduced below that payable at normal retirement. The plan may have some service requirement for early retirement, such as ten years of service, or it may permit early retirement simply upon attainment of the early retirement age.

Under most defined-benefit plans, the monthly early retirement benefit is reduced below the monthly normal retirement benefit payable at age 65 because of two factors. First, the early retirement benefit will usually be limited to the participant's accrued benefit, and the participant will often have not accrued the full benefit at early retirement. Second, most plans require an actuarial reduction. The actuarial reduction is a mathematical adjustment based on (1) longer life expectancy at early retirement, (2) loss of investment earnings to the plan fund due to payments beginning earlier, and (3) loss of the possibility that the participant might die before payments begin—mortality.

Most plans do not require employer consent for early retirement. If employer consent is required, the IRS limits the early retirement benefit to the vested accrued benefit that would be payable if the employee terminated employment unilaterally, in order to avoid the possibility that the employer will favor highly compensated employees in granting early retirement benefits.

For defined-contribution plans, early retirement is usually treated the same as a termination of employment, and the benefit payable at early retirement is simply the amount of the participant's account balance as of that date. Thus, many defined-contribution plans do not specify an early retirement age.

Some employers offer a "subsidized" early retirement benefit—one that is reduced by less than the full amount dictated by the three factors discussed above—as an incentive for retirement. The subsidized benefit is often offered during a limited "window" period, during which the employee must either choose the benefit or lose the opportunity to receive it forever (or at least until the employer decides to offer another window benefit). There are specific legal protections under the Age Discrimination Act for employees in this situation.

Late Retirement
A qualified plan design should also cover the possibility of late retirement—retirement after the normal retirement age. Under the age discrimination rules discussed below, the plan must continue benefit accruals for employees who continue working after the normal retirement age unless the plan's benefit formula stops benefit accruals after a specified number of years and the employee has enough years of service to cease accruals for that reason. Benefit formulas must be designed carefully to ensure appropriate treatment of older employees. In smaller businesses, older participants are often owners or key employees who will want the plan to provide substantial benefits. On the other hand, many larger employers want to encourage earlier retirement and will want to provide only the minimum late retirement benefit required under the law

WHO WILL PAY FOR THE PLAN? | Plan Qualification Requirements

Most qualified pension plans are funded entirely by the employer. Pension plans requiring contributions by employees, referred to as contributory plans, were once popular but are currently of diminishing importance. There are two reasons for this. First, employee contributions to a qualified plan other than "salary reductions" (see below) are after-tax contributions—the employee receives no tax deduction or exclusion for the contribution. Also, employee contributions involve administrative complications such as Code Section 401(m).

Many employers believe that retirement plan benefits are appreciated more by employees if the employees themselves contribute (or feel that they are contributing) toward their cost. In most cases, of course, most of an employee's income comes in the form of compensation from the employer, so there is some degree of illusion in this approach. Some employers may also believe that a contributory approach lowers plan costs, but this is not actually true. To the extent that a contributory approach results in the loss of tax benefits (in effect, losing a contribution to the plan by the U.S. Treasury), a contributory plan actually costs the employer more for the same level of benefits. A better justification for contributory plans is that they give the employee some degree of choice in allocating his or her compensation between cash and deferred benefits.

Currently, the most favorable contributory plan design is to use salary reductions in a plan that is permitted to use salary reductions—a Section 401(k) plan, a Section 403(b) plan, a Section 457 plan, or a SIMPLE plan. Qualified pension plans cannot use salary reductions, except for some older plans that were "grandfathered" (permitted to use older law) when current law was enacted. Salary reductions are subject to FICA and FUTA (Social Security and federal unemployment) taxes but not to federal income tax. Thus, the tax benefits of qualified plans are not completely lost to the employee if the salary reduction approach is used.

VESTING | Plan Qualification Requirements

A qualified plan must provide a minimum nonforfeitable, or vested, benefit for participants who attain certain service requirements. Once vested, the participant cannot forfeit this minimum vested benefit. For example, the plan cannot require that an employee forfeit part or all of the vested benefit required by the Code even if the employee commits an act of misconduct, such as embezzlement or going to work for a competitor. The strictness of the vesting rules was designed to provide additional benefit security and to protect employees against arbitrary acts of the employer.

Vesting at Normal Retirement Age and Termination of Employment
The plan must provide a fully vested benefit at the normal retirement age. The plan must also provide that benefits are vested under a specified "vesting schedule" during the participant's employment, so that if the participant terminates employment prior to retirement age, he or she is entitled to a vested benefit with some stated minimum amount of service. The vested benefit can be payable immediately on termination or deferred to the plan's normal retirement age.

If the plan provides for employee contributions, the participant's accrued benefit is divided between the part attributable to employee contributions and the part attributable to employer contributions. The part attributable to employee contributions must at all times be 100 percent vested. The part attributable to employer contributions must be vested in accordance with a vesting schedule set out in the plan.

There is some flexibility in designing a vesting schedule in order to meet various employer objectives. However, the vesting schedule must be at least as favorable as one of two alternative minimum standards, five-year vesting or three-to seven-year vesting.

Five-Year Vesting
The vesting schedule satisfies this minimum requirement if an employee with at least five years of service is 100 percent vested in the employer-provided portion of the accrued benefit. This rule is satisfied even if there is no vesting at all before five years of service. This rule is sometimes referred to as cliff vesting.

Years of Service - Vested Percentage

3 - 20

4 - 40

5 - 60

6 - 80

7 or more - 100

Three-to Seven-Year Vesting
A vesting schedule satisfies this minimum standard if the vesting is at least as fast as in the following table on the right:

In applying the vesting rules, all of a participant's years of service for the employer must be taken into account, even years prior to plan participation, except that years of service prior to age 18 may be excluded. The plan's vesting schedule may also ignore service prior to a break in continuous service with the employer; however, there are elaborate restrictions on how this may be done [Code Section 411(a)(6)].

Probably the most common vesting provision in defined-benefit plans is the five-year provision, because of its simplicity and because it is generally the most favorable to the employee. Defined-contribution plans are often designed with a more generous (to the employee) vesting schedule using the three- to seven-year schedule or one that is even faster.

Top-Heavy Vesting
To complete this discussion, it should be mentioned that plans that are top-heavy, as defined in the Code, are required to provide faster vesting than under most of the schedules previously mentioned. The top-heavy minimum vesting schedule is shown in the table at the left:

Years of Service - Vested Percentage

2 - 20

3 - 40

4 - 60

5 - 80

6 or more - 100

A 100 percent vesting provision with two years' eligibility also meets the top-heavy minimum vesting requirement. As discussed below, the top-heavy requirements have a significant impact in designing a vesting schedule for plans of smaller employers.

Choosing a Vesting Schedule
Choosing an appropriate vesting schedule is an important plan design decision. When a pension plan participant terminates employment, invested funds contributed to the plan for that participant in excess of any benefits paid to the participant on termination (forfeitures) are generally used to reduce future employer costs for the pension plan. Strict vesting, therefore, can reduce a pension plan's cost to the employer. In a defined-contribution plan, forfeitures also can be reallocated to remaining participants' accounts. Thus, there should be a reason for adopting more than a strict minimum vesting schedule. Some reasons for using liberal vesting include the need to provide employee incentive and involvement in situations where a five-year vesting schedule might appear too remote and therefore of no value to employees. Also, a simplified liberal vesting schedule may reduce administrative costs.

Vesting on Plan Termination
The final vesting rule relates to a plan that has terminated. The IRS will regard a plan as having terminated either if it is formally terminated or if the employer permanently ceases to make contributions to the plan. When a plan is terminated, all benefits must be fully vested to the extent funded. Therefore, when a defined-contribution plan terminates, all participants are immediately 100 percent vested in their account balances. When a defined-benefit plan terminates, participants are 100 percent vested in their accrued benefits; however, if the plan funds are insufficient, they are vested only to the extent that the plan is funded. Many terminated qualified defined-benefit plans are insured by the Pension Benefit Guaranty Corporation (PBGC).