CLASSIFICATION OF QUALIFIED PLANS

There are two broad classifications of qualified plans. The first classification differentiates between pension plans and profit-sharing plans and the second between defined-benefit and defined-contribution plans. These broad classifications are useful in identifying plans that meet broad overall goals of the employee. Once detailed employer objectives have been determined, a specific qualified plan program can be developed for the employer using one or more of the types of plans from a menu of specific plan types. The specific plan types contain a lot of flexibility in design to meet employer needs, and one or more different plans or plan types can be designed covering the same or overlapping groups of employees to provide the exact type of benefits that the employer desires.

Pension and Profit-Sharing Plans

One way of broadly classifying qualified plans is to distinguish between pension plans and profit-sharing plans. A pension plan is a plan designed primarily to provide income at retirement. Thus, benefits are generally not available from a pension plan until the employee reaches a specified age, referred to as the normal retirement age. Some plans also provide an optional benefit at an earlier age (the early retirement age). The design of a pension plan benefit formula must be such that an employee's retirement benefit is reasonably predictable in advance. Because the object of a pension plan is to provide retirement security, the employer must keep the fund at an adequate level. Pension plans are subject to the minimum funding rules of the Code, and these generally require that the employer make regular deposits to avoid a penalty.

By contrast, a profit-sharing plan is designed to allow a relatively short-term deferral of income; it is a somewhat more speculative benefit to the employee because the employer's contribution can be based on profits. Furthermore, a profit-sharing plan can provide for a totally discretionary employer contribution so that even if the employer has profits in a given year, the employer need not make a contribution for that year. The minimum funding rules do not apply. However, there must be substantial and recurring contributions or the plan will be deemed to be terminated.

In a profit-sharing plan, it is difficult to determine the employee's benefit in advance, and the plan is considered more an incentive to employees than a predictable source of retirement income. Because it is not exclusively designed for retirement income, employees may be permitted to withdraw funds from the plan before retirement. The plan may allow amounts to be withdrawn as early as two years after the employer has contributed them to the plan. However, as with any qualified plan, preretirement withdrawals may be subject to a 10 percent penalty. Finally, the deductible annual employer contribution is limited to 15 percent of payroll, an amount less than would usually be deductible under a pension plan.

Defined-Benefit and Defined-Contribution Plans

Qualified plans are also divided into defined-benefit and defined-contribution plans. A defined-contribution plan has an individual account for each employee; defined-contribution plans are, therefore, sometimes referred to as individual-account plans. The plan document describes the amount the employer will contribute to the plan, but it does not promise any particular benefit. When the plan participant retires or otherwise becomes eligible for benefits under the plan, the benefit will be the total amount in the participant's account, including past investment earnings on the amounts put into the account. The participant can look only to his or her own account to recover benefits; he or she is not entitled to amounts in any other account. Thus, the participant bears the risk of bad plan investments.

In a defined-benefit plan the plan document specifies the amount of benefit promised to the employee at normal retirement age. The plan itself does not specify the amount the employer must contribute annually to the plan. The plan's actuary will determine the annual contribution required so that the plan fund will be sufficient to pay the promised benefit as each participant retires. If the fund is inadequate, the employer is responsible for making additional contributions. There are no individual participant accounts, and each participant has a claim on the entire fund for the defined benefit. Because of the actuarial aspects, defined-benefit plans tend to be more complicated and expensive to administer than defined-contribution plans.

Specific Types of Qualified Plans

As Figure 1 indicates, within the broad categories (pension, profit-sharing, defined-benefit, defined-contribution), there are specific types of plans available to meet various retirement-planning objectives.

Figure 1: Types of Qualified Plans

Defined-Benefit Pension Plan

All defined-benefit plans are pension plans; they are designed primarily to provide income at retirement. A defined-benefit plan specifies the benefit in terms of a formula, of which there are many different types. Such formulas may state the benefit in terms of a percentage of earnings measured over a specific period of time, and might also be based on years of service. For example, a defined-benefit plan might promise a monthly retirement benefit equal to 50 percent of the employee's average monthly earnings over the five years prior to retirement. Or instead of a flat 50 percent, the plan might provide something like 1.5 percent for each of the employee's years of service, with the resulting percentage applied to the employee's earnings averaged over a stated period. Employer contributions to the plan are determined actuarially. Thus, for a given benefit, a defined-benefit plan will tend to result in a larger employer contribution on behalf of employees who enter the plan at older ages, because there is less time to fund the benefit for them.

Cash-Balance Pension Plan

In a cash-balance plan (also called a guaranteed account plan and various other titles), each participant has an "account" that increases annually as a result of two types of credits: a compensation credit, based on the participant's compensation, and an interest credit equal to a guaranteed rate of interest. As a result of the guarantee, the participant does not bear the investment risk. Unlike defined-benefit formulas, the plan deposits are not based on age, and younger employees receive the same benefit accrual as those hired at older ages. The plan is funded by the employer on an actuarial basis; the plan fund's actual rate of investment return may be more or less than the guaranteed rate, and employer deposits are adjusted accordingly. Technically, because of the guaranteed minimum benefit, the plan is treated as a defined-benefit plan. From the participant's viewpoint, however, the plan appears very similar to a money-purchase plan, described below.

Target-Benefit Pension Plan

A target plan uses a benefit formula (the "target") like that of a defined-benefit plan. However, a target plan is a defined-contribution plan and, therefore, the benefit consists solely of the amount in each employee's individual account at retirement. Initial contributions to a target plan are determined actuarially, but the employer does not guarantee that the benefit will meet the target level, so the initial contribution level is not adjusted to reflect actuarial experience. Like a defined-benefit plan, a target-benefit plan provides a relatively higher contribution on behalf of employees entering the plan at older ages.

Money-Purchase Pension Plan

A money-purchase pension plan is a defined-contribution plan that is in some ways the simplest form of qualified plan. The plan simply specifies a level of contribution to each participant's individual account. For example, the plan might specify that the employer will contribute each year to each participant's account an amount equal to 10 percent of that participant's compensation for the year. The participant's retirement benefit is equal to the amount in the account at retirement. Thus, the account reflects not only the initial contribution level but also any subsequent favorable or unfavorable investment results obtained by the plan fund. The term money purchase arose because in many such plans, the amount in the participant's account at retirement is not distributed in a lump sum but rather is used to purchase a single or joint life annuity for the participant.

Profit-Sharing Plan

As described earlier, the significant features of a profit-sharing plan are that employer contributions are, within limits, discretionary on the part of the employer and that employee withdrawals before retirement may be permitted. Profit-sharing plans that are designed to allow employee contributions are sometimes referred to as savings or thrift plans.

Section 401(k) Plan

A Section 401(k) plan, also called a cash or deferred plan, is a plan allowing employees to choose (within limits) to receive compensation either as current cash or as a contribution to a qualified profit-sharing plan. The amount contributed to the plan is not currently taxable to the employee. Such plans have become popular because of their flexibility and tax advantages. However, such plans must include restrictions that may be burdensome to the employer or the employees. The most significant restrictions are a requirement of immediate vesting for amounts contributed under the employee election and restrictions on distribution of these amounts to employees prior to age 59½.

Stock Bonus Plan

The stock bonus plan resembles a profit-sharing plan except that employer contributions are in the form of employer stock rather than cash and the plan fund consists primarily of employer stock.

The fiduciary requirements of the pension law forbid an employer to invest more than 10 percent of a pension plan fund in stock of the employer company. This prevents the employer from utilizing pension plan funds primarily for financing the business rather than providing retirement security for employees. However, the 10 percent restriction does not apply to profit-sharing or stock bonus plans.

Stock bonus plans are intended specifically to give employees an ownership interest in the company at relatively low cost to the company. Stock bonus plans are also used by closely held companies to help create a market for stock of the employer.

ESOP

Employee stock ownership plans (ESOPs) are similar to stock bonus plans in that most or all of the plan fund consists of employer stock: employee accounts are stated in shares of employer stock. However, ESOPs are designed to offer a further benefit: the employer can use an ESOP as a mechanism for financing the business through borrowing or "leveraging." Various tax incentives exist to encourage this.

GROUP TERM CARVE-OUTS : Bonus Plans, Determining the Best Plan

GROUP TERM CARVE-OUTS
Prior to 1984, employees had no taxable income if they were provided with postretirement coverage under a group term life insurance plan. After that time, coverage in excess of $50,000 became subject to the imputed income rules of Section 79, based on Table I cost, which are relatively high at older ages. As a result, employers increasingly turned to group term carve-outs. While carve-outs can be used for any employee with more than $50,000 of group term coverage, they typically apply only to shareholders and key executives.

Bonus Plans
In the simplest sense, a carve-out works like this: The employer decides which employees are to be covered under the carve-out plan and limits coverage for these employees under its group term plan to the $50,000 that can be received tax free. The employer then gives any premium savings to each "carved-out" employee in the form of a bonus, which is fully deductible to the employer as long as the employee's overall compensation is reasonable. The bonus amounts are either paid directly to an insurance company for individual coverage on the lives of the participants in the carve-out plan or, in some cases, provided to the employees as compensation to pay life insurance premiums. In most cases, the coverage purchased under the carve-out plan is some form of permanent life insurance protection that provides paid-up coverage at retirement. Traditional whole life insurance, universal life insurance, variable universal life insurance, and variable life insurance are all viable alternatives. At retirement, the employee can either keep the coverage in force (possibly at a reduced paid-up amount) or surrender the policy for its cash value.

The popularity of carve-out plans lies in the fact that a comparable or greater amount of life insurance coverage can often be provided to participants at a lower cost than if the participants had received all their coverage under the group term life insurance plan. Because the carve-out plan does not qualify as a plan of insurance under Section 79, each participant has taxable income in the amount of the bonus. However, this income is offset by the absence of any imputed income from Table I.

In reality, carve-out plans are more complex. In many cases, the cost of permanent coverage for an employee may actually be greater than the cost of group term coverage during the working years. However, this high cost is often more than compensated for by the cash value at retirement and the absence of imputed income after retirement. Under some carve-out plans, participants must pay this increased premium cost with after-tax dollars. Under other plans, the employer increases the bonus amount. In effect, the employer is now paying more than if the carve-out plan did not exist, but this arrangement is often acceptable to the employer as a way of providing shareholders and key executives with a benefit that is not available to other employees. In many plans, the bonus is also increased to compensate the employee for any additional income taxes that must be paid because of the carve-out plan. Such an arrangement is commonly referred to as a zero-tax approach.

A carve-out plan can pose a potential problem if there are rated or uninsurable employees, but the problem is ameliorated if the plan has enough participants that the insurance company will use simplified underwriting or grant concessions on impaired risks. Any employee who is still uninsurable can be continued in the group term plan.

Other Types of Carve-Out Plans
While a bonus arrangement is the most common type of carve-out plan, other alternatives are available. Some carve-out plans are designed as death-benefit-only plans, under which the employer agrees only to pay a death benefit to the employee's beneficiary out of corporate assets. The employer often funds the plan with corporate-owned life insurance on the employee's life. With this approach, the employee has no taxable income, but death benefits will result in taxable income to the beneficiary. In addition, the employer is unable to deduct the premiums as a business expense but does receive the death proceeds tax free.

Some firms also use split-dollar life insurance in carve-out plans. The most common approach is to use a collateral assignment arrangement, under which the employer pays most of the premium and the employee collaterally assigns a portion of the cash value and death benefit to the employer equal to the employer's premium payments. At retirement (or any other predetermined time), the employee withdraws the cash value necessary to repay the employer, who then removes the collateral assignment. At that time, the employee has full control of the policy, and the remaining cash value can be used to keep coverage in force. Many split-dollar arrangements are also used to provide nonqualified retirement benefits to key employees as a supplement to the benefits under the employer's qualified retirement plan.

Determining the Best Plan
In many instances, carve-out plans are the most cost-effective approach for providing benefits to key employees. The best plan depends on the overall benefit objectives of employer. A proper analysis of alternatives involves a complex consideration of many factors, including the employer's tax bracket, the effect on the employer's financial statements, the employee's tax bracket, premium costs, and the time value of money.