What are the basic requirements for vesting under ERISA?

ERISA Section 203 establishes the minimum vesting standards for an ERISA-covered pension plan. Under that section, each pension plan must provide that an employee’s right to his normal retirement benefit is nonforfeitable upon the attainment of normal retirement age. ERISA Section 203(a)(1) states that an employee’s accrued benefit derived from the employee’s own contributions must, at all times, be conforfeitable.

Section 904 of the Pension Protection Act of 2006, has altered the mandatory vesting requirements for qualified benefit plans by eliminating ERISA Section 203(a)(4) and IRC Section 411(a)(12). The PPA also amended ERISA Section 203(a)(4) and IRC Section 411(a)(2) by providing that for plan years beginning after 2006, employer non-elective contributions must vest at least as rapidly as the mandated vesting schedules for employer matching contributions—that is, either a three-year cliff vesting schedule or a schedule of 20 percent after two years, 40 percent after three years, 60 percent after four years, 80 percent after five years, and 100 percent after six years. 

IRS Notice 2007-7 has clarified that employer discretionary contributions remitted to a plan trust prior to 2007 may remain under the pre-PPA vesting provisions of either a five-year cliff vesting schedule or a 3/20 schedule graduating at 20 percent per year after three years and culminating in 100 percent vesting after seven years. 

Most qualified retirement plans provide for a graduated vesting schedule on a “2/20” basis. That is a vesting schedule that provides for 2 percent vesting after two years of credited service and then increases the vesting percentage by 20 percent for each additional year of credited service until the participant becomes 100 percent vested. However, employer-matching contributions (as defined under IRC Section 401(m)(4)(A)) must be vested on a three-year cliff or six-year graded vesting schedule.

For defined contribution plans, the “accrued benefit” is the balance of assets allocated to the participant’s individual account. For purposes of a defined benefit plan, “accrued benefit” is defined as the employee’s accrued benefit as determined under the plan and expressed in the form of an annual benefit commencing at normal retirement age.

Both ERISA and the Internal Revenue Code generally prohibit any plan amendment that has the effect of decreasing accrued benefits under a plan. This would include any amendment increasing the vesting schedule. The IRS takes this provision very seriously and has disqualified plans for violations of this prohibition. Such violations are often referred to as the “death penalty” for qualified plans.

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).

COMMONLY CONTROLLED EMPLOYERS | Plan Qualification Requirements

Often an employer organization (incorporated or unincorporated) is owned or controlled in common with other such organizations. The qualified plan designer often must coordinate plan coverage for the first employer with plan coverage for employees of other members of the commonly controlled group of employers.

The Code has several provisions relating to this issue; their basic objective is to prevent a business owner from getting around the coverage and nondiscrimination requirements for qualified plans by artificially segregating employees to be benefited from the plan into one organization with the remainder being employed by subsidiaries or organizations with lesser plan benefits or no plan at all. While this is still technically possible, the controlled group rules restrict this practice considerably.

Controlled Group Rules in General
Because the forms of business ownership can be tangled and complex, the common control rules for qualified plans are appropriately complicated. There are three sets of these rules.

1. Under Code Section 414(b), all employees of all corporations in a controlled group of corporations are treated as employed by a single employer for purposes of Sections 401, 408(k), 410, 411, 415, and 416. The major impact of this comes from the participation rules of Section 410, which require that the participation and coverage tests be applied to the entire controlled group rather than to any single corporation in the group. Code Section 414(c) provides similar rules for commonly controlled partnerships and proprietorships.

2. Code Section 414(m) provides that employees of an affiliated service group are treated as employed by a single employer. This requirement similarly has its major impact in determining participation in a qualified plan; however, it applies to other employee benefit requirements as well.

3. A leased employee is treated as an employee of the lessor corporation under certain circumstances, under Code Section 414(n).

Some examples will give a general idea of the impact of these provisions on plan design; Note that the common thread of these examples is that the related organization's employees must be taken into account in applying the participation rules. This does not mean that these employees must necessarily be covered.

• Alpha Corporation owns 80 percent of the stock of Beta Corporation. Alpha and Beta are members of a parent subsidiary controlled group of corporations. In applying the participation and coverage rules of Code Section 410, Alpha and Beta must be considered as a single employer.

• Medical Services, Inc., provides administrative and laboratory services for Dr. Sam and Dr. Joe, each of whom is an incorporated sole practitioner. Dr. Sam and Dr. Joe each own 50 percent of Medical Services, Inc. If either Dr. Sam or Dr. Joe adopts a qualified plan, employees of Medical Services, Inc., will have to be taken into account in determining if plan coverage is nondiscriminatory.

• Calculators Incorporated, an actuarial firm, contracts with Temporary Services, Inc., an employee-leasing firm, to lease employees on a substantially full-time basis. The leased employees will have to be taken into account in determining nondiscrimination in any qualified plan of Calculators, unless Temporary maintains a minimum (10 percent nonintegrated) money-purchase pension plan for the leased employees.