What is ERISA?
The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for individuals in these plans.
ERISA protects the assets of millions of Americans to ensure as far as possible that funds placed in retirement plans during their working lives will be there when they retire.
ERISA does not require any employer to establish a pension plan. It only requires that those who establish plans must meet certain minimum standards. The law generally does not specify how much money a participant must be paid as a benefit.
ERISA does specify when an employee must be allowed to become a participant, how long they have to work before they have a “nonforfeitable” interest in their pension, how long a participant can be away from their job before it might affect their benefit, and whether their spouse has a right to part of their pension in the event of their death. Most of the provisions of ERISA are effective for plan years beginning on or after January 1, 1975.
ERISA does the following:
Requires plans to provide participants with information about the plan, including plan features and funding. The plan must furnish some information regularly and automatically. Some is available free of charge, some is not.
Sets minimum standards for participation, vesting, benefit accrual and funding. The law defines how long a person may be required to work before becoming eligible to participate in a plan, to accumulate benefits, and to have a nonforfeitable right to those benefits. The law also establishes detailed funding rules that require plan sponsors to provide adequate funding for your plan.
Requires accountability of plan fiduciaries. ERISA generally defines a fiduciary as anyone who exercises discretionary authority or control over a plan’s management or assets, including anyone who provides investment advice to the plan. Fiduciaries who do not follow the principles of conduct may be held responsible for restoring losses to the plan.
Gives participants the right to sue for benefits and breaches of fiduciary duty.
Guarantees payment of certain benefits if a defined plan is terminated, through a federally chartered corporation, known as the Pension Benefit Guaranty Corporation.
There have been a number of amendments to ERISA, expanding the protections available to health benefit plan participants and beneficiaries. One important amendment, the Consolidated Omnibus Budget Reconciliation Act (COBRA), provides some workers and their families with the right to continue their health coverage for a limited time after certain events, such as the loss of a job. Another amendment to ERISA is the Health Insurance Portability and Accountability Act (HIPAA) which provides important new protections for working Americans and their families who have preexisting medical conditions or might otherwise suffer discrimination in health coverage based on factors that relate to an individual’s health. Other important amendments include the Newborns’ and Mothers’ Health Protection Act, the Mental Health Parity Act, and the Women’s Health and Cancer Rights Act.
In general, ERISA does not cover group health plans established or maintained by governmental entities, churches for their employees, or plans which are maintained solely to comply with applicable workers compensation, unemployment, or disability laws. ERISA also does not cover plans maintained outside the United States primarily for the benefit of nonresident aliens or unfunded excess benefit plans.”
What is a Defined Contribution Plan?
A defined contribution (DC) plan, or individual account plan, defines the contribution amount to be deposited into the participant’s account. A plan may provide that all eligible participants will receive an allocation equal to some percentage of their compensation. Or the plan may define the contribution as a specific dollar amount, such as $1,000 per pay period.
What are the benefits and risks of a Defined Contribution Plan?
In a DC plan, the employer is not responsible for the ending value of the participant’s retirement nest egg. This responsibility is the participant’s, and therefore the employer is able to transfer the fiduciary responsibility for account value on to the participant. Participants may also like the sense of control and choice that they have under the DC plan scenario.
DC plans (and especially 401(k) plans) have become hugely popular for these reasons, but there is growing understanding, and therefore controversy, about the fact that the investment performance of individual investors is typically less than that of the overall market, and that increased choice and control, in inexperienced or uninformed hands, may not lead to optimal retirement outcomes.
Given the high level of fiduciary responsibility that employers have, it is important that participants are given as much information and education as they need, in order to make wise investment choices.
Significant problems with DC plans include: a) under-saving (or non-participation) by participants, which erodes retirement wealth, and which may skew plan contributions too much in favor of employers, leading to corrective distributions; b) premature withdrawal of funds by participants, which mitigates tax benefits; c) high expenses, which erodes retirement wealth; d) poor diversification and asset allocation, which has the same outcome.
Employers should seek out advisors who will help them address these problems through careful plan design, education of participants, appropriate plan management, and a reasonable cost structure.
What is a 401(k) Plan?
By far the most common type of Defined Contribution (DC) plan, a 401(k) plan refers to IRS Code Section 410(k), which allows employees to make contributions toward their retirement on a pre-tax basis. A 401(k) arrangement may also allow employer contributions in the form of a match to employee deferrals.
A simple 401(k) with match typically goes on the company’s books as a business expense. However when appropriate, 401(k) plans can be redesigned to become powerful compensation tools for both participants and business owners.
What is a Profit Sharing Plan?
A profit sharing plan is a type of qualified retirement plan where all contributions are made by the employer. It is a defined contribution plan under which the plan may provide, or the employer may determine annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution.
A profit sharing component is often combined with a 401(k) plan to maximize tax deferrals and retirement savings.
A profit sharing plan can become a great compensation planning tool by providing different levels of contributions for various groups of employees, and can by tying contributions to individual or company performance benchmarks, thereby incentivizing business performance and productivity.
Under these types of plans, contributions can be allocated using a compensation-to-compensation, integrated, or cross-tested formula.
DCM Financial Partners typically determines the appropriate allocation method after a careful evaluation of the compensation, job classification, and ages of eligible employees.
Profit sharing plans offer considerable flexibility and can be designed without annual funding requirements.
What is a Defined Benefit Plan?
A participant’s benefit at retirement with a DC plan such as a 401(k) will simply be the vested balance of his account. This account balance is subject to wide variability, a large portion of which comes from the underlying performance of assets in the financial markets, as well as the amount of savings contributed to the plan by the participant.
A Defined Benefit (or DB) plan, on the other hand, defines the benefit that will be paid at retirement, regardless of the value of the account balance, or any savings deferral by participants. The plan document specifically states the benefit to be paid, according to some predetermined formula, and this statement is contractually binding.
What are the benefits and risks of a Defined Benefit Plan?
Participants tend to like DB plans, because they are not responsible for the decision- making involved in maximizing the value of the account. As long as they have met the benchmarks of the plan by being good faith employees, participants are entitled to a certain pre-determined account value upon retirement.
There are also benefits to employers. Defined Benefit contributions are not limited to the same contribution levels found with DC plans like the 401(k). Contributions to a DB plan are based on the level of benefits, years of service, and the number of years until retirement. In some cases, annual contributions can exceed $200,000 for a single HCE (Highly Compensated Employee). DB plans can therefore be a great planning tool for business owners or professionals seeking to maximize their retirement benefits.
The most significant risk of DB plans is that employers must find money to pay to retirees regardless of the performance of their investments in the financial markets. In years when the financial markets may be catastrophically negative, this may pose a significant business risk to the employer.
A famous recent example of such a situation has been the near bankruptcy of General Motors. At the risk of oversimplification, GM’s revenues from vehicle sales are insufficient for it to finance its payments to retired participants in its DB plan. The decision to adopt a DB plan for a small business must therefore be made in the light of that business’ ability to meet potential future payouts.
What is a Cash Balance Plan?
There are two general types of pension plans—Defined Benefit Plans and Defined Contribution Plans. In general, defined benefit plans provide a specific benefit at retirement for each eligible employee, while defined contribution plans specify the amount of contributions to be made by the employer and employee toward an employee’s retirement account.
In a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account.
A cash balance plan is a type of defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.
With a traditional DB plan the calculation of the retirement benefit is often a complex formula that takes into account years of service, a percentage of pay, and several other variables. In a cash balance plan, however, the formula is usually more straightforward. The plan documents specify the percentage of pay each participant will have contributed to their account as well as the interest crediting rate.
The combination of participant contribution and employer mandated payment leads some people to classify a cash balance plan as a “hybrid” plan. In any event, the participant’s benefit at retirement is simply a function of their account balance at retirement.
Cash balance plans can be use in combination with 401(k) and profit sharing arrangements to provide significant contributions to selected groups of employees. This type of “Combination Plan” design is very common in professional groups or closely held businesses where the primary owners are seeking to maximize retirement plan contributions.
“Combination Plans” can be flexibly designed so that the owners and a few employees are covered by a cash balance plan, and another group of employees covered by the profit sharing plan. In certain situations this type of plan design can achieve multiple planning objectives while minimizing employer costs.
Is there a federal pension law that governs cash balance plans?
Yes. Federal laws, including the Employee Retirement Income Security Act (ERISA), the Age Discrimination in Employment Act (ADEA), and the Internal Revenue Code (IRC), provide certain protections for the employee benefits of participants in private sector pension and health benefit plans.
If an employer offers a pension plan, the law sets standards for fiduciary responsibility, participation, vesting (the minimum time a participant must generally be employed by the employer to earn a legal right to benefits), benefit accrual and funding. The law also requires plans to give basic information to workers and retirees. The IRC establishes additional tax qualification requirements, including rules aimed at ensuring that proportionate benefits are provided to a sufficiently broad-based employee population.
The U.S. Department of Labor, the Equal Employment Opportunity Commission (EEOC), and the Internal Revenue Service (IRS) have responsibilities in overseeing and enforcing the provisions of the law. Generally, the U. S. Department of Labor focuses on the fiduciary responsibilities, employee rights, and reporting and disclosure requirements under the law, while the EEOC concentrates on the portions of the law relating to age discriminatory employment practices. The IRS generally focuses on the standards set by the law for plans to qualify for tax preferences.
How long does a participant have to wait to become a member of a pension plan and to become vested in their benefits?
Generally, a plan may require a person to reach age 21 to be eligible to participate in the plan and to have a year of service. Vesting means the employee has earned a non-forfeitable right to benefits funded by employer contributions. Employees always have a non-forfeitable right to their own contributions.
Beginning in 2002, there were two basic vesting schedules. Under the three-year schedule, workers are 100% vested after three years of service under the plan. The six-year graduated schedule allows workers to become 20% vested after two years and to vest at a rate of 20% each year thereafter until they are 100% vested after six years of service. Plans may have faster vesting schedules.
Who enforces and regulates the provisions of an employee’s pension plans?
The U.S. Department of Labor enforces Title I of the Employee Retirement Income Security Act (ERISA), which, in part, establishes participants’ rights and fiduciaries’ duties. However, certain plans are not covered by the protections of Title I. They are:
Federal, state, or local government plans, including plans of certain international organizations.
Certain church or church association plans.
Plans maintained solely to comply with state workers’ compensation, unemployment compensation or disability insurance laws.
Plans maintained outside the United States primarily for non-resident aliens. Unfunded excess benefit plans – plans maintained solely to provide benefits or contributions in excess of those allowable for tax-qualified plans.
The U.S. Department of Labor’s Employee Benefits Security Administration (EBSA) is the agency charged with enforcing the rules governing the conduct of plan managers, investment of plan assets, reporting and disclosure of plan information, enforcement of the fiduciary provisions of the law, and workers’ benefit rights.
Can employees receive pension money if they are laid off?
Generally, if an employee is enrolled in a 401(k), profit sharing or other type of defined contribution plan (a plan in which they have an individual account), the plan may provide for a lump sum distribution of their retirement money when they leave the company.
However, if the employee participates in a defined benefit plan (a plan in which the employee receives a fixed, pre-established benefit) benefits begin at retirement age. These types of plans are less likely to contain a provision that enables employees to withdraw money early.
Whether the employee participates in a defined contribution or a defined benefit plan, the form of his pension distribution (lump sum, annuity, etc.) and the date his pension money will be available to him depend upon the provisions contained in the company plan documents. Some plans do not permit distribution until participants reach a specified age. Other plans do not permit distribution until they have been separated from employment for a certain period of time. In addition, some plans process distributions throughout the year and others only process them once a year. Employers and employees should contact their pension plan administrator regarding the rules that govern the distribution of pension funds.
One of the most important documents employees should have is the Summary Plan Description (SPD). It outlines what the participant benefits are and how they are calculated. A copy of the SPD should be available from the employer or pension plan administrator.
In addition to the SPD, employers may also provide an individual benefit statement showing the value of the pension benefits that the participant has actually earned to date and their vesting status. These documents contain important information, whether the participant withdraws your money now or later.
When should participants expect to receive distributions from their pension plans after terminating employment?
Generally, the law requires plans to pay retirement benefits no later than the time a participant reaches normal retirement age. But, many plans, including 401(k) plans, provide for earlier payments under certain circumstances. For example, a plan’s rules may provide that participants in a 401(k) plan would receive payment of his or her benefits after terminating employment. The plan’s SPD or Summary Plan Description should set forth the plan’s rules for obtaining the distribution as well as the timing of distribution after termination of employment.
Does the Uniformed Services Employment and Reemployment Rights Act (USERRA) require that an employee receive pension credit while absent to perform military service?
USERRA applies to a wide range of pension plans including defined benefit and defined contribution plans. Upon reemployment following qualifying military service, an employee must be treated for vesting and benefit accrual purposes as if he or she had been continuously employed. If benefits are tied to employee contributions, the employee must be allowed a specified period of time to make up contributions missed during the period of military service.
What is the employer’s Fiduciary Responsibility?
The Employee Retirement Income Security Act (ERISA) protects plan participants by requiring that those persons or entities who exercise discretionary control or authority over plan management or plan assets, or who have discretionary authority or responsibility for the administration of a plan, or who provide investment advice to a plan for compensation (or have any authority or responsibility to do so) are subject to “fiduciary responsibilities.” Plan fiduciaries include, for example, plan trustees, plan administrators, and members of a plan’s investment committee.
The primary responsibility of fiduciaries is to run the plan “solely in the interest of participants and beneficiaries” and for the exclusive purpose of providing benefits and paying plan expenses. Fiduciaries must act prudently and must diversify the plan’s investments in order to minimize the risk of large losses. In addition, they must follow the terms of plan documents to the extent that the plan terms are consistent with ERISA. They also must avoid conflicts of interest. In other words, they may not engage in transactions on behalf of the plan that benefit parties related to the plan, such as other fiduciaries, service providers, or the plan sponsor.
Fiduciaries who do not follow these principles of conduct may be personally liable to restore any losses to the plan, or to restore any profits made through improper use of plan assets. Courts may take whatever action is appropriate against fiduciaries who breach their duties under ERISA, including their removal.
The scope of who may be a plan fiduciary is wide, and the legal standard to which fiduciaries are held is extremely high. Fortunately, ERISA encourages plan sponsors to get help in carrying out their fiduciary duties.
Sponsors are becoming more aware of these obligations, and often request that their advisors assist them by embracing some fiduciary responsibility. Advisors are often brokers however, and brokers who are compensated by a broker dealer, by recommending certain investments over others, put themselves in a position of conflict of interest if they embrace an unacknowledged fiduciary obligation on behalf of a client they are trying to serve, even in good faith.
An employer who enters into such an “unacknowledged fiduciary” relationship with a broker may also be held liable for engaging in a “prohibited transaction” with that broker, thereby risking the qualification status of their company’s retirement plan.
Employers should therefore seek advisors who are not compensated differently depending upon the investment choices of their clients, in order to avoid unwittingly entering into such a “prohibited transaction” scenario.
What protections do the fiduciary rules of ERISA provide?
ERISA protects plans from mismanagement and misuse of assets through its fiduciary provisions. ERISA defines a fiduciary as anyone who exercises discretionary control or authority over plan management or plan assets, anyone with discretionary authority or responsibility for the administration of a plan, or anyone who provides investment advice to a plan for compensation or has any authority or responsibility to do so. Plan fiduciaries include, for example, plan trustees, plan administrators, and members of a plan’s investment committee.
The primary responsibility of fiduciaries is to run the plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. Fiduciaries must act prudently and must diversify the plan’s investments in order to minimize the risk of large losses. In addition, they must follow the terms of plan documents to the extent that the plan terms are consistent with ERISA. They also must avoid conflicts on behalf of the plan that benefit parties related to the plan, such as other fiduciaries, service providers, or the plan sponsor.
Fiduciaries who do not follow these principles of conduct may be personally liable to restore any losses to the plan, or to restore any profits made through improper use of plan assets. Courts may take whatever action is appropriate against fiduciaries who breach their duties under ERISA including their removal.
What information is a pension plan required to disclose?
The Employee Retirement Income Security Act (ERISA) requires plan administrators – the people who run plans – to give participants in writing the most important facts they need to know about the company pension plan. Some of these facts must be provided to regularly and automatically by the plan administrator. Others are available upon request, free of charge or for copying fees. Participant requests should be made in writing.
One of the most important documents participants are entitled to receive automatically when they become participants in an ERISA-covered pension plan or beneficiaries receiving benefits under such a plan, is a summary of the plan, called the summary plan description or SPD.
Plan administrators are legally obligated to provide the SPD to all participants, free of charge. The SPD is an important document that discloses what the plan provides and how it operates. It states when employees began to participate in the plan, how service and benefits are calculated, when benefits become vested, when individuals will receive payment and in what form, and how participants may file claims for benefits.
Participants should read their SPD to learn about the particular provisions that apply to them. If a plan is changed participants must be informed, either through a revised SPD, or in a separate document, called a summary of material modifications, which also must be provided free of charge.
In addition to the SPD, the plan administrator must automatically give to each participant, each year, a copy of the plan’s summary annual report. This is a summary of the annual financial report that most pension plans must file with the Department of Labor. These reports are filed on government forms called Form 5500 or 5500-C/R. The summary annual report is also provided at no cost. To learn more about plan assets, individual participants may ask the plan administrator for a copy of the annual report in its entirety.
If participants are unable to get the SPD, the summary annual report, or the annual report from the plan administrator, they may be able to obtain a copy by writing to:
U.S. Department of Labor
EBSA Public Disclosure
Room N-1513200 Constitution Avenue, NW
Washington, DC 20210
Participants should include their name, address, and telephone number to assist the Employee Benefits and Security Administration in responding to their request. There may be a nominal copying charge.
If you have information that plan assets are being mismanaged or misused, send details to nearest regional or district office of the U.S. Department of Labor.
All of the records concerning one or more individual’s employment with the pension plan sponsor and their participation in the pension plan were destroyed as a result of a natural disaster. What should be done?
The plan records for many participants whose companies were affected by the 9/11 terrorist attacks of 2001, Hurricane Katrina in 2005, and other catastrophes were destroyed.
In the event of such a calamity, participants should search their personal records for any material or documents that would help to establish employment and participation in the plan. They should specifically look for pay statements and W-2 forms showing that they were covered under a plan and the amounts they may have contributed to the plan. They may also have benefit or account statements issued by the plan that they may have kept with other important papers. For example, many 401(k) plans distribute regular account statements. These records may show the names of the investment vehicles in which a 401(k) account was invested.
When participants began employment with the employer sponsoring the plan, they may have been given an employee handbook and beneficiary designation forms to complete. Participants should check to see if they have copies of these, which may also help to establish their rights under the plan.