The Basics of
Pension Plans Regulated by ERISA
Regulation of Defined Benefit PlansWhat are the primary aspects of pension
plan regulation under ERISA?
What is a fiduciary?
What are the basic fiduciary standards for
defined contribution and other retirement plans?
What is a prohibited
Are there exemptions to prohibited
What sanctions are imposed by ERISA on fiduciaries
that do not meet their responsibilities?
How do funding and vesting provisions affect plan
How does ERISA affect corporate governance
What reporting and disclosure requirements are
established by ERISA?
What is the basic nondiscrimination rule?
What is the definition of Highly Compensated
What are the minimum coverage
What are private plan terminations and what is
required of the employer in a termination?
What are plan reversions?
Q: What are the primary aspects of pension plan
regulation under ERISA?
A: The Employee Retirement Income
Security Act of 1974 (ERISA) is the principal legislation governing
private pension funds. The Department of Labor (DOL) and the
IRS enforce ERISA jointly. ERISA consists of four "Titles" as
- Title I Employee rights, including provisions related to
reporting and disclosure, participation, vesting, funding, and
fiduciary liabilities and responsibilities
- Title II - Requirements as a condition of qualification
for tax deferral under the IRC, and tax provisions (as administered
by the IRS), including those related to the deduction of
contributions and taxation of benefits
- Title III - Provisions related to administration and
- Title IV - Provisions related only to defined benefit
Q: What is a
A: A fiduciary is a person or a member of
a Board given possession of property (in this case, plan assets)
"in trust", i.e., with the legal obligation to administer it solely
for the purpose specified. Typically the employer's Board of
Directors designates one or more committees to act as fiduciary
charged with administration of the plans and oversight of the
management of plan assets.
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Q: What are the
basic fiduciary standards for defined contribution and other
A: The cornerstone of ERISA's fiduciary
standards is found in Section 404, which explicitly sets forth
ERISA's requirements for prudence in asset management.
Specifically, Section 404(a)(1) directs a fiduciary to "discharge
his duties with respect to the plan solely in the interest of the
participants and beneficiaries and for the exclusive purpose of
providing benefits to participants and their beneficiaries, and
defraying reasonable expenses of administering the plan."
ERISA further requires that a fiduciary act "with the care,
skill, prudence and diligence under the circumstances then
prevailing that a prudent man acting in a like capacity and
familiar with such matters would use in the conduct of an
enterprise of like character and with like aims."
The "prudent man" standard has been interpreted and applied as a
"prudent expert" standard. It is more stringent than
standards contained in most other corporate and securities laws,
which generally require only that there be no negligence or gross
Q: What is a prohibited
A: A prohibited transaction is an
economic transaction directly, or indirectly, involving plan assets
and parties related to the plan. Such a
"party-in-interest" includes fiduciaries, counsel, or employees of
the plan, persons providing services to the plan, an employer whose
employees are covered by the plan, a relative of any of the
preceding, or various other people and entities with ties to the
employer or plan (ERISA Section 3(14)).
Prohibited transactions include the sale, exchange, or lease of
property, a loan or other extension of credit, the furnishing of
goods, services, or facilities, and the transfer or use of plan
assets involving a party-in-interest. Prohibited transactions
also include the acquisition of employer securities or employer
real estate in excess of the limits set by law.
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Q: Are there
exemptions to prohibited transactions?
A: ERISA provides three kinds of
exemptions from prohibited transaction rules.
Statutory exemptions cover certain routine
transactions, such as payment of benefits to a participant who is
also a fiduciary. Class exemptions have been
granted for certain transactions that are not specifically defined
in ERISA, but are considered acceptable by the DOL, and
individual exemptions are granted on a
case-by-case basis. These exemptions require that the
individual or party-in-interest demonstrate that the transaction is
in the best interest of the plan participants.
Q: What sanctions are
imposed by ERISA on fiduciaries that do not meet their
A: Civil liabilities and/or criminal
charges can be imposed on a fiduciary that breaches any of the
responsibilities, duties, or obligations imposed under Title I of
ERISA. The fiduciary is liable for any loss to the plan
resulting from each breach. A fiduciary is also liable to the
plan for any profits that the fiduciary or other party-in-interest
made through the use of plan assets. Tax sanctions, in the
form of special excise taxes, can be imposed on "disqualified
persons" (essentially the same as parties-in-interest) who
participate in prohibited transactions. A fiduciary must be
aware that if a plan is "disqualified" all earnings of the plan
would immediately be subject to taxation.
Q: How do funding
and vesting provisions affect plan administration?
A: To be qualified under ERISA, a
retirement plan must be funded. This means that contributions
by both employer and employees must be placed in a separate fund
held by a third party. The third party is usually a trustee
or insurance company.
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Q: How does ERISA
affect corporate governance issues?
A: Private pension funds purchase equity
securities for investment rather than to gain control of the
companies whose securities they buy. With ownership, however,
comes the responsibility to exercise ownership rights, including
the voting of proxies. In accordance with ERISA, these voting
decisions, like investment decisions, must be made solely in the
interest of plan participants.
In those situations where a change in control of the corporation
is at issue, the voting decision must be free of bias toward either
the existing management or the prospective acquirer, and must
reflect an objective assessment regarding where the greatest value
to plan participants lies.
ERISA regulations, as interpreted by the Department of Labor,
require that proxy decisions be made by the plan sponsor unless
such authority has been fully delegated to the investment
manager. If the plan sponsor delegates the right to make
voting decisions to an investment manager, the sponsor cannot
interfere with the manager's decisions but retains the
responsibility to monitor those decisions. In any case, the
proxies must be voted solely in the interest of plan
Q: What reporting
and disclosure requirements are established by ERISA?
A: ERISA reporting and disclosure
requirements apply to all private pension plans. These
requirements are detailed and complex, and necessitate filings with
several Federal agencies.
These filings include:
- Internal Revenue Services:
Annual Report (Form 5500) providing a description of the plan, plan
financial statements, insurance and actuarial information, and a
summary of plan assets;
- Department of Labor: Summary
Plan Description, including the ERISA statement of rights,
summarizing the provisions of the plan in language understandable
by the average plan participant; and
- Pension Benefit Guaranty Corporation:
Quarterly and annual reports setting forth the computation of
In addition, ERISA requires that plan participants be provided
copies of the Summary Plan Description and an annual summary of the
plan financial statements. Copies of supporting plan
documents, as well as filings with Federal agencies, are also to be
provided to plan participants on request.
The Retirement Protection Act of 1994 attached to GATT
legislation mandates timely notification to participants in the
event that a defined benefit plan becomes materially
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Q: What is the basic
A: A retirement plan is qualified under
ERISA only if it does not discriminate in favor of Highly
Compensated Employees (HCEs). The plan must comply in both
form and operation to this rule. To satisfy this basic
nondiscrimination rule, there are three requirements:
1) The contributions or benefits of the plan must be
nondiscriminatory in amount,
2) The benefits, rights, and features provided under the plan
must be available in
a nondiscriminatory manner, and
3) The effect of plan amendments and terminations must be
Q: What is
the definition of Highly Compensated Employees (HCEs)?
A: An HCE is an employee who was a 5%
owner of the sponsoring company at any time during the current or
preceding year or who had compensation during the prior year in
excess of $80,000. The compensation limit is adjusted for
inflation in $5,000 increments. Alternatively, the sponsor
can elect to include those employees exceeding the compensation
limit only if they are in the "top paid group", generally defined
as the top 20% of employees ranked on the basis of
Q: What are the
minimum coverage requirements?
A: In order to receive favorable tax
treatment, a retirement plan must satisfy one of two coverage tests
- either the ratio percentage test or the average benefit
test. Under the ratio percentage test, the percentage of
NHCEs who benefit under the plan must equal 70% of the percentage
of HCEs who benefit under the plan. Under the average
benefits test, the plan must cover a nondiscriminatory group of
NHCEs and the benefits (expressed as a percentage of compensation)
provided to NHCEs must be at least 70% as great as provided to
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Q: What are
private plan terminations and what is required of the employer in a
A: ERISA provides for two types of plan
termination under the regulatory oversight of the PBGC:
- Distress TerminationThe PBGC takes over the plan and pays all guaranteed
benefits up to a maximum determined by the PBGC. The plan
sponsor and any controlled group of companies are liable to the
PBGC for any unfunded benefits. Only financially troubled
employers, as determined by the PBGC, can qualify for distress
termination. Prioritization of benefits payable in a distress
termination is set forth in detail by ERISA, with benefits
attributable to employee contributions heading the list followed by
other PBGC guaranteed benefits.
- Standard TerminationBenefits are funded through the purchase of annuities or
through lump sum payments to participants. In standard
terminations, the plan administrator must give 60 days notice to
plan participants and the PBGC and must receive approval of the
PBGC before proceeding.
Q: What are
A: Plan reversions generally refer to the
disposition of assets following standard termination by an employer
of a defined benefit plan. In many cases, reversion is not
attractive to the employer since any remaining surplus following
termination without a successor plan is reduced by a confiscatory
combination of ordinary federal income tax, excise tax and
termination benefits enhancements totaling 80% or more of the
residual surplus before the sponsor can recapture the
remainder. Plan assets in excess of the insurance premium and
other costs of termination, including the aforesaid income and
excise taxes, may in certain circumstances "revert" to the
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