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The Resource for the Global Finance Profession

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 transaction?
Are there exemptions to prohibited transactions?
What sanctions are imposed by ERISA on fiduciaries that do not meet their responsibilities?
How do funding and vesting provisions affect plan administration?
How does ERISA affect corporate governance issues?
What reporting and disclosure requirements are established by ERISA?
What is the basic nondiscrimination rule?
What is the definition of Highly Compensated Employees (HCEs)?
What are the minimum coverage requirements?
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 summarized below:

  • 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 enforcement
  • Title IV -  Provisions related only to defined benefit retirement plans

Q:  What is a fiduciary? 

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 retirement plans? 

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 negligence.

Q: What is a prohibited transaction? 

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 responsibilities? 

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 participants.

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 premiums due.

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 underfunded.

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Q:  What is the basic nondiscrimination rule? 

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 nondiscriminatory.

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 compensation.

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 HCEs.

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Q:  What are private plan terminations and what is required of the employer in a termination? 

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 plan reversions? 

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 employer.


bulletTable of Contents 

bulletPensions Liabilities and Funding 


bulletRegulation of Defined Benefit Plans 

bulletThe Basics of Defined Benefit

bulletInvestment of Defined Benefit Plan Assets 

bulletTypes of Pension Plans 







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