Regulation of Defined Contribution PlansWhat are the primary
aspects of defined contribution plan regulation under
Does other legislation and regulation affect
defined contribution plans?
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
What sanctions are imposed by ERISA on
fiduciaries that do not meet their responsibilities?
How do funding and vesting provisions affect plan
What is the basic nondiscrimination
What is the definition of Highly
Compensated Employees (HCEs)?
How does the definition of HCEs relate to
defined contribution plans?
Are there additional nondiscrimination tests for
What are the minimum coverage
How are contributions regulated?
What are the minimum distribution
How are distributions taxed and when do they
What are the additional limitations on
distributions from 401(k) plans?
What are some of the distribution requirements
in an ESOP?
What are the requirements of an ERISA Section
What investment education materials are allowed
to be distributed by employers?
Are the requirements for maintaining a
qualified defined contribution plan static?
Q: What are the
primary aspects of defined contribution plan regulation under
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
- Title II - Requirements as to conditions of qualification
for tax deferral under
the IRC, and tax provisions (as administered by the IRS),
those related to the deduction of contributions and taxation
- Title III - Provisions related to administration and
- Title IV - Provisions related only to defined benefit
Q: Does other
legislation and regulation affect defined contribution
A: There is an increasing amount
of legislation affecting defined contribution plans, such as the
Small Business Job Protection Act of 1996, the Taxpayer Relief Act
of 1997 and more recently, the Economic Growth and Tax Relief
Reconciliation Act of 2001. In addition, there are numerous
Treasury and DOL regulations, as well as revenue rulings and
procedures. The SEC may also require the filing of Form 11-K
for plans containing employer securities.
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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.
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 an absence of various
forms of negligence.
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Q: What is a
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, legal 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.
Q: Are there
exemptions to prohibited transactions?
A: ERISA provides three kinds of
exemptions from prohibited transactions 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. 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.
sanctions are imposed by ERISA on fiduciaries that do not meet
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 those 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.
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Q: How do
funding and vesting provisions affect plan
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
generally a bank trustee or insurance company.
Vesting represents the nonforfeitable amount in participants'
account balances. Participants are always 100% vested in
their own contributions and earnings on those contributions.
Under the 2001 tax bill, a plan is not a qualified plan unless a
participant's employer contributions, and their earnings, vest at
least as fast as under either a three-year cliff vesting or a
six-year graded vesting schedule, effective for contributions for
plan years beginning after 2001. The three-year cliff vesting
schedule means that the entire amount attributed to employer
contributions is forfeited if the participant leaves the employer
prior to his or her third service anniversary, but nothing is
forfeited if the participant is credited with three or more years
of service. The graded vesting schedule requires 20% vesting
after two years of service, increasing 20% per year
thereafter. It should be noted that vesting rules for
top-heavy (i.e., plans in which at least 60% of the
contributions/benefits are held for "key employees") and
multi-employer plans are different.
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
Q: What is
the definition of Highly Compensated Employees
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
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Q: How does
the definition of HCEs relate to defined contribution
A: The definition of HCEs is
relevant to a plan's general nondiscrimination requirements, the
actual deferral percentage (401(k) plans), the actual contributions
percentage test, and minimum coverage requirements, as well as
other more specific situations.
Q: Are there
additional nondiscrimination tests for 401(k)
A: A 401(k) plan that provides
for matching and/or after-tax contributions must also satisfy an
Actual Contribution Percentage (ACP) test. In the ACP test,
the average of the actual contributions ratio (sum of employee and
employer matching contributions divided by employee compensation)
of the HCEs may not be more than a specified percentage of the
average of the actual contribution ratio of the non-highly
compensated employees (NHCEs). The plan must also satisfy the
Actual Deferral Percentage (ADP) test. In the ADP test the
average employee contribution ratio (sum of employee contributions
divided by employee compensation) of HCEs may not be more than a
specified percentage of the ADP of the NHCEs. The "Multiple
Use" test, which potentially limited combined 401(k), after-tax and
employer matching contributions on behalf of HCEs, was repealed for
years starting in 2002 under the tax legislation passed in
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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are contributions regulated?
A: Under the Economic Growth and
Tax Relief Reconciliation Act of 2001 limits on elective deferrals
by 401(k) plan participants, set a maximum of $10,500 in 2001, will
gradually increase to $15,000 in 2006 with indexing in $500
increments thereafter. For 2001 total annual contributions to
defined contribution plans are limited to the lesser of $35,000 or
25% of the employee's compensation, but for subsequent years the
total contribution limit is $40,000, and the 25% of employee
compensation cap is eliminated. The annual compensation that
may be taken into account in determining contributions or benefits
under a qualified plan is limited in 2001 to $170,000, and is
raised to $200,000 for subsequent years, with future indexing in
Finally, beginning in 2002 401(k) plan participants age 50 and
over may make additional pre-tax "catch-up" contributions (over and
above the otherwise applicable limit) running from $1,000 in 2002
to $5,000 in 2006, with indexing in $500 increments thereafter
2006. Catch-up contributions would not be taken into account
in applying other contribution limits.
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are the minimum distribution requirements?
A: Minimum distribution requirements
are the rules governing when distributions from a qualified plan
must commence and which define the maximum time period over which
benefits can be paid. Distributions generally must begin by
April 1 of the year following the year in which the participant
reaches age 70 1/2. Subsequent annual distributions must be
made by December 31 of each year. The balance must be
1) The life of the participant,
2) The lives of the participant and his designated
3) A period not extending beyond the participant's life
4) A period not extending beyond the joint life expectancy of
the participant and his designated beneficiary.
After 1996, the rules were changed for non-5-percent owners (see
above under the definition of HCEs). The required beginning
date for non-5-percent owners is now the later of the year
following the year in which the participant reaches age 70 1/2 or
the year in which he retires. It should be noted that if a
participant does not receive a distribution in the later of the
calendar year in which he retires or reaches age 70 1/2, he would
be required to receive two distributions the following year - by
April 1 and again by December 31. Minimum distributions are
not eligible for rollover.
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Q: How are distributions taxed and when do they
distributions are taxed as ordinary income. In some instances
balances are not taxed as ordinary income when they are paid out,
such as when assets are rolled over into another qualified plan or
IRA. It should be noted that loans in good standing are
generally not considered distributions.
In addition to being taxed, 401(k) distributions prior to age 59
1/2 are also assessed significant penalties. Other
distribution limits are listed below. Although in-service
distributions may be allowed, there are numerous restrictions
depending on the type of defined contribution plan.
What are the additional limitations on distributions from 401(k)
A: In addition to the age 59 1/2
provision, a distribution to a participant can't be made earlier
1) The participant's retirement, death, disability, or
separation of service,
2) The occurrence of participant hardship, subject to plan
3) The termination of the plan without the establishment of a
Also, if the employer, or substantially all the assets of the
employer, are acquired by a third party, then an employee who
continues working for the acquirer may not take a distribution of
plan assets at that time (the "same desk" rule).
are some of the distribution requirements in an
A: Distributions under an ESOP
must begin no later than one year after the end of the plan year in
which the individual terminates employment by reason of death,
disability or of the reaching of retirement age, unless the
participant elects otherwise. If the participant otherwise
terminates employment, distributions must begin the fifth plan year
following the plan year after termination, again, unless the
participant elects otherwise. Generally, distributions must
be made in substantially equal installments over a period not
longer than five years. If a participant's balance exceeds
$500,000, the time period can be extended one year for each
$100,000 in excess of $500,000. However, the distribution
period cannot exceed 10 years.
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are the requirements of an ERISA Section 404(c)
A: The DOL issued final
regulations (ERISA Reg. 2550.404c-1) which set forth the
requirements for maintaining a 404(c) plan. An ERISA Section
404(c) plan must include at least three investment options that are
materially different from one another in terms of risk and return
characteristics. The plan must provide enough information to
allow participants to make informed investment decisions, enable
diversification of investments, and allow the participants to
change investments at least quarterly; more frequent changes are
mandated in cases where the market volatility to which the
investment alternative may reasonably be expected to be subject to
is relatively high. A participant will not be considered to
have enough information unless provided with a description of the
investment options, including their investment objectives and risk
and return characteristics. A participant also needs to be
informed that the plan is intended to constitute an ERISA Section
Participants must be provided, directly or upon request, the
1) The annual operating expenses of each investment options and
aggregate amount of expenses expressed as a
percentage of net assets;
2) Copies of any financial statements, prospectuses, and reports
3) A list of the assets in the portfolio in each investment
4) Information on the value of shares as well as past and
performance net of expenses.
Finally, participants must also be informed that the plan
fiduciaries are not liable for investment losses that are incurred
as a result of investment instructions given by a participant, as
long as the DOL requirements are satisfied.
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investment education materials are allowed to be distributed by
A: According to the Pension and
Welfare Benefits Administration Interpretive Bulletin 96-1,
employers may distribute the following information to participants
without such employers being considered investment advisors:
1) Plan information;
2) General financial and investment information;
3) Asset allocation models, and;
4) Interactive investment materials.
Under the provisions of the 2001 tax act, after 2001 an employer
may provide retirement planning services to participants on a
non-taxable basis, as long as such services are available on
substantially the same terms to a reasonable classification of
the requirements for maintaining a qualified defined contribution
A: New legislation and
regulations have had an increasing impact on defined contributions
plans in recent years, reflecting the growing importance of these
investment/savings vehicles to the U.S. private retirement
system. Therefore, it is very important for a sponsoring
employer to monitor changing requirements for qualified plans
closely, and to make amendments to plan design, administration and
operation as appropriate.
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