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Defined Contribution Plans

Regulation of Defined Contribution PlansWhat are the primary aspects of defined contribution plan regulation under ERISA?
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 transactions?
What sanctions are imposed by ERISA on fiduciaries that do not meet their responsibilities?
How do funding and vesting provisions affect plan administration?
What is the basic nondiscrimination rule?
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 401(k) plans?
What are the minimum coverage requirements?
How are contributions regulated?
What are the minimum distribution requirements?
How are distributions taxed and when do they occur?
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 404(c) plan?
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 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 to conditions 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:  Does other legislation and regulation affect defined contribution plans? 

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 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.

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 an absence of various forms of negligence.

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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, 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.

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 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 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 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 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.

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Q:  How does the definition of HCEs relate to defined contribution plans? 

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) plans? 

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 2001.

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:  How 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 $5,000 increments. 

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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Q:  What 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 distributed over:

1) The life of the participant,

2) The lives of the participant and his designated beneficiary,

3) A period not extending beyond the participant's life expectancy, or

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 occur? 

A:  Generally 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. 

Q:  What are the additional limitations on distributions from 401(k) plans? 

A:  In addition to the age 59 1/2 provision, a distribution to a participant can't be made earlier than:

1) The participant's retirement, death, disability, or separation of service,

2) The occurrence of participant hardship, subject to plan design,

3) The termination of the plan without the establishment of a successor plan.

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). 

Q:  What are some of the distribution requirements in an ESOP? 

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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Q:  What are the requirements of an ERISA Section 404(c) plan? 

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 404(c) plan.

Participants must be provided, directly or upon request, the following information:

1) The annual operating expenses of each investment options and the
    aggregate amount of expenses expressed as a percentage of net assets;

2) Copies of any financial statements, prospectuses, and reports available to
    the plan;

3) A list of the assets in the portfolio in each investment option, and;

4) Information on the value of shares as well as past and current investment
    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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Q:  What investment education materials are allowed to be distributed by employers? 

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 employees. 

Q:  Are the requirements for maintaining a qualified defined contribution plan static? 

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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bulletTable of Contents 

bulletIntroduction 

bulletThe Basics of Defined Contribution
   
Plans 

bulletSaving for Retirement with Defined
   
Contribution Plans 

bulletManaging and Administering Defined
   
Contribution Plans 

bulletRegulation of Defined Contribution
    Plans
 

 

 

 

 

 

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