Section 10.2: Employer-Sponsored Retirement Plans (Qualified Plans)

  • 🏛️ Overview

    • Employer-sponsored retirement plans fall under the Employee Retirement Income Security Act (ERISA).

    • These are called Qualified Plans.

    • Qualified = employer-sponsored + tax advantages + specific federal oversight and contribution rules.

🧮 Types of Qualified Plans

1. Defined Benefit Plans (Traditional Pension Plans):

  • Definition: The plan specifies the benefit amount an employee will receive at retirement.

  • Benefit is based on:

    • Years of service

    • Age at retirement

    • Final average salary (commonly last 3–5 years)

  • Goal: Replace a portion of pre-retirement income.

  1. Example:
    A pension pays 2% per year of service, based on the average of the last 5 years’ salary, up to 70%.

    • Employee worked 40 years → 40 × 2% = 80%, but max is 70%.

    • If final average salary = $60,000 → $60,000 × 70% = $42,000/year for life.

  2. Key Points:

    • Employer contributes enough to meet the promised future benefit.

    • Employer bears the investment risk (must ensure funds are there to pay retirees).

    • Once retirement benefits begin, the amount is fixed (no changes).

    • Government pensions sometimes include a cost-of-living adjustment (COLA).

    • Actuaries are hired to calculate required employer contributions.

    • These plans are declining in popularity due to employer cost and risk.

2. Defined Contribution Plans:

  • Definition: The plan specifies how much money is contributed to the plan, not how much will be received at retirement.

  • Contributions may be made by:

    • Employer

    • Employee (through payroll deduction)

    • Or both

  • Investment decisions (and risk) belong to the employee.

  • The retirement benefit depends on investment performance.

  • When an employee retires or leaves the company, they can roll assets into an IRA.

  1. Examples of Defined Contribution Plans:

    • 401(k) Plans (Salary Reduction Plans)

      • Employee contributions made via payroll deduction.

      • Employers often match a portion of contributions.

    • 403(b) Plans

      • For employees of schools, hospitals, churches, and charitable organizations.

    • Profit-Sharing Plans

      • Employer contributions vary depending on company profits.

    • Money Purchase Plans

      • Employer makes fixed contributions each year.

    • SIMPLE Plans

      • For small businesses with fewer than 100 employees.

  2. Key Points:

    • Much more common today than Defined Benefit Plans.

    • Investment risk: on the employee, not the employer.

    • Employer liability: smaller and more predictable.

    • Portability: Employees can move plan assets between employers—ideal for a mobile workforce.

IRAs

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IRAs 〰️

⚖️ Defined Benefit vs. Defined Contribution — Summary:

Feature / Benefit Plan / Contribution Plan

  • Benefit Formula / Pre-determined (based on salary & service) / Based on account balance & investment performance

  • Who contributes? / Employer / Employer, Employee, or both

  • Who bears risk? / Employer / Employee

  • Payout / Fixed lifetime benefit / Depends on investment value

  • Popularity today / Declining / Increasing

  • Portability / Not portable / Portable (can be rolled into IRA)

✺ Review questions ✺

  • The Employee Retirement Income Security Act (ERISA).

  • Qualified Plans.

  • The amount of retirement income the employee will receive.

  • The employer.

  • Because the plan capped benefits at 70% of the final average salary.

  • A Defined Contribution Plan.

  • The employee

  • 401(k), 403(b), and Profit-Sharing Plans.

  • Defined Contribution Plans — because they shift investment risk to the employee and are portable.

  • Schools, hospitals, churches, and charitable organizations.