Types of retirement plans

Retirement plans are classified as either defined benefit plans or defined contribution plans, depending on how benefits are determined.

In a defined benefit (or pension) plan, benefits are calculated using a fixed formula that typically factors in final pay and service with an employer, and payments are made from a trust fund specifically dedicated to the plan. Separate accounts for each participant do not exist.

By contrast, in a defined contribution plan, each participant has an account, and the benefit for the participant is dependent upon both the amount of money contributed into the account and the performance of the investments purchased with the funds contributed to the account.

Some types of retirement plans, such as cash balance plans, combine features of both defined benefit and defined contribution schemes.

Defined contribution plansedit

According to Internal Revenue Code Section 414, a defined contribution plan is an employer-sponsored plan with an individual account for each participant. The accrued benefit from such a plan is solely attributable to contributions made into an individual account and investment gains on those funds, less any losses and expense charges. The contributions are invested (e.g., in the stock market), and the returns on the investment are credited to or deducted from the individual's account. Upon retirement, the participant's account is used to provide retirement benefits, often through the purchase of an annuity. Defined contribution plans have become more widespread over recent years and are now the dominant form of plan in the private sector. The number of defined benefit plans in the U.S. has been steadily declining, as more employers see pension funding as a financial risk they can avoid by freezing the plan and instead offering a defined contribution plan.

Examples of defined contribution plans include individual retirement account (IRA), 401(k), and profit sharing plans. In such plans, the participant is responsible for selecting the types of investments toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual funds to selecting individual stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages. The funds in such plans may not be withdrawn without penalty until the investor reaches retirement age, which is typically the year in which taxpayer reaches 59.5 years of age.

Money contributed can be from employee salary deferrals, employer contributions, or employer matching contributions. Defined contribution plans are subject to Internal Revenue Code Section 415 limits on how much can be contributed. As of 2015, the total deferral amount including the employee and employer contribution is capped at $53,000. The employee-only amount is $18,000 for 2015, but a plan can permit participants who are age 50 or older to make "catch-up" contributions of up to an additional $6,000.

Defined benefit plansedit

Commonly referred to as a pension in the US, a defined benefit plan pays benefits from a trust fund using a specific formula set forth by the plan sponsor. In other words, the plan defines a benefit that will be paid upon retirement. The statutory definition of defined benefit encompasses all pension plans that are not defined contribution and therefore do not have individual accounts.

While this catch-all definition has been interpreted by the courts to capture some hybrid pension plans like cash balance (CB) plans and pension equity plans (PEP), most pension plans offered by large businesses or government agencies are final average pay (FAP) plans, under which the monthly benefit is equal to the number of years worked multiplied by the member's salary at retirement multiplied by a factor known as the accrual rate. At a minimum, benefits are payable in normal form as a Single Life Annuity (SLA) for single participants or as a Qualified Joint and Survivor Annuity (QJSA) for married participants. Both normal forms are paid at Normal Retirement Age (usually 65) and may be actuarially adjusted for early or late commencement. Other optional forms of payment, such as lump sum distributions, may be available but are not required.

The cash balance plan typically offers a lump sum at and often before normal retirement age. However, as is the case with all defined benefit plans, a cash balance plan must also provide the option of receiving the benefit as a life annuity. The amount of the annuity benefit must be definitely determinable as per IRS regulation 1.412-1.

Defined benefit plans may be either funded or unfunded. In a funded plan, contributions from the employer and participants are invested into a trust fund dedicated solely to paying benefits to retirees under a given plan. The future returns on the investments and the future benefits to be paid are not known in advance, so there is no guarantee that a given level of contributions will meet future obligations. Therefore, fund assets and liabilities are regularly reviewed by an actuary in a process known as valuation. A defined benefit plan is required to maintain adequate funding if it is to remain qualified.

In an unfunded plan, no funds are set aside for the specific purpose of paying benefits. The benefits to be paid are met immediately by contributions to the plan or by general assets. Most government-run retirement plans, including Social Security, are unfunded, with benefits being paid directly out of current taxes and Social Security contributions. Most nonqualified plans are also unfunded.

Hybrid and cash balance plansedit

Hybrid plan designs combine the features of defined benefit and defined contribution plan designs. In general, they are treated as defined benefit plans for tax, accounting, and regulatory purposes. As with defined benefit plans, investment risk is largely borne by the plan sponsor. As with defined contribution designs, plan benefits are expressed in the terms of a notional account balance, and are usually paid as cash balances upon termination of employment. These features make them more portable than traditional defined benefit plans and perhaps more attractive to a highly mobile workforce. A typical hybrid design is the cash balance plan, where the employee's notional account balance grows by some defined rate of interest and annual employer contribution.

In the United States, conversions from traditional plan to hybrid plan designs have been controversial. Upon conversion, plan sponsors are required to retrospectively calculate employee account balances, and if the employee's actual vested benefit under the old design is more than the account balance, the employee enters a period of wear away. During this period, the employee would be eligible to receive the already accrued benefit under the old formula, but all future benefits are accrued under the new plan design. Eventually, the accrued benefit under the new design exceeds the grandfathered amount under the old design. To the participant, however, it appears as if there is a period where no new benefits are accrued. Hybrid designs also typically eliminate the more generous early retirement provisions of traditional pensions.

Because younger workers have more years in which to accrue interest and pay credits than those approaching retirement age, critics of cash balance plans have called the new designs discriminatory. On the other hand, the new designs may better meet the needs of a modern workforce and actually encourage older workers to remain at work, since benefit accruals continue at a constant pace as long as an employee remains on the job. As of 2008, the courts have generally rejected the notion that cash balance plans discriminate based on age,citation needed while the Pension Protection Act of 2006 offers relief for most hybrid plans on a prospective basis.

Although a cash balance plan is technically a defined benefit plan designed to allow workers to evaluate the economic worth their pension benefit in the manner of a defined contribution plan (i.e., as an account balance), the target benefit plan is a defined contribution plan designed to express its projected impact in terms of lifetime income as a percent of final salary at retirement (i.e., as an annuity amount). For example, a target benefit plan may mimic a typical defined benefit plan offering 1.5% of salary per year of service times the final 3-year average salary. Actuarial assumptions like 5% interest, 3% salary increases and the UP84 Life Table for mortality are used to calculate a level contribution rate that would create the needed lump sum at retirement age. The problem with such plans is that the flat rate could be low for young entrants and high for old entrants. While this may appear unfair, the skewing of benefits to the old worker is a feature of most traditional defined benefit plans, and any attempt to match it would reveal this backloading feature.

Requirement of permanenceedit

To guard against tax abuse in the United States, the Internal Revenue Service (IRS) has promulgated rules that require that pension plans be permanent as opposed to a temporary arrangement used to capture tax benefits. Regulation 1.401-1(b)(2) states that "thus, although the employer may reserve the right to change or terminate the plan, and to discontinue contributions thereunder, the abandonment of the plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan from its inception was not a bona fide program for the exclusive benefit of employees in general. Especially will this be true if, for example, a pension plan is abandoned soon after pensions have been fully funded for persons in favor of whom discrimination is prohibited..." The IRS would have grounds to disqualify the plan retroactively, even if the plan sponsor initially got a favorable determination letter.

Qualified retirement plansedit

Qualified plans receive favorable tax treatment and are regulated by ERISA. The technical definition of qualified does not agree with the commonly used distinction. For example, 403(b) plans are not considered qualified plans, but are treated and taxed almost identically.

The term qualified has special meaning regarding defined benefit plans. The IRS defines strict requirements a plan must meet in order to receive favorable tax treatment, including:

• A plan must offer life annuities in the form of a Single Life Annuity (SLA) and a Qualified Joint & Survivor Annuity (QJSA).
• A plan must maintain sufficient funding levels.
• A plan must be administered according to the plan document.
• Benefits are required to commence at retirement age (usually age 65 if no longer working, or age 70 1/2 if still employed).
• Once earned, benefits may not be forfeited.
• A plan may not discriminate in favor of highly compensated employees.
• A plan must be insured by the PBGC.

Failure to meet IRS requirements can lead to plan disqualification, which carries with it enormous tax consequences.

SIMPLE IRAsedit

A SIMPLE IRA is a type of Individual Retirement Account (IRA) that is provided by an employer. It is similar to a 401(k) but offers simpler and less costly administration rules. Like a 401(k) plan, the SIMPLE IRA is funded by a pre-tax salary reduction. However, contribution limits for SIMPLE plans are lower than for most other types of employer-provided retirement plans.

SEP IRAsedit

A Simplified Employee Pension Individual Retirement Account, or SEP IRA, is a variation of the Individual Retirement Account. SEP IRAs are adopted by business owners to provide retirement benefits for the business owners and their employees. There are no significant administration costs for self-employed person with no employees. If the self-employed person does have employees, all employees must receive the same benefits under a SEP plan. Because SEP accounts are treated as IRAs, funds can be invested the same way as is the case for any other IRA.

Keogh or HR10 plansedit

Keogh plans are full-fledged pension plans for the self-employed. Named for U.S. Representative Eugene James Keogh of New York, they are sometimes called HR10 plans.

Nonqualified plansedit

Plans that do not meet the guidelines required to receive favorable tax treatment are considered nonqualified and are exempt from the restrictions placed on qualified plans. They are typically used to provide additional benefits to key or highly paid employees, such as executives and officers. Examples include SERP (Supplemental Executive Retirement Plans) and 457(f) plans.