Occupational pension schemesTypes
What are the main types of private pensions and retirement plans that are provided to a broad base of employees?
Broad-based qualified plans are either defined benefit plans, including traditional arrangements and cash balance plans, or defined contribution plans, including profit-sharing, stock bonus and money-purchase pension plans. Other forms of broad-based, employer-sponsored, tax-favoured retirement arrangements include 403(b) plans and 457(b) and 457(f) arrangements for non-profit employers and, for smaller employers, simplified employee pensions (SEPs) and savings incentive match plan for employees (SIMPLE) 401(k) plans or individual retirement accounts or annuities (IRAs). Individuals may also maintain their own IRAs, but it is uncommon for an employer to have any involvement with an IRA that is not part of a SEP or SIMPLE IRA.Restrictions
Are employers required to arrange or contribute to supplementary pension schemes for employees? What restrictions or prohibitions limit an employer’s ability to exclude certain employees from participation in broad-based retirement plans?
Employers are not required to adopt a private pension or retirement arrangement, although doing so is a useful recruiting tool and in some industries is expected. Qualified plans are subject to a myriad of eligibility, vesting, non-discrimination and other requirements that are generally designed to ensure that they are broad-based and do not disproportionately favour highly paid workers. Applicable law can treat related entities with sufficient common ownership to create a parent-subsidiary, brother-sister or affiliated service group (a controlled group) as a single employer to ensure that these requirements are not avoided.
Employers have substantially more flexibility with respect to non-qualified plans, but these may only be offered to a select group of management or highly compensated employees (generally representing no more than 10 per cent to 15 per cent of the workforce) and lack some of the tax benefits available with qualified plans.
Can plans require employees to work for a specified period to participate in the plan or become vested in benefits they have accrued?
Once employees have reached the age of 21 and have completed one year of service, they must generally be offered the opportunity to participate in a qualified plan within six months. If a qualified plan provides that an employee is 100 per cent vested upon entry, a two-year-of-service requirement can replace the one-year-of-service requirement.
Qualified plans that offer a tax-favoured employee deferral feature (known as a 401(k) deferral) must, beginning in 2024 for calendar year plans, offer employees who have attained age 21 and completed at least 500 hours of service in three consecutive years the opportunity to make employee deferrals.
The rate at which an employee must fully vest in a qualified plan has been accelerating over the last several decades. Currently, the minimum vesting requirements are:
Years of service
|Less than 1||0%||0%||0%||0%|
|7 or more||100%||100%||100%||100%|
Unvested benefits must immediately vest with respect to affected employees if the plan undergoes a ‘partial termination’, which can result from certain employer actions (such as a layoff) and certain types of amendments, or in the event of a complete discontinuance of contributions or a plan termination.Overseas employees
What are the considerations regarding employees working permanently and temporarily overseas? Are they eligible to join or remain in a plan regulated in your jurisdiction?
It is possible for US taxpayers to continue to participate in a qualified plan while working abroad if the plan document so permits and if various non-discrimination and operational requirements are satisfied. For example, a qualified plan’s definition of compensation will need to explicitly include certain foreign income. If the US taxpayer is employed by a foreign affiliate, a US tax deduction may not be available for contributions made by the foreign affiliate. If the benefits are taxed locally (immediately or later), any advantages may be undermined.Funding
Do employers and employees share in the financing of the benefits and are the benefits funded in a trust or other secure vehicle?
Defined benefit qualified plans are typically funded solely by the employer. Defined contribution qualified plans often have a tax-favoured employee deferral feature. Employee deferrals can be made on a pre-tax (traditional) or after-tax (Roth) basis, with different income tax rules applying to each type at distribution. Qualified plan assets are required to be held in trust, the assets of the trust are protected from the employer’s creditors and grow on a tax-deferred basis.
Non-qualified plans are funded by employers, although they may also permit an employee to defer the receipt of otherwise taxable compensation. Assets need not be held in trust, but if a trust is used, the assets must remain available to the employer’s creditors and any earnings are taxable to the employer. As a result, participants are considered general, unsecured creditors of the employer. If assets are held in a trust that protects the assets from an employer’s creditors, the benefit of deferred tax for the employee is lost.
What rules apply to the level at which benefits are funded and what is the process for an employer to determine how much to fund a defined benefit pension plan annually?
The maximum permitted participant benefit under a defined benefit qualified plan is an annual life annuity, beginning at normal retirement age, of 100 per cent of average compensation for the highest three years of service or, if less, US$245,000 (for 2022; indexed for inflation). The employer bears the actuarial risk of ensuring that assets sufficient to pay benefits are contributed to the plan’s related trust, and it typically funds within a minimum and maximum deductible contribution corridor, as determined with the assistance of an actuary and in compliance with tax rules. Mortality and interest rates are prescribed by applicable tax law and asset shortfalls are amortised over seven years.
The maximum contributions, by employers and employees, and allocations under a defined contribution qualified plan for a year is the lesser of 100 per cent of the employee’s compensation or US$61,000 (for 2022; indexed for inflation). Tax-favoured employee deferrals are capped at US$20,500 (for 2022; indexed for inflation). Employees who have attained or will attain age 50 by the end of a year may make additional employee deferrals of up to US$6,500 (for 2022; indexed for inflation).
Minimum employer contributions may be required for plans with benefits that are skewed too much in favour of owners and officers. Moreover, any of the limits described above may be reduced as necessary to satisfy non-discrimination testing requirements and may be limited by other provisions of the Internal Revenue Code.Level of benefits
What are customary levels of benefits provided to employees participating in private plans?
Plan types and levels of benefits vary widely, largely by industry. Historically, defined benefit qualified plans were the most common form of private plan in the US, generally basing benefits on a percentage of average compensation or a dollar amount for each year of service. While this is still somewhat true for industrial employers, particularly with unionised workforces, service businesses and employers in the technology and life sciences spaces tend to offer only defined contribution qualified plans. The latter will typically permit employees to make employee deferrals and may also include matching or other forms of employer contributions (such as a profit-sharing allocation).Pension escalation
Are there statutory provisions for the increase of pensions in payment and the revaluation of deferred pensions?
Except for increases in accrued benefits in the case of late retirement, there are generally no statutory requirements for pension escalation or revaluation. Employers may, by design, provide such features if in compliance with applicable tax rules.Death benefits
What pre-retirement death benefits are customarily provided to employees’ beneficiaries and are there any mandatory rules with respect to death benefits?
Defined benefit and money-purchase pension defined contribution qualified plans must provide benefits in the form of a qualified joint and survivor annuity (QJSA) or a qualified preretirement survivor annuity (QPSA). A QJSA is an annuity for the life of the participant, and if the participant is married, a survivor annuity for the life of the spouse of not less than 50 per cent of the amount payable while the participant was alive. These plans may also be required to offer a qualified optional survivor annuity (QOSA) of either 50 per cent (if the survivor portion of the QJSA is at least 75 per cent) or 75 per cent (if the survivor portion of the QJSA is less than 75 per cent). A QPSA is an annuity for the life of a deceased participant’s surviving spouse where the participant dies before retirement but after reaching the plan’s earliest retirement age. In that situation, the QPSA cannot be less than the survivor portion of the QJSA. For a participant who dies on or before the plan’s earliest retirement age, payments to the surviving spouse may not be less than the survivor portion of the QJSA, determined as if the participant terminated at death, survived until the earliest retirement age, commenced a QJSA and then died the following day.
Those plans, and other types of defined contribution qualified plans, can offer other distribution forms, including other forms of annuities, instalment distributions and lump sums, but a properly witnessed spousal consent to waive the QJSA or QOSA form will be required.
The QJSA, QOSA and QPSA requirements do not apply to other types of defined contribution qualified plans as long as the default beneficiary of the participant’s entire vested benefit is the surviving spouse and the participant does not elect a life annuity form. The participant can designate an alternative beneficiary, but the spouse must provide a properly witnessed spousal consent.
It is common but not required to accelerate vesting if an employee dies while employed.Retirement
When can employees retire and receive their full plan benefits? How does early retirement affect benefit calculations?
A qualified plan must allow participants to take distributions by the sixtieth day following the close of the plan year in which occurs the later of: (1) the participant attaining age 65 or, if earlier, the plan’s normal retirement age; (2) the tenth anniversary of the participant’s commencement of participation; or (3) the participant’s termination of service. A plan’s normal retirement age is typically either age 62 or 65. Participants are required to begin taking distributions shortly after attaining age 72 except with respect to active employees who own not more than 5 per cent of the employer.
Defined contribution qualified plans generally allow a terminated employee to receive a distribution immediately following termination. With a defined benefit qualified plan, distributions are typically deferred until normal retirement age, although a plan may permit commencement of benefits at early retirement, often age 55. Such a benefit may be actuarially adjusted to take a longer distribution period into account.
Distributions received prior to age 59 and one-half may be subject to a 10 per cent excise tax in addition to ordinary income tax, unless ‘rolled’ over into another tax-favoured vehicle (another employer plan or individual retirement account, for example) or unless a special exception applies.Early distribution and loans
Are plans permitted to allow distributions or loans of all or some of the plan benefits to members that are still employed?
Yes, depending on how the plan is designed. Defined benefit and money-purchase pension defined contribution qualified plans can, but are not required to, permit in-service distributions as early as age 59 and one-half. Other types of defined contribution qualified plans can permit in-service distributions after a fixed number of years, on the attainment of a stated age (generally age 59 and one-half) or upon the occurrence of a stated event (such as termination of employment, disability or hardship). In-service distributions received prior to age 59 and one-half are generally subject to a 10 per cent excise tax, in addition to ordinary income tax, unless another exception applies.
Qualified plans may also, but again are not required to, allow participants to borrow up to the lesser of US$50,000 (reduced by the highest outstanding principal balance in the past 12 months) or the larger of one-half of the present value of the participant’s vested benefit or US$10,000. Requirements under the Internal Revenue Code and Employee Retirement Income Security Act (ERISA) are designed to ensure that a loan is neither a taxable distribution nor a prohibited transaction. A defaulted loan may result in ordinary income tax and, possibly, a 10 per cent excise tax.Change of employer or pension scheme
Is the sufficiency of retirement benefits affected greatly if employees change employer while they are accruing benefits?
The impact of changing employers generally depends on the type of qualified plan. Traditional defined benefit qualified plans generally base benefits on a combination of compensation and years of service. As a result, the maximum benefit is generally earned over an employee’s career with the employer maintaining the plan, and termination prior to normal retirement age can significantly reduce the available benefit (even when the employee is fully vested). Defined contribution and certain other defined benefit qualified plans provide a benefit equal to an account balance that, once partially or fully vested, can generally be received in the form of a lump-sum distribution without any reduction.
In what circumstances may members transfer their benefits to another pension scheme?
Most, but not all, distributions from a qualified plan may be deposited or ‘rolled over’ into another tax-favoured employer plan or individual retirement account, thus allowing the employee to continue to defer taxes. Exceptions include annuities, instalments over at least 10 years and hardship distributions. The Internal Revenue Service has a helpful chart on its website.Investment management
Who is responsible for the investment of plan funds and the sufficiency of investment returns?
ERISA requires every qualified plan to have a ‘plan administrator’ and both ERISA and the Internal Revenue Code require that qualified plan assets be held in trust. Those responsible for managing the trust’s assets may be the plan administrator, the trustee, an investment manager appointed under ERISA or another fiduciary (such as an investment committee).
In the case of a defined benefit qualified plan, the employer will be responsible for any shortfall in investment returns through minimum required contributions. In a defined contribution qualified plan, participants may manage their own investments. This transfers responsibility for investment risk (but not fund selection) to the participant. The plan administrator, trustee, investment manager or other fiduciary remains responsible for adding, monitoring the performance of and removing the funds offered to participants.Reduction in force
Can plan benefits be enhanced for certain groups of employees in connection with a voluntary or involuntary reduction in workforce programme?
Yes. Defined benefit qualified plans will sometimes offer early retirement window incentives, treating participants as older (closer to normal retirement age), crediting additional years of service for vesting or benefit accrual purposes or adjusting compensation. Special allocations or additional years of service for vesting purposes may also be provided under a defined contribution qualified plan.
In modifying any qualified plan for this purpose, care must be taken to ensure that non-discrimination requirements are met and that any changes are compliant with other applicable laws, such as age discrimination laws.Executive-only plans
Are non-broad-based (eg, executive-only) plans permitted and what types of benefits do they typically provide?
Non-broad-based plans are permitted but such arrangements do not have the same tax-favoured status as qualified plans. These non-qualified plans can be structured as defined benefit or defined contribution arrangements and with or without employee contributions. No immediate deduction is available to employers, and benefits are generally subject to social security tax at vesting and ordinary income tax at distribution. For non-profit employers, benefits are generally subject to tax at vesting rather than at distribution.
Non-qualified plans are generally exempt from most provisions of ERISA as long as they are maintained primarily for a select group of management or highly compensated employees.
How do the legal requirements for non-broad-based plans differ from the requirements that apply to broad-based plans?
To avoid current income tax on the benefits, non-qualified plans must be unfunded and unsecured, meaning that the promised benefit is paid from the employer’s general assets, which are subject to claims of the employer’s creditors. No immediate deduction is available for the employer with respect to non-qualified plans and they must be designed to be exempt from or compliant with section 409A of the Internal Revenue Code. This means that payments must generally be made on certain pre-specified dates and any employee deferral elections generally must be made prior to the year amounts are earned. Amounts paid pursuant to a non-qualified plan are not eligible to be rolled over to a broad-based plan or other tax-favoured account.
To avoid most of the requirements of ERISA, the non-qualified plan must also be limited to a select group of management or highly compensated employees.Unionised employees
How do retirement benefits provided to employees in a trade union differ from those provided to non-unionised employees?
Employers with union employees may be required to collectively bargain with respect to retirement benefits. This may result in participation in a multi-employer plan in which several unrelated employers (but typically in the same industry) make contributions on behalf of their union employees. This allows the employees to more easily change jobs within the same industry (trucking or airlines, for example) without losing benefits. Multi-employer plans are more often than not defined benefit qualified plans, and they are jointly administered by a board of employer and union representatives.
There has been a trend more recently to limit the potential liability of contributing employers to liabilities attributable to their own workforce, as well as to allow employers to participate in a multi-employer defined contribution arrangement, typically with an employee deferral feature.
How do the legal requirements for trade-union-sponsored arrangements differ from the requirements that apply to other broad-based arrangements?
A multi-employer plan must satisfy the qualified plan requirements of ERISA and the Internal Revenue Code and are subject to the Multiemployer Pension Plan Amendments Act (MPPAA), a part of ERISA. The MPPAA provides that if a multi-employer plan is underfunded, all contributing employers can be required to make additional contributions, even if the liability did not arise with respect to the employer’s own union employees. As a result, employers can face significant liability to a multi-employer plan if the plan is not sufficiently funded by all employers. Minimum required contributions are determined by an actuary based on best estimate assumptions, and asset shortfalls are amortized over 15 years. Severely underfunded plans are required to implement formal procedures to avoid insolvency.
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21 February 2022