Employee Benefits Strategies

Retirement Programs

Retirement plans provide economic security for employees upon retirement. This can be accomplished in a number of ways that defer current compensation to some future time.

The least visible benefit to the employee is the retirement plan. In a retirement plan, earnings are put aside in an investment account or fund annually for the employee's eventual retirement. Upon retirement, the employee begins to receive that money. A retirement plan is a trade-off between current income and future financial security. The interest in retirement programs increases with age. Unfortunately, unless the employee realizes the value of retirement savings in the early years of their career, savings do not have time to grow significantly enough to provide a comfortable retirement.

There are two major forms of retirement programs: defined benefit and defined contribution.

Defined benefit plans

Pensions are a common example of defined benefit plans. Upon retirement, the employee is guaranteed a set income for as long as they live. There is usually a clause that allows a percentage continuance beyond that for a spouse. The exact benefit amount is determined by the employee's income and the number of years of service. The current pay rate or an average of the pay rate for a specified time period determines the amount to be paid. The length of service determines the percentage of the base pay that will be paid out each month.

Defined contribution plans

In a defined contribution plan, employees don't know what income they will receive upon retirement, but they do know how much money there is in the retirement plan fund earmarked for them. Upon retirement, the employee can take that money out and develop a retirement-income program. In some plans, the employee may convert the balance to an annuity.

The cash balance in the defined contribution plan comes from employee contributions plus the growth and returns earned on those contributions. Most employers also make contributions on the employee's behalf. The employer contributions can be determined in a number of ways to include a flat percentage of the employee's pay each year, an employer match on a specified percentage of employee contributions, or a discretionary amount based on a profit-sharing program.

Defined contribution plans are more common than defined benefit plans. Part of the reason is their comparative simplicity. The employer contribution is much easier to calculate and understand under a defined contribution plan and the cost is usually much less.

Qualified retirement plans

There are many types of defined contribution plans available, but we will discuss two: the 401(k) and the SEP.

• 401(k) Plans. A 401(k) plan allows the employee to put aside, up to a specified limit, an amount of income per year on a tax-deferred basis. The employer may provide a flat percentage of the employee's pay each year, an employer match on a specified percentage of employee contributions, or a discretionary amount based on a profit-sharing program. The balance deposited may go into a single fund or may be allocated among a number of funds by the employee. If there are multiple funds, the employee can manage investments as needed. Today 401(k) plans are the fastest-growing retirement-plan benefit.
• SEPS and IRAs. Another form of retirement program allowed by law is the simplified employee retirement plan (SEP). This is a form of individual retirement account (IRA) in which the employer is allowed to contribute a percentage of the employee's income into a savings account. This is a popular plan because it requires little administration, making it especially prevalent among small organizations. For more information, see DLC Course 74: Trends in Retirement Plans

SEPs and 401(k) plans are qualified plans. Under the U.S. IRS Tax Code, qualified plans have tax advantages that allow employees to contribute before-tax dollars to their plans. Taxes are only paid when the individual withdraws funds at retirement. Qualified plans are secured, but are subject to restrictive rules and extensive regulations.

Non-qualified retirement plans

In contrast, non-qualified plans don't receive favorable tax treatment but have far fewer restrictions than qualified plans. They must remain “unfunded” to avoid current taxation. This means actual funding for benefits is not secure and is subject to seizure by creditors. These plans are used primarily in executive compensation.

For a review of non-qualified plans, please see DLC Course 42: Accumulated Earnings and Deferred Compensation