History of EBSA and ERISA

          The Employee Benefits Security Administration (EBSA) is the regulatory arm, under the Department of Labor, for enforcing the fiduciary reporting and disclosure provisions of Title I of the Employee Retirement Income Security Act of 1974 (ERISA). Prior to February 2003, EBISA was formerly known as Pension and Welfare Benefits Administration (PWBA).  Prior to January 1986, the agency was known as the Pension and Welfare Benefits Program (PWBP).[1]

The provisions of Title 1 were ratified to deal with public concerns about the mismanagement and abuse of private pension plans. ERISA was a conclusion of years of legislation dealing with implications of labor and tax aspects of employee benefit plans. Since its ratification it has undergone many changes to meet the evolution of the changing retirement and health care needs of employees. In addition, EBSA’s role has also evolved to coincide with this shifting environment.

ERISA administration is divided among four government entities: The U.S. Department of Labor (DOL), the Internal Revenue Service of the Department of the Treasury (IRS), and the Pension Benefit Guaranty Corporation (PBGC). Title I comprises of regulations for reporting and disclosure, vesting, participation, funding, fiduciary responsibilities, and civil enforcement. Title II of ERISA amended the IRC to align with the regulations established in Title l. Title III deals with jurisdiction and with coordination efforts of enforcement and regulations by the DOL and the IRS. Title IV is concerned with the insurance of defined benefit pension plans which is administered by the PBGC.

 In 1978, there was a reorganization of administrative responsibilities due to an overlapping of the IRS and the DOL concerning provision of Title I and the tax code. Since then the DOL is responsible for disclosure, reporting, and fiduciary requirements. The IRS is responsible for participation, vesting, and funding. Nevertheless the DOL may supersede in maters that concern rights of participants. [2]

            Prior to the enactment of ERISA, the IRS was the main regulatory arm concerning pensions. The Revenue Acts of 1921 and 1926 gave employers the ability to deduct employer’s pension contribution from corporate income, and allowed for assets within the pension fund to accrue tax free. Participants in pension plans also received favorable tax treatment as they were not taxed until the benefits were received. As a qualification of favorable tax treatment these pension plans had to meet minimum requirement concerning employer contributions and employee coverage. Further legislation was mandated with the passage of the Revenue Act of 1942 which provided more restrictive participation requirements and also disclosure.[3]

            The DOL involvement with regulating employee benefit plan came to fore with the enactment of the Welfare and Pension Plans Disclosure Act of 1959 (WPPDA). With its passage came the requirement of employers and labor unions (plan sponsors) to file financial reports and plan descriptions. Furthermore this information was to be made available to plan participants and their beneficiaries. The concept of this was to provide employees with adequate information to monitor their plans and head off abuse and mismanagement of fund assets by plan administrators. In 1962, the WPPDA was revised and the Secretary of Labor was given the role of enforcement, interpretation, and investigatory powers over employee benefits. Today ERISA has a much broader scope than its predecessor.

ERISA

            ERISA was signed into law on September 2, 1974 by President Gerald Ford. ERISA is a federal law that sets minimum standards for most voluntarily established pension and health plans in private industry. The primary objective of Title I of ERISA is to provide safeguards that protect the concern of individuals and their beneficiaries in these benefit plans. ERISA implemented rules which qualified plans must adhere to under the premise of discouraging misuse of fund assets by fiduciaries. ERISA covers two types of plans: defined benefit and defined contribution.

“ERISA also:

•  Requires plans to supply participants with important information about plan features and funding. The plan must furnish some information regularly and automatically. Some of this information is available free of charge and some is not.
•  Sets minimum standards for participation, vesting, benefit accrual and funding. The law defines how long a person may be required to work before becoming eligible to participate in a plan, to accumulate benefits, and to have a non-forfeitable right to those benefits. The law also establishes detailed funding rules that require plan sponsors to provide adequate funding for the plan.
• Requires accountability of plan fiduciaries. ERISA generally defines a fiduciary as anyone who exercises discretionary authority or control over a plan's management or assets, including anyone who provides investment advice to the plan. Fiduciaries that do not follow the principles could be accountable for losses.
•  Gives participants the right to sue for benefits and breaches of fiduciary duty.
• Guarantees payment of certain benefits if a defined plan is terminated, through a federally chartered corporation, known as the Pension Benefit Guaranty Corporation.
•  Protects the plan from mismanagement and misuse of assets through its fiduciary provisions.”[4]

Interestingly enough, ERISA was enacted in response to inconsistencies of large pension funds, specifically the Teamsters Pension Fund, which had been involved in making debatable loans to some Las Vegas casinos.[5]

Pension Benefit Guaranty Corporation (PBGC)

            The first company to initiate a private pension plan was American Express Company in 1875. Thereafter, many other companies followed suit including banks, utilities and manufacturers. These early pensions were nearly all defined benefit plans in which participants paid in contributions and received a specific monthly amount at retirement. These plans were largely unprotected. In an example of one of the most appalling incidents of workers losing there retirement benefits took place in 1963 when Studebaker ended its employee pension plan and approximately 4000 worker lost their promised pension benefits.

In September 1974, the Pension Benefit Guaranty Corporation (PBGC) was established under ERISA. The entity started with a $100,000 borrowed from the DOL under the provisions of ERISA. “PBGC issued its first pension check for $140.75 on February 28, 1975, to a participant in the International City Bank of New Orleans Employee Retirement Plan.”[6]  PBGC currently protects nearly 44.3 million workers, retirees and their beneficiaries in more than 31,000 private defined benefit plans.

The Pension Benefit Guaranty Corporation (PBGC) is a non-profit, federally chartered, and quasi-independent entity created for the purpose of protecting, and the continuation and maintenance of defined benefit plans under the private sector. If a plan should end up without sufficient funds to pay benefits to its participants, PBGC insurance program will pay the benefit up to the limits prescribed by law. In most cases participants receive the full amount accumulated before the pension plan ended.

 “PBGC’s Board of Directors consists of the Secretaries of Labor, Treasuries, and Commerce, with the Secretary of Labor serving as the chairperson. PBGC is headed by an Executive Director — On February 13, 2004, Vincent K. Snowbarger was appointed Acting Executive Director by U.S. Labor Secretary Elaine L. Chao. The Corporation is aided by a seven-member Advisory Committee appointed by the President of the United States to represent the interests of labor, employers, and the general public. ERISA outlines several specific responsibilities for PBGC's Advisory Committee, including advising on policies and procedures for PBGC's investments, the trusteeship of terminated plans, and on other matters as determined by PBGC.”[7]

 In effect the PBCG is an insurance company for privately held pension plans. Its objective is to provide payments to participants and their beneficiaries, and to maintain insurance premiums at optimal levels to secure its objectives.

            The PBGC finances its operation from insurance premiums of insured pension plan, from investment income, and from recoveries of bankruptcies. The PBGC receives no funds from general tax revenues. In 2003 total premium revenue was estimated at $973 million. Single employer-pension plans pay a flat fee of $19 per participant. Underfunded plans of single-employer pensions are subject to an addition annual variable rate that ranges from $9 per $1000 of unfunded vested benefits. Smaller programs in which there are multiemployer pay an annual fee of $2.60 per participant. The premiums that PBGC collects are dependent on the information reported by plan administrators. PBGC established a compliance program (Premium Compliance Evaluation) to help it members in adherence in accessing accuracy of participant numbers reported by the single-employer plans and determining variable-rate premiums.

            PBGC guarantees the basic benefits before termination date of the plan which include the following:

• Pension benefits at normal retirement age.
• Most all early retirement benefits.
• Disability benefits for disabilities which occurred before the plan terminated.
• Certain benefits for survivors of plan participants.

PBGC does not guarantee health care, vacation pay, or severance pay. The pension benefit PBGC pays depends on provisions of your plan, legal limits, the form of your benefit, your age, and amounts PBGC recovers from employers for plan underfunding.    PBGC has guaranteed payment to 834,000 workers and retirees in 3,287 insolvent single-employer plans and over 100,000 participants in multiemployer plans. There limits on amounts, set by law, which PBGC can guarantee. For example, in 2004, a single-employer plan adjusted annually for Social Security and based on the date the plan terminates is guaranteed $44,386.32 annually ($3,698.86 monthly) for a single life annuity beginning at age 65. The amount is adjusted downward on a graduated scale according to age (see table below). This amount is a fixed amount and is not contain cost of living adjustments (COLA).

 

Year Plan Terminated	Monthly Guarantee Limit At Age 65	Monthly Guarantee Limit At Age 62	Monthly Guarantee Limit At Age 60	Monthly Guarantee Limit At Age 55
2004	$3,698.86	$2,922.10	$2,404.26	$1,664.49
2003	$3,664.77	$2,895.17	$2,382.10	$1,649.15
2002	$3,579.55	$2,827.84	$2,326.71	$1,610.80

 

Recent trends in private pension plans suggest an overall decrease in these types of plans. This trend started in the mid-1980s and has continued to present. The total number of single-employer and multiemployer pension plans reached its peak in 1985 with 114,000 and has since has declined to 31 million in 2003. In the same time frame the number of participants in these plans increased from 38 million to 43.9 million. The reduction in plans is primarily concentrated in small businesses with less than 100 participants.[8]

Business failures along with pension plan losses in the financial markets, in addition to low interest rate have increase the claims against PBGC. This resulted in a net loss in 2003 of $7.600 billion compared with a net loss of $11.370 billon in 2002 and a loss of $1.972 billion in 2001. The improvement in revenue in 2003 was attributed to an increase of $3,179 billion of investment income, $161 million premium revenue, and an overall decrease in from completed and possible terminations of pension plans. This was offset by increases in actuarial charges of $3.359 billion and administrative and other charges of $147 million. Overall losses decreased from of $9.313 billion in 2002 to a loss of $5.377 billion in 2003, this was primarily due to new plans classified as probable and the termination of underfunded pension plans. “Future losses remain unpredictable as PBGC’s loss experience is highly sensitive to losses from large claims.”[9]

Qualified and Nonqualified Plans

 

The determination of whether a plan is qualified or nonqualified is by its tax status under the law.[10] Qualified and nonqualified both have different tax implications for both employees and employers. Both programs can be useful for employers in attracting and retaining employees depending on different situations. Careful consideration should be used in determining which type an employer chooses in establishing a retirement program for their employees. A qualified plan is established by an employer to provide retirement benefits for employees and their beneficiaries.

Qualified Plans are a program established under the established tax laws by which an employer provides retirement income for employees and their beneficiaries. Qualified plans are not IRA based like SIMPLE or SEP IRAs and are therefore subject to different rules concerning distributions and contributions. Qualified plans can either be defined benefit or defined contribution plans, which are discussed later. Any type of business entity may adopt a qualified plan, including sole proprietorships, partnerships, corporations, and government. Employees on the other hand, may not adopt a qualified plan but may be a participant in their employer’s plan. Examples include money purchase plans and profit sharing.

Qualified plans have several advantages such as favorable federal tax treatment for employers. A qualified plan allows the employer’s portion of the contributions to be tax deductible. The benefits to plan participants include current tax deferral of their contributions. In addition, plan participants are not taxed until they start making withdrawals from there accounts. In order to maintain this tax status, plans must operate under the provisions set forth by the IRC, DOL, and ERISA. Some of those provisions include participation, vesting, coverage, and nondiscrimination.

Employers wishing to formally establish a qualified plan must complete an adoption agreement. The adoption agreement contains a general description of the plan in addition to operating provisions. Furthermore, employers must notify employees with a Summary Plan Description. The SPD must be provided to all employees in a non-legal format that is easily understood. The SPD must include information such as:

·        Identification number and location of the plan.

·        A description of what the plan provides for employees and how it operates.

·        When employees may begin to participate.

·        How employees service and benefits are calculated.

·        When employees benefits will become vested.

·        When employees will receive benefits and in what form

·        Circumstances under which employees may lose or be denied benefits.

·        The employees’ rights under ERISA.

In the event of any revisions in the provisions of the plan, employees must be notified either in a revised SPD or in different document referred to as a Summary of Material Modification (SMM). [11]

Employers have a choice in the types of plans they can choose. They can either choose an individually designed plan or they may choose one that is a prototype provided by a sponsor and already approved by the IRS. Individual plans are ones which are designed and are unique to meet the needs of an employer. No other entity may use an individually designed document. Typically, this type of plan is used by large companies who want to fulfill certain specifications that may not be met under a prototype-plan.

IRS pre-approved prototype and master plans, are typically used by small businesses. These types of plans can be used by any number of employers, unlike individual designed plans. When a master plan is used, a single trust or custodian is set up to accommodate all adopting employers. The prototype plan uses a separate trust or custodian for each employer.  There are numerous organizations that sponsor IRS approved master and prototype plans including:

·        Banks, some savings & loans and credit unions

·        Trade or professional organizations

·        Insurance companies

·        Attorneys

·        Financial planners

·        Accountants

 

There are some disadvantages to qualified plans as well. In order for an employer to benefit from tax laws they must adhere to the many stringent governmental regulations that guarantee the plan is administered with nondiscriminatory goals. Over time government regulations have become increasingly more cumbersome and complex. This puts additional administrative and cost responsibilities on employers. Another disadvantage to a qualified plan is the annual compensation cap in effect. An employer can contribute up to 25 percent of compensation to each eligible employee’s account as long as it does not exceed $40,000 annually. If an employee’s annual remuneration exceeds $200,000 (indexed for future years) then they may not be considered under the employer’s plan. This could be detrimental to retirements of employees who have high annual compensation packages.

Nonqualified plans can present an alternative to qualified plans by offering supplemental employer benefits and income deferral opportunities along with a great deal of flexibility in their design. These plans are less weighted down with and/or restricted by governmental regulations. For example, a nonqualified plan could be used by an employer to establish “golden handcuffs” for a perspective employees if they promise to stay for their career or for a specified period of time.  In addition, nonqualified plans could be used to attract and retain employees who are further down the road in there careers by offering them rapid benefit accumulation. [12]

Nonqualified plans can benefit lower-paid employees. Considering the contribution cap on qualified plans, it may be a better alternative to use nonqualified plans to cover highly compensated employees. This could provide a means to offer less compensated employee’s qualified plans.

There are some disadvantages to nonqualified plans as well. From the perspective of employers, the tax advantage is for contributions and deferred compensation can not be realized until the participant actually receives the benefits. Another disadvantage is that the employer usually limits the employees selected as participants. These are usually management or highly compensated individuals, so there is a burden placed on employers in deciding which employees are appropriate. Furthermore, nonqualified plans cannot be funded in the same manner as qualified plans. Funding of nonqualified plans can precipitate government reporting and disclosure and premature tax event for employees. Unfunded obligations can also have an adverse affect on financial statements.

From the employees perspective there are concerns security of the promised benefit. These concerns include bankruptcy, sale of the company, change of control of the company, or even if management changes their mind.[13]

 

Defined Benefit and Defined Contribution

          As stated earlier qualified plans can either be classified as defined benefit or defined contribution plans. Defined benefits are the most common. Most people have this type of plan where they work. In this type of plan employees makes contributions to their individual accounts and, in most instance, employers make some sort of matching contribution usually as a percentage of the employee’s yearly earnings. These employer contributions are added to the individual’s account and are invested at the employee’s discretion into the employer’s plan. Upon retirement, the employee ultimately receives the balance of the account, which is based on their contributions which will have been affected by capital gains and losses. The value of the account will fluctuate due to changes in the value of the underlying investment and market conditions. Examples of such plans include 401(k) plans, 403 (b) plans, profit sharing and other which will be discussed later in more detail.

            A defined contribution plan (traditional pension plans) is a promise to pay a specific monthly benefit upon the participant’s retirement and thereafter to any surviving spouse. It can be stated as a fixed monthly dollar figure or the plan may use a benefit formula to calculate an amount based on salary and years of service. Defined benefit plans traditionally encompassed most of working American’s retirement incomes but over the last two decades there has been a trend to replace them with defined contribution plans. Defined benefit plans are insured, to some degree, by the Pension Benefit Guaranty Corporation (PBGC).

Defined Benefit vs. Defined Contribution Plan

In the later part of the 1990s many people who had contributed to defined contribution plans saw the value of their retirement accounts explode with the “over exuberance” of the stock market. Those same people saw their retirement accounts decimated with the aftermath of the bursting of the stock market bubble while those in defined benefit plans retained a relatively stable and secure return. In essence there are some advantages and disadvantages and arguments can be made for and against both types of plans.

Defined benefit advantages from the perspective of the employee:

·        Defined benefit plans provide a degree of security to workers for retirement. They are not affected by market risk, outliving their retirement, or if an employee becomes disabled.

·        Employees are not subject to investment risk. Pension funds minimize their investment in financially risky assets. They invest in a mix of assets that provided optimum growth and risk exposure that outpace inflation.

·        Defined benefit plans are not subject to employees’ ability to save. Low wage earners are disadvantaged with defined contribution plans. In addition, employer contributions are usually tied to employee savings. Defined benefit plans have compulsory employee contributions that provide workers a secure retirement.

·        Most defined benefits plans have cost of living adjustments (COLA) and pension formulas that are tied to the employee’s highest paid years adding an inflation guard to the benefit.

·        Defined benefit plans usually provide death and disability insurance adding increased security. Under defined contribution plans employees must purchase these types of insurance.

·        Defined benefit plans usually have provisions that allow for portability with shorter vesting periods, reciprocity agreements, and buyback for prior years or related service. Defined contribution plans allow for borrowing.

Defined contribution plans from the perspective of the employer:

• Defined benefit plans allow employers to set income-replacement goals for their workforce. Employees using defined contribution plans may work longer and at a higher wage if they failed to save enough for retirement. Older workers may also bargain for higher employer contributions to their defined contribution plans versus a younger employee.
• Defined contribution plans can be costlier to administer than defined benefit plans. If comparing apples to apples, comparable benefits would suggest comparable employer contributions. Defined contribution plans require features like employee loans, varied investment options, education, information obligations, and account statements to be sent out.
• By pooling pension fund assets employers are able to benefit from varied investment options provided to large funds. Furthermore, the positive investment performance and earnings from the pooling effect of some funds has limited employer contributions. Their performance has shown that earnings have surpassed actuarial assumptions resulting in interest being credited to employee accounts.
• There is a high cost for employers associated with switching for defined benefit to defined contribution. The state of Michigan wanted to make the switch from defined benefit plan so it had offered its employees an early retirement at a cost of $270 million to win approval. The accumulation of lengthy unfunded contributions to defined benefit plans are still liabilities that must be paid in the event the employer switches plans. Some state governments are now in favor of moving back to defined benefit plans after making the switch for this very reason.
• Defined benefit plans offer employees an incentive to remain within public service (one of the larger users of this type of plan). Employees could alternately earn a higher wage in the private sector but are enticed to remain in government positions due to the added security in retirement benefits.
• The ease at which to budget pension plans is an attractive feature. Defined benefit plans use actuarial projections which are made well in advance which give employers plenty of time to financially plan for the expense. The liabilities in mature funds rarely changes on an annual basis.

Public policy may actually be enhanced from the use of defined benefit plans. Recent trends reflect a shift of administrative cost incurred by employers, who use defined contribution plans, to employees. There are significant management fees paid to various financial intermediaries that come out of these savings whereas pension funds typically have their own management.

In addition, defined contribution plans may add to the burden on society if participants fail to save enough, make poor investment choices, or if they outlive their retirements. This may instigate the need for financial assistance and social welfare programs such as Medicaid and welfare benefits. Alternatively, many defined contribution plans have become insolvent in recent year which resulted in taxpayers paying millions of dollars for the bailout via the PBGC and consequently had the same affect of dependence on social assistance to many retirees.

By mandating retirement savings which comes in the form of a small employee contribution, defined benefit plans allow low wage-earns to secure a retirement that they might not otherwise have achieved.[14]

Finally, defined benefit plans actually can contribute to corporate governance. An example is the California Public Employees Retirement System (CalPers). They have significant influence (similar to a small country) in the corporate world. They recently led the charge and made “road kill” out of Dick Grasso who was expelled from his CEO position on the New York Stock Exchange (NYSE) for a questionable compensation package.

There are some advantages to defined contributions as well:

·        Employees have more control over their investment choices. Typically there are multitude choices of financial intermediaries and investment vehicles. In defined contribution plans, employees have not say as to how fund assets are invested.

·        Growth could be more significant over time and has the potential to significantly outpace inflation. There is historical evidence that suggest that stock market returns (on average), over significant time, has had a larger return than the (safe) investments made by defined contribution plans. The disadvantage is the lack of investor knowledge and investment risk as previously pointed out.

·        Employees who maximize their contribution can realize a significant reduction in their annual tax obligations. Contributions made on a pre-tax basis are deferred until the benefit is actually taken at retirement.

·        Growth on the underlying investment(s) is also deferred until the benefit is taken.

·        There are some distinctive benefits with regard to distribution as opposed to a defined benefit plan. These include being able to access the account at age 55. Some defined benefit plans have a higher retirement age.

·        Tax deductibility makes it attractive for employers to utilize this type of plan.

·        Employers can use high contributions to attract and retain employees.

Example of Defined Benefit Plans

Starting in about 1999, some of the largest firms turned to benefit innovation and adopted a new type of pension plan commonly referred to as a “Cash—balance plan.” It is also a way of addressing employees wants verses needs and can also be construed as looking at the external competitive environment as a means of attracting and retaining employees. This type of plan has some distinct advantages and disadvantages. The foremost benefit is that it is attractive to younger workers especially those in their 20s and 30s because of the plans portability if the employee switches jobs. Older workers, those 40 and older, are disadvantaged because this plan can eliminate new benefits in the near term. It seems that employers choose this type of pension plan when it best suits their needs. However, like all benefit plan changes it must be approved by the Department of Labor.

The cash balance plans are a type of defined benefit plan. Participants of these plans each have a separate account into which employers make contributions. These contributions are based on a percentage of pay and are credited with interest. Plan providers, by law, must provide annuity payouts options.

This type of plan is differentiated from defined contribution plans in that it do not define the employers’ contributions but as an alternative it defines future accrued benefits in each individual account. These plans are unique because they look at the lump sum of an individual’s plan verses the plan’s overall assets which are not directly tied to the individual’s account.

The employer’s contributions are determined by using actuarial estimation and figured in present value calculations, so the employers match may be less than the sum of the additions to that of the plan participant’s account. This is an effective way of controlling an internal cost structure to employers. Interest rates are generally tied to some type of risk free security or bond index such as Treasury bill fund rates.

Something else that is distinctive about this particular plan is that the employer/sponsor determines how the assets will be invested and therefore assumes 100 percent of the risk. The cash balance plan can be highly lucrative to the employer if there is a positive difference in the amount invested and the rate of return (ROR) promised to the employee. These gain/losses also affect future contributions in fully funding the plan. If ROR are high enough then funding will be self-perpetuating. Cash balance funds seek the highest ROR that is consistent with the level of acceptable risk (as stated above, in most cases, these are a relative safe investment) and over an extended time period, management is likely to receive a higher return than the stated rate especially if the stated rate is low.

            Employers who offer cash balance plans are subject to same vesting and funding requirements as other defined benefit plans that fall under ERISA regulations. The only difference is that unlike defined contribution plans, cash balance plans must be insured by PBGC because it is possible for participants to loose part of their accrued contributions.

            These plans could be a real inducement to employers who are looking to control there cost. The mixture of being a defined benefit plan (affects taxation as it is a write-off to the employer), having a comparatively low stated interest rate, and assuming a viable ROR in the equity markets, could alleviate any funding by the employer and thus eliminate the employer’s future obligations.         

Traditionally, most retirement plans are geared in the direction of the total retirement benefit and take into account age and length of employment but cash balance plans accentuate annual accumulations and thus may not be quite as flexible as the more traditional plans in providing specific levels of retirement.