Spring/Summer Series Part 1: Basic Details

When I first entered this field, my immediate supervisor gave me a three step approach to learning what I needed to know to take care of qualified plans. First, she had me read relevant  IRC Sections along with some of the regulations. (This proved to be very exciting! No, wait, the other thing...mind-numbingly boring.) Next, she handed me a client’s file and said, “Read the plan document.” (Not quite as boring. Far more exciting than watching paint dry.) Finally, she told me to look over what had been done for the client the year before.

All in all, this was an effective way to introduce someone to the world of pensions. It got me started on a rewarding career. But in my Spring / Summer Series, I’m going to do something a little bit different. As I said in my introduction earlier this month, I’m going to give some basic information about different types of qualified plans. (Qualified, meaning they meet the requirements of IRC 401(a).) If it inspires anyone to read the Internal Revenue Code, great! If it inspires anyone to become a pension actuary, even better! And if any of my readers come away with at least a basic understanding of qualified retirement plans, better still!

In my introduction, I said I would break down the series into five parts. I’ve added a sixth. (And who knows, I may add more later! We actuaries a wild and unpredictable bunch!) For this first entry, I’d like to lay out some basic information that’s not specific to any one type of plan, such as:

Eligibility and coverage. Congress recognizes the administrative burden of covering all employees in a plan, no matter how long they work for an employer. For instance, students working during college breaks may be unlikely to come back after graduation, so an employer can legitimately exclude anyone under age 21 from its plan. And employees sometimes don’t work out, either by their own choice or the employer’s. Employers can exclude short-term employees from their plans. Collective bargaining agreements often address retirement benefits for union members. An employer can exclude employees in that category.

Even after excluding employees by statute, an employer may have some category of employees who it does not want to cover. Whether it’s the commissioned sales force, the Third Street office, or Employees Who Never Have Change for the Vending Machine, an employer can choose not to cover some people. But only within reason. And reason, according to Congress and the Internal Revenue Code, means that the ratio of covered Non-Highly Compensated Employees (NHCE) to covered Highly Compensated Employees (HCE) must be at least 70% That is, if your plan covers 100% of the HCE, it must cover 70% of the NHCE. If your plan covers 50% of the HCE, it must cover 35% of the NHCE.

HCE/NHCE. I suppose this is a good time to define Highly Compensated and Non-Highly Compensated Employees. An HCE is an employee who owned 5% of the employer in the current or prior year, or anyone who made over a certain amount (currently $125,000) in the prior year. (The employer can elect to limit those in the second criteria to the top 20% of earners.) An NHCE is anyone who is not an HCE.

Vesting.  When we say that a participant’s account balance is vested, we simply means it is non-forfeitable. If an employee leaves an employer for any reason, that employee is entitled to the vested portion of her benefit. When and to what extent an employee becomes vested must be included in the plan document. The three types of vesting are graded, immediate, and cliff. Immediate is exactly what the name implies: an employee is fully vested as soon as he enters the plan. Cliff is similar, in that an employee goes from 0% vested to 100% vested all at once, but not necessarily upon entering the plan. Graded is when an employee becomes fully vested over a period of years, such as 20% after two years of service, 40% after three, all the way up to 100% after six years of service. There are minimum vesting schedules described in the IRC, but any vesting schedule that is at least as good as those can be used in a qualified plan.

Top-Heavy. A Top-Heavy plan is one in which 60% or more of the benefits are for key employees (owners and certain officers). Many, if not most, small plans are Top-Heavy. Being Top-Heavy means that minimum contribution and vesting requirements must be met.

Of course you realize there is much more information I could give, but I don’t want to overload. As we go along, I’m happy to address any questions. Even more, I welcome any feedback. Especially, but not limited to, the good kind.

Next up: Profit sharing plans.