alt="images"/>Exhibit 1-1 Defined contribution and defined benefit
| Defined contribution | Defined benefit | |||
| Pension | Welfare | Pension | Welfare | |
| Purpose | Fund retirement income | Pay current, post-employment or post-retirement benefits | Fund retirement income | Pay current, post-employment or post-retirement benefits |
| Benefit Amount | Based on participant account balances | Same as pension | Based on a formula defined in the plan document | Same as pension |
| Actuary Required | No | Maybe | Yes | Maybe |
| Contributions | Made on a discretionary basis or by formula | Specified by terms of the plan | Actuarially determined | Pay-as-you-go, determined by actuary or by formula |
| Assets | Value equals accumulated benefits | Same as pension | Value not equal to accumulated benefits | Same as pension |
| Individual Accounts | Balance represents accrued benefit for each participant | Same as pension | No—even cash balance plans lack individual accounts | No |
| Examples of Plans | Profit-sharing, stock bonus, 401(k), money purchase, target benefit, thrift or savings, ESOP, 403(b) | Flexible spending accounts, medical, dental, disability, legal services, severance | Defined benefit pension plan, cash balance | Medical, dental, life, disability, legal services, severance |
You might wonder why some plans end up classified as both defined contribution and defined benefit. This status relates to how benefits are determined, and not by the type of benefit provided. Consider a simple fringe benefit (not an ERISA plan). For example, if the employer promises to provide meals for all full-time employees without regard to the dollar cost or amount consumed, that is a defined benefit arrangement. In contrast, if the employer says that it will set aside $2,000 at the beginning of the year to cover meal costs, and the employee can choose when and how to spend it but that when it is used up, there is no more coverage, the plan would be a defined contribution arrangement.
Popular plan types
Pension plans
Defined contribution plans
Profit-sharing plans
Profit-sharing plans are defined contribution plans in that they provide individual accounts for each participant, and benefits are based on the amount contributed to the account, along with any income, gains, and forfeiture allocations less an allocated share of expenses and losses. Profit-sharing plans are distinguished from other defined contribution plans because the contribution is usually discretionary. Management or the board of the plan sponsor can choose whether or not to make a contribution in any year and the amount of such contribution. Some of these plans do include formulas for determining the contribution, but that is not required.
What is required is that the plan document include a specific formula for allocating the contribution. Some plans allocate the contribution based solely on compensation. Others use a combination of compensation and years of service. It is permissible, within limits, for these plans to allocate higher contribution rates on wages above the Social Security wage base than on wages earned below that level. Some plans employ a concept known as cross-testing or age-weighted formulas. These plans allocate different contribution rates to different employee classes. The plans may be tested for discrimination based upon the future benefit levels provided by these contributions, rather than the current contribution rate.
Even with the complexity of concepts such as cross-testing, profit-sharing plans are among the simplest of plan designs. As we cover the tax compliance issues of plans, you will note that profit-sharing plans are exempt from some of these requirements.
Stock bonus plans
These are substantially similar to profit-sharing plans. The primary difference is that they are expected to make plan distributions in employer securities; however, in recent years, even that requirement has been diluted. As such, other than employee stock ownership plans (ESOPs), you rarely see a stock bonus plan.
You may encounter a stock bonus plan as a component of an ESOP sponsored by an S Corporation. Because of a very rigorous testing rule that applies solely to these arrangements, it sometimes becomes necessary to transfer a portion of the shares out of the ESOP into another non-ESOP defined contribution plan or component within a single plan. This could include a profit-sharing, stock bonus or 401(k) plan.
401(k) plans
This is potentially the most common pension plan in today’s economy. Commonly referred to by their IRC section, 401(k) plans, also known as CODAs (cash or deferred arrangements), must be part of a profit-sharing or stock bonus plan. However, no employer contribution is required. Basically, a 401(k) arrangement allows employees to defer part of their salaries to the plan. If the contribution election is made, the employee may defer income tax on the amount until the monies are distributed in future years. The employer may make a matching contribution that goes only to those employees who are deferring, a contribution that is shared by all eligible employees, or a combination of both.
These plans are subject to more restrictions than profit-sharing or stock bonus plans that are funded solely by employer contributions.
As with all defined contribution plans, the employee bears the investment risk. In contrast, the plan sponsor or employer has a predictable benefit cost as defined by the plan design.
There are five types of contributions that can be made to a 401(k) plan, although only elective contributions are actually required. The five types are as follows:
Elective pretax contributions. Employees elect to have a portion of their compensation contributed and tax-deferred under the CODA. These contributions must be fully vested and there are restrictions on withdrawals. These are subject to a special discrimination test referred to as the average deferral percentage (ADP) test.
Voluntary
