FUNDAMENTALS OF EMPLOYEE BENEFIT PROGRAMS
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K
Document Page Count:
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Document Creation Date:
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Publication Date:
June 30, 1987
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SOCIAL SECURITY
HEALTH INSURANCE
RETIREMENT PLANNING
IRAs
401(K) PLANS
PENSION PLANS
CHILD CARE PLANS
EDUCATION ASSISTANCE
HEALTH CARE COST
MANAGEMENT
LIFE INSURANCE
SURVIVOR BENEFITS
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Employee Benefit Research Institute
The Employee Benefit Research Institute (EBRI) is a Washington-based,
nonprofit, nonpartisan, public policy research institution. EBRI's
overall goal is to promote the development of soundly conceived pri-
vate and public employee benefit plans. The Employee Benefit Re-
search Institute Education and Research Fund (EBRI-ERF) is a
nonprofit, nonpartisan, education and research organization that was
established by EBRI in 1979.
Through research, policy forums, workshops, and educational pub-
lications, EBRI and EBRI-ERF contribute to the expansion of knowl-
edge in the field and to the formulation of effective and responsible
health, welfare, and retirement policies. This work is intended to
complement the research and education programs conducted by aca-
demia, the government, and private institutions.
EBRI and EBRI-ERF's educational and research materials aid the
public, the media, and public- and private-sector decision makers in
addressing employee benefit issues before policy decisions are made.
EBRI and EBRI-ERF seek a broad base of support among interested
individuals and organizations as well as those sponsoring employee
benefit plans or providing professional services in the employee ben-
efit field.
More information on the Employee Benefit Research Institute and on
the EBRI Education and Research Fund can be obtained by writing:
President, EBRI, 2121 K Street, NW, Suite 600, Washington, DC 20037-
2121, (202) 659-0670.
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EBRI
Dear Customer,
We're pleased to provide you with the publication you ordered
from the Employee Benefit Research Institute (EBRI).
EBRI's extensive collection of books and journals is one of the
primary ways the Institute pursues its educational mission to help the
public better understand employee benefit programs and issues.
We also want to notify you of some future changes in procedures
for ordering books and single issues of periodicals from EBRI.
Beginning July 1, 1988, please direct your order or any inquiry
EBRI
P.O. Box 4866
Hampden Station
Baltimore, MD 21211
301-338-6946
Prepayment by check, Mastercard, or Visa will be required and
your order will automatically be shipped to you UPS (at $3.95 per order)
unless otherwise indicated. Please use your street address when order-
ing.
We hope these procedures will facilitate our service to you. We
look forward to serving you in the near future.
Sincerely,
Dallas Salisbury
President
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Fundamentals
of
Employee
Benefit
Programs
THIRD EDITION
AN EBRI-ERF
PUBLICATION
EBRI
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? 1987 Employee Benefit Research Institute
Education and Research Fund
2121 K Street, NW, Suite 600
Washington, DC 20037-2121
(202) 659-0670
Second Printing.
All rights reserved. No part of this publication may be used or reproduced in
any manner whatsoever without permission in writing from the Employee Ben-
efit Research Institute except in the case of brief quotations embodied in news
articles, critical articles, or reviews. The ideas and opinions expressed in this
publication do not necessarily represent the views of the Employee Benefit
Research Institute, the EBRI Education and Research Fund, or their sponsors.
Library of Congress Cataloging in Publication Data
Main entry under title:
Fundamentals of employee benefit programs.
Includes index.
1. Employee fringe benefits-United States.
1. Employee Benefit Research Institute (Washington, D.C.)
HD4928.N62U634 1987 331.25'5'0973
ISBN 0-86643-052-0
ISBN 0-86643-051-2 (pbk.)
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Table of Contents
Chapter I
Trends in the Provision and Taxation of Employee Benefits ... 1
Introduction ......................................................... 1
What Are Employee Benefits? .................................... 2
Why We Have Employee Benefits ................................ 3
Tax Incentives Encourage Benefit Availability ................. 5
Employer-Provided Pensions ..................................... 5
Employer-Provided Health Insurance ........................... 5
Employee Benefits Available at All Earnings Levels .......... 6
Pensions Provide Savings ......................................... 7
Total Cost of Employee Benefits ........................... ... 7
Size of Tax-Favored Benefits ..................................... 7
Growth of Tax-Favored Benefit Costs ........................... 8
Benefit Cost Variation by Employer ............................. 10
Benefit Cost Variation by Employee Age ........................ 10
New Forms of Employee Benefits ................................ 10
Impact of Tax Reform ............................................. 11
Importance of Employee Communications ..................... 13
Conclusion ........................................................... 15
Additional Information ............................................ 15
Chapter II
Social Security ........................................................ 17
Introduction ......................................................... 17
What Is Social Security? .......................................... 17
Participation ........................................................ 18
Benefits .............................................................. 19
Old-Age, Survivors and Disability Insurance; Hospital
Insurance and Supplementary Medical Insurance
How Social Security Is Funded .................................. 23
Outlook .............................................................. 24
Conclusion ........................................................... 25
Additional Information ............................................ 25
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Chapter III
Employee Retirement Income Security Act ....................... 27
Introduction ......................................................... 27
ERISA Overview ................................................... 28
Scope of ERISA ..................................................... 29
Reporting and Disclosure ......................................... 29
Reporting to Participants/Beneficiaries; Government
Agencies and Reports
Minimum Standards ............................................... 31
Participation; Vesting; Joint and Survivor Annuities;
Preretirement Survivor Annuities; Benefit Accrual;
Funding
Fiduciary Standards ............................................... 34
Basic Standards; Impact of Fiduciary Standards
Additional Employee Protection ................................. 35
Plan Termination Insurance ...................................... 35
Termination Policy; Covered Plans and Benefits;
Employer Liability to PBGC
Conclusion ................................................... ..... 39
Additional Information ............................................ 39
Chapter IV
Pension Plans .......................................................... 41
Introduction ......................................................... 41
Qualified Plans ..................................................... 41
Taxation ............................................................. 43
Plan Design ......................................................... 43
Coverage; Defined Contribution Plans; Defined Benefit
Plans; Contribution Limits; Pension Plan Integration;
Vesting; Loans; Other Features
Plan Administration ............................................... 51
Funding .............................................................. 52
Plan Termination ................................................... 53
Conclusion ........................................................... 54
Additional Information ............................................ 54
Chapter V
Multiemployer Plans ................................................. 55
Introduction ......................................................... 55
Multiemployer Plan Characteristics ............................. 55
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Number of Plans; Industries Covered by Multiemployer
Plans; Benefits; Investment Performance of Plan Funds
Funding .............................................................. 58
Establishing the Plan .............................................. 58
Administrative Differences Between Multiemployer and
Single-Employer Plans
Plan Administrators ................................................ 59
Industry Practices .................................................. 60
Transferral of Pension Credits; Vesting; Normal
Retirement Age Under Multiemployer Plans; Early
Retirement Options; Restrictions
Advantages of Multiemployer Plans ............................. 61
Employee Advantages; Employer Advantages;
Nonnegotiated Plans
Conclusion ........................................................... 63
Additional Information ............................................ 64
Chapter VI
Defined Benefit and Defined Contribution Plans:
Understanding the Differences ...................................... 65
Introduction ......................................................... 65
Defined Benefit; Defined Contribution
The Major Differences ............................................. 66
Achievement of Retirement Income Objectives; Plan Cost;
Ownership of Assets and Investment Risk; Ancillary
Benefit Provisions; Postretirement Benefit Increases;
Employee Acceptance; Employee Benefits and Length of
Service; Plan Administration; Taxes
Conclusion ........................................................... 73
Additional Information ............................................ 74
Chapter VII
Integrating Pension Plans With Social Security .................. 75
Introduction ......................................................... 75
Offset Plans ......................................................... 75
Excess Plans ........................................................ 78
Maximum Integration Level; Integration Percentage;
Defined Benefit Excess Plans; Defined Contribution
Excess Plans
Step-Rate Excess Plans ............................................ 82
Adjustments to Maximum Integration Percentages ........... 83
Top-Heavy Plans ................................................... 85
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Tax Reform Act of 1986 ........................................... 85
Conclusion ........................................................... 86
Additional Information ............................................ 86
Chapter VIII
Profit Sharing Plans .................................................. 87
Introduction ......................................................... 87
Types of Profit Sharing Plans ..................................... 88
Plan Design ......................................................... 88
Vesting; Coverage; Employer Contributions
Allocation of Employer Contributions ........................... 89
Employee Contributions ........................................... 91
Investments ......................................................... 92
Distributions ........................................................ 92
Retirement, Disability and Death Benefits; Withdrawals;
Loans
Taxation ............................................................. 94
Integration of Profit Sharing Benefits With Social Security
Benefits .............................................................. 95
Conclusion ........................................................... 96
Additional Information ............................................ 97
Chapter IX
Thrift Plans ............................................................ 99
Introduction ......................................................... 99
Coverage, Participation and Vesting ............................. 99
Employee Contributions ........................................... 100
Employer Contributions ........................................... 101
Investments ......................................................... 102
Distributions ........................................................ 102
Retirement, Disability and Death Benefits; Withdrawals;
Loans
Taxation ............................................................. 1 03
Plan Administration ............................................... 1 04
Conclusion ........................................................... 104
Additional Information ............................................ 105
Chapter X
401(k) Cash or Deferred Arrangements ............................ 107
Introduction ......................................................... 107
Types of 401(k) Arrangements .................................... 108
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401(k) Thrift Plans; Profit Sharing Plans; "Stand Alone"
Salary Reduction Plans; Cafeteria Plans
Contributions .......................................................
110
Distributions ........................................................
111
Special Legal Requirements ......................................
111
Coverage; "Fail Safe" Devices; Vesting and Participation;
Distributions
Taxation .............................................................
115
Contributions; Distributions; Five-Year Income Averaging;
Rollovers; Loans
Plan Operation ......................................................
117
401(k) Arrangements, Worker Mobility and Cost
Containment ........................................................
117
Conclusion ...........................................................
118
Additional Information ............................................
119
Chapter XI
Employee Stock Ownership Plans .................................. 121
Introduction ......................................................... 121
Leveraged ESOPs ................................................... 121
Other ESOPs ........................................................ 122
Plan Design ......................................................... 123
Distribution Requirements ........................................ 124
Taxation ............................................................. 124
Conclusion ........................................................... 126
Additional Information ............................................ 127
Chapter XII
Tax-Sheltered Annuities ............................................. 129
Introduction ......................................................... 129
Eligibility ............................................................ 129
Funding .............................................................. 130
Plan Operation ...................................................... 131
Types of Plans; Salary Agreement; Contributions;
Employee Rights
Taxation ............................................................. 133
Social Security; Distributions; Early Distribution Tax;
Early Distribution Restrictions; Death Benefits
Employer Responsibilities ........................................ 134
Conclusion ........................................................... 134
Additional Information ............................................ 135
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Chapter XIII
Individual Retirement Accounts .................................... 137
Introduction ......................................................... 137
Eligibility ............................................................ 137
Contribution Limits ................................................ 139
Maximum Contributions; Minimum Contributions
Employer-Sponsored IRAs ........................................ 141
Distributions ........................................................ 141
Lump-Sum Payments; Periodic Certain; Life Annuity;
Joint and Survivor Annuity
Rollovers ............................................................ 142
Rollovers Between IRAs; Rollovers Between Employer
Plans and IRAs
Taxation ............................................................. 142
Income Taxes; Estate Taxes; Penalties
Investments ......................................................... 144
Conclusion ........................................................... 145
Additional Information ............................................ 145
Chapter XIV
Simplified Employee Pensions ...................................... 147
Introduction ......................................................... 147
Participation ........................................................ 148
Contributions ....................................................... 148
Employers; Employees
Distributions ....................................................... 150
Taxation ............................................................. 150
Plan Design ......................................................... 151
Integration; Plan Operation
Conclusion ........................................................... 152
Additional Information ............................................ 152
Chapter XV
Retirement Plans for the Self-Employed .......................... 153
Introduction ......................................................... 153
1981 Legislative Changes in Keoghs ............................. 154
1982 Legislative Changes in Keoghs ............................. 154
Tax Reform Act of 1986 ........................................... 155
Eligibility ............................................................ 155
Contribution and Benefit Limits ................................. 155
Distributions ........................................................ 156
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Rollovers ............................................................ 157
Taxation ............................................................. 157
Conclusion ........................................................... 158
Additional Information ............................................ 158
Chapter XVI
Planning for Retirement ............................................. 159
Introduction ......................................................... 159
Considerations for the Employee ................................. 160
Financial Planning; Preventive Health Care; Health Care
Costs; Living Arrangements; Use of Leisure Time;
Interpersonal Relationships; Estate Planning
Considerations for the Employer ................................. 170
Interest in Retirement Planning Programs; Program
Content; Program Design; Timing and Length of
Counseling Sessions; Group Size; Who Should Attend;
Participants' Ages
Conclusion ........................................................... 173
Additional Information ............................................ 173
Chapter XVII
Health Insurance ...................................................... 175
Introduction ......................................................... 175
Employee Participation ........................................... 176
Continuation of Employer-Provided Coverage
Plan Operators ...................................................... 177
Health Insurance Benefits ......................................... 178
Postpaid Plan Benefits; Prepaid Plan Benefits;
Deductibles, Coinsurance and Maximum Coverage Limits
Basic Health Insurance ............................................ 179
Hospitalization; Physician Care; Surgical
Major Medical Insurance .......................................... 180
Supplemental Plans; Comprehensive Plans
Other Health Care Plans .......................................... 181
Retiree Health Insurance .......................................... 181
Nondiscrimination Rules .......................................... 181
Conclusion ........................................................... 183
Additional Information ............................................ 183
Chapter XVIII
Managing Health Care Costs ........................................ 185
Introduction ......................................................... 185
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Improving Incentives for Economic Health Care Use ......... 186
Restricting Use of Benefits ........................................ 187
Restructuring Service Delivery ................................... 188
Adopting Flexible Benefit Plans .................................. 188
Effectiveness of Plan Redesign ................................... 190
Prospective Medicare Pricing ..................................... 190
Conclusion ........................................................... 191
Additional Information ............................................ 192
Chapter XIX
Health Maintenance Organizations ................................ 193
Introduction ......................................................... 193
How HMOs Work ................................................... 193
Types of HMOs ..................................................... 194
The 1973 Health Maintenance Organization Act ............... 195
Rate Requirements ................................................. 197
Conclusion ........................................................... 197
Additional Information ............................................ 198
Chapter XX
Preferred Provider Organizations ................................... 201
Introduction ......................................................... 201
Types of PPOs ....................................................... 202
Differences Between HMOs and PPOs ........................... 203
Managing Costs ..................................................... 203
Legal Issues ......................................................... 204
Conclusion ........................................................... 204
Additional Information ............................................ 205
Chapter XXI
Dental Care Plans ..................................................... 207
Introduction ......................................................... 207
Services .............................................................. 207
Payment of Benefits ................................................ 208
Other Dental Plan Features ....................................... 209
Predetermination of Benefits; Alternative Benefits; Cost
Sharing; Benefit Limits; Claims Payment
Nondiscrimination Rules .......................................... 211
Conclusion ........................................................... 211
Additional Information ............................................ 211
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Chapter XXII
Prescription Drug Plans .............................................. 213
Introduction ......................................................... 213
Services .............................................................. 213
Payment of Benefits ................................................ 214
Conclusion ........................................................... 215
Additional Information ............................................ 216
Chapter XXIII
Vision Care Plans ..................................................... 217
Introduction ......................................................... 217
Services .............................................................. 218
Payment of Benefits ................................................ 218
Nondiscrimination Rules .......................................... 219
Conclusion ........................................................... 219
Additional Information ............................................ 220
Chapter XXIV
Employee Assistance and Health Promotion Programs .......... 221
Introduction ......................................................... 221
Employee Assistance Programs ................................... 222
Types; Setting Up a Program; Advantages to Employers
Health Promotion Programs ...................................... 223
Types; Setting Up a Program; Advantages to Employers
Conclusion ........................................................... 225
Additional Information ............................................ 225
Chapter XXV
Group Life Insurance Plans ......................................... 227
Introduction ......................................................... 227
The Insurance Contract ............................................ 228
Plan Provisions ..................................................... 228
Eligibility; Amounts of Insurance; Employee Cost;
Dependent Life Insurance; Accidental Death and
Dismemberment Insurance; Beneficiary Provisions;
Benefits for Retired Persons and Older Workers;
Conversion Privileges; Disability Benefits; Optional Forms
of Payment
Taxation ............................................................. 232
Group Universal Life Programs .................................. 233
Conclusion ........................................................... 233
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Additional Information ............................................ 234
Chapter XXVI
Survivor Benefits ..................................................... 235
Introduction ......................................................... 235
Social Security Survivor Benefits ................................ 235
Survivor Income Plans ............................................ 236
Plan Provisions; Taxation
Pension Plan Death Benefits ...................................... 238
Taxation
Conclusion ........................................................... 240
Additional Information ............................................ 240
Chapter XXVII
Disability Income Plans .............................................. 241
Introduction ......................................................... 241
Public Programs .................................................... 241
Social Security; Workers' Compensation;
Nonoccupational Temporary Disability Insurance
Private Programs ................................................... 243
Short-Term Disability Plans; Long-Term Disability Plans
Conclusion ........................................................... 245
Additional Information ............................................ 246
Chapter XXVIII
Educational Assistance Benefits .................................... 247
Introduction ......................................................... 247
Employer-Provided Assistance .................................... 247
Types of Educational Assistance ................................. 248
Tuition Aid; Training Funds; Educational Leave;
Scholarships and Educational Loans
Federal Educational Assistance Programs ...................... 249
Pell Grants; Supplemental Educational Opportunity
Grants (SEOGs); College Work-Study (CWS); Perkins
Loans; Guaranteed Student Loans (GSLs); PLUS/SLS
Loans
State Student Incentive Grant Program ........................ 252
Other Federal Assistance Programs .............................. 252
Taxation ............................................................. 252
Employer-Provided Assistance; Individual; Federal Loans
and Grants
Conclusion ........................................................... 254
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Additional Information ............................................ 254
Chapter XXIX
Legal Services Plans .................................................. 255
Introduction ......................................................... 255
Plan Design ......................................................... 256
Limited Service Plans; Comprehensive Service Plans
Payment of Benefits ................................................ 256
Services .............................................................. 258
Consultation; General Nonadversarial; Domestic
Relations; Trial and Criminal
Exclusions and Limitations ....................................... 259
Taxation ............................................................. 259
Employee Retirement Income Security Act .................... 260
Conclusion ........................................................... 260
Additional Information ............................................ 261
Chapter XXX
Child Care Programs and Options .................................. 263
Introduction ......................................................... 263
Child Care and the Employer ..................................... 264
Employer-Supported Child Care Centers; Information and
Referral Services; Flexible Personnel Policies; Flexible
Benefit or "Cafeteria Plans"; Flexible Spending Accounts
Federal Programs ................................................... 267
Taxation ............................................................. 268
Employer-Provided Child Care; Individual Income Tax
Credit
Parental Leave ...................................................... 269
Maternity Leave; Unpaid Leave; Paternity Leave;
Adoption Leave
Future Outlook ..................................................... 271
Conclusion ........................................................... 272
Additional Information ............................................ 272
Chapter XXXI
Flexible Compensation Plans ........................................ 273
Introduction ......................................................... 273
Types of Plans ...................................................... 274
Tradeable Benefits ................................................. 275
Reimbursement Accounts ......................................... 275
Funding .............................................................. 276
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Establishing a Flexible Compensation Plan ....................
277
Benefit Taxation ....................................................
277
Advantages of Flexible Compensation ...........................
278
Conclusion ...........................................................
280
Additional Information ............................................
280
Chapter XXXII
Guidance on Evaluating an Employee Benefit Package .........
281
Introduction .........................................................
281
What to Expect .....................................................
281
How to Get Started ................................................
283
Pension Plans .......................................................
284
Health Plans ........................................................
285
Disability ............................................................
287
Group Term Life Insurance .......................................
288
Dental and Vision Care Plans .....................................
290
Conclusion ...........................................................
290
Additional Information ............................................
291
Index ................................................................... 293
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Foreword
Keeping pace with rapid and continuous change is a challenge each
of us faces every day. Nowhere is this challenge more apparent than
in the rapidly changing field of employee benefits. The Tax Reform
Act of 1986 made the most comprehensive and dramatic changes in
employee benefits since the landmark Employee Retirement Income
Security Act of 1974. Some of these changes are effective in 1987;
others take effect in 1988 and 1989.
Dramatic as these changes are, they are by no means the only
sources of change in the employee benefit field. The employers that
sponsor these benefit programs are now reevaluating their benefit
packages in the wake of tax reform, and many will make decisions
that will substantially alter their benefits package to keep them cost-
effective and responsive to employer and employee needs. As people
live longer, and continue to alter their lifestyles and their patterns
of work, their expectations change about what they need to promote
their economic security.
One of the biggest employee needs is the need for economic security.
Promoting economic security is what employee benefits are all about.
It is security during working years against the loss of family income
because of ill health, disability, unemployment and premature death.
In retirement years, economic security is the insurance against pov-
erty and low income, and it is the assurance that one will have the
ability to obtain the medical care that grows more important, and
more expensive, as we age.
The United States has a long commitment to economic security of
its citizens, based upon government-mandated programs, voluntary
employer-sponsored programs and individual efforts that are often
encouraged by the government and by employers. This combination
of public and private programs has been so successful, and so per-
vasive, that many consumers take it for granted. But it is one of the
most important components of a worker's total compensation. It is
also an area that is subject to great change.
I am proud to introduce the third edition of the Fundamentals of
Employee Benefit Programs, which has as its goal education about the
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extent and the importance of employee benefits and the many changes
being made by employers and by federal lawmakers.
In 1979, the Employee Benefit Research Institute (EBRI) began de-
veloping a series of educational pamphlets, which provided basic in-
formation about the primary employer-sponsored benefit plans. The
pamphlets were drafted by employee benefit experts, and they were
used widely for employee training and consumer education. In 1983,
the pamphlets were updated and compiled into one volume, used by
more than 10,000 individuals and widely acclaimed as a thorough,
accurate and readable primer on the whole range of employee benefits.
Tax and pension law changes in 1984 and new federal regulations
caused EBRI staff, in cooperation with benefit experts, to issue an
expanded and updated second edition in 1985. Now, this third edition
incorporates the many changes wrought by the Tax Reform Act of
1986. By popular demand, new chapters have also been added on
Simplified Employee Pensions (SEPs), Preferred Provider Organiza-
tions (PPOs), Employee Assistance and Health Promotion Programs,
and Guidance on Evaluating an Employee Benefit Package. Also, sug-
gestions for additional information have been added to each chapter.
The inclusion of a comprehensive index also makes this book an even
quicker and more thorough reference guide.
This book is, however, a primer. It does not provide binding legal, in-
vestment or employee benefit plan design information. Due to constant
economic, legal and regulatory changes, individuals should always seek
specific legal, financial planning and employee benefit information from
legal counsel, financial institutions and employee benefit professionals.
An advance word about the organization of this book: Each chapter
is designed to be read as a freestanding piece, rather than to assume
that the book is being read as a whole, which would require the reader
to search for various definitions of terms; instead an editorial decision
has been made to restate each term's meaning in each chapter as a
convenience to the reader.
Appreciation is expressed to the sponsors of the Employee Benefit
Research Institute, who generously made their benefit experts available
to oversee the technical information in this project, and especially to
the staff of EBRI, in particular, Frank McArdle, Chris Dolan, Anne May-
berry, Nancy Newman, Bonnie Newton, Cindy O'Connor, Stephanie Poe
and Lisa Schenkel, whose dedicated efforts made this third edition
possible.
DALLAS L. SALISBURY
President
June 30, 1987
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I. Trends in the Provision and Taxation
of Employee Benefits
Introduction
Employee benefit programs in the United States have a long his-
tory. They are part of a national commitment to provide economic
security to active workers, displaced and disabled workers, and re-
tirees and their families. Most American workers take the presence
of employer-provided employee benefits for granted. They also take
the current tax-favored treatment of these benefits for granted. Al-
though many employee benefit plans are relatively young, the exist-
ence of such programs dates back to colonial times. Here is a list of
landmark programs:
(1) Plymouth Colony settlers' military retirement program in 1636;
(2) Gallatin Glassworks' profit sharing plan in 1797;
(3) American Express Company's private-employer pension plan in 1875;
(4) Montgomery Ward Company's group health, life and accident insur-
ance program in 1910;
(5) Baylor University Hospital's formalized prepaid group hospitalization
plan in 1929.
Government involvement in employer-provided benefit plans be-
gan soon after that. In 1935, the U.S. Congress mandated the basic
retirement income portion of Social Security and in 1965 established
Medicare health insurance protection.
The tax treatment of these employee benefit programs has been
relatively consistent over time. Health insurance contributions by
employers are tax- exempt, and retirement and capital accumulation
programs are tax-deferred.' Nearly all current American workers have
experienced the present tax treatment of primary benefits (retire-
ment, health, life and disability) for their entire careers. The law has
changed over time to include nondiscrimination requirements such
'For more information, see Deborah J. Chollet, Employer-Provided Health Benefits:
Coverage, Provision and Policy Issues (Washington, DC: EBRI, 1984) and Sophie M.
Korczyk, Retirement Security and Tax Policy (Washington, DC: EBRI, 1984).
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that benefits are now generally available to all workers. Minimum
standards for retirement, capital accumulation and welfare programs
ensure that benefit promises are kept. Recent tax reform legislation
makes the nondiscrimination rules for pension and welfare benefits
even more stringent.
The growth of employee benefits as a form of employee compen-
sation has attracted increasing attention in recent years chiefly be-
cause of a concern that the growth of benefits occurs at the expense
of growth in wage and salary income. Slower growth of wages and
salaries, in turn, implies slower growth of the tax base. Erosion of
the tax base affects the public sector's ability to finance government
programs in general and the Social Security system in particular. In
addition, growth of nontaxable benefits may generate an important
redistribution of the tax burden across the population. These effects
of growth in employee benefits, and in tax-exempt benefits in par-
ticular, merit careful attention.
What Are Employee Benefits?
Employee benefits represent virtually any form of compensation
provided: (1) in a form other than direct wages; and (2) paid for in
whole or in part by the employer, even if provided by a third party
(e.g., the government, an insurance company or a health maintenance
organization). Generally, news stories, cost surveys and government
reports lump all benefits together. However, different benefits serve
different social and economic needs.
Many benefits are required by law. These include employer con-
tributions to Social Security, Medicare, unemployment insurance and
workers' compensation insurance.
Other employee benefit programs are voluntary (discretionary). They
serve different goals, and receive different tax treatment. Some of
them are fully taxable (primarily, payment for time not worked).
Other programs insure the employee against financial risks and are
tax-exempt (including employer contributions for health coverage, for
up to $5,000 of child care and the employer cost for the first $50,000
of group life insurance plans).
Certain benefits are designed primarily to help the employee meet
special needs and are tax-favored for that purpose. Other tax-exempt
benefits have traditionally been called "fringes" and are intended to
meet employer needs (including employer provision of purchase dis-
counts, job site cafeterias, special bonuses and awards, van pools,
clubs and parking).
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"Reimbursement account" benefit programs allow employees to
have spending accounts-funded by the employer or through salary
reduction-to pay certain expenses specified in the law. Monies al-
located to reimbursement accounts are also tax-exempt (including
health care reimbursement, dependent care reimbursement, etc.).
Retirement income benefit programs help protect employees against
income loss at retirement. Taxes are deferred until benefits are re-
ceived, but withdrawals before age 59 1/2 are generally taxed as or-
dinary income and an additional 10 percent penalty tax is imposed,
unless the withdrawal meets one of several exceptions. Defined ben-'
efit (pension) plans are those in which the employee is promised a
benefit and the employer bears the risk/reward of investment returns.'
Defined contribution (capital accumulation) plans are those in which'
the employee is promised a contribution and the employee bears the
risk/reward of investment returns.
Other programs provide for the deferral of salary until termination
of employment, and generally pay benefits as a lump sum (including
contributions to some profit sharing plans, money purchase plans,
employee stock ownership plans (ESOPs) and salary reduction plans).
Again, taxes are deferred until benefits are received, but withdrawals
before age 59 1/2 are generally taxed as ordinary income and an
additional 10 percent penalty tax is imposed, unless the withdrawal
meets one of several exceptions.
Why We Have Employee Benefits
The Congress, public- and private-sector employers and public- and
private-sector employee representatives have historically shown con-
cern for the welfare of workers, their dependents and their eventual
survivors. This concern has created what some have described as a
"social contract" between the government, employers and American
workers and their families.
A formal employee benefit program can meet needs arising from
death, disability, medical problems, or the desire to retire, in a fair,
consistent, efficient and reliable way.
The nation benefits from employee benefits in many ways.
(1) Morale is improved if workers and their families are relieved of worry
and fear over possible financial disaster from unexpected or unplanned
events. Retirement, for example, may be unplanned if the individual
does not save enough to afford retirement.
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(2) Social Security retirement, employer-based pensions that pay lifetime
benefits, employer-based pensions that provide for capital accumula-
tion and individual retirement accounts (IRAs) have all been estab-
lished to meet the national goal of allowing retirees to maintain
preretirement lifestyles. Experience in this country and in other nations
has shown that this "organized" savings effort is essential, particularly
at low- and middle-income levels.
(3) Social Security disability, Medicare, Medicaid and employer-based
health, life, and disability insurance programs have been established
to protect the working, nonworking and retired against financial dis-
aster.
(4) The nation achieves other work force objectives by providing employer-
based employee benefit programs. For example, when workers can
afford to retire, channels for promotion are kept open. If bad economic
times require work force reductions, voluntary early retirements can
be encouraged with employer-based pension programs. Employer-based
profit sharing, employee stock ownership and stock purchase programs
strengthen worker identification with the success of the company and
thus enhance productivity, work quality and competitiveness.
(5) Experience in the United States and abroad has shown that a com-
bination of social and employer-based programs is the most efficient
and effective way to meet economic security needs and objectives.
Social programs like Social Security, Medicare and Medicaid help the
poor. They also give middle- and upper-income workers a basic level
of support. Employer-based tax-favored employee benefit programs
build upon these programs. These include, for example, health insur-
ance programs for both active workers and retirees.
As pay-as-you-go social programs-such as Social Security and
Medicare-age, and as the "return on contributions" continues to
drop, popular support may be endangered. For these social programs
to retain public support from the middle-class, employer-based pro-
grams that benefit middle-class beneficiaries must continue to be
available, especially if the federal government makes further reduc-
tions in social program benefits to the middle class.
Employer-based benefits have now been a part of the work place
for the entire working lives of most of those working today for gov-
ernment, unionized private employers, large nonunionized private
employers and many small employers. Employee benefits are viewed
by most workers as part of a contract that should and will not be
abolished-by employers or the government. This attitude is the most
likely explanation for survey results indicating that employees today
take for granted a good benefit package and would strongly oppose
government efforts to take away or tax employee benefits.
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Tax Incentives Encourage Benefit Availability
Expanded employer pension and welfare plans over the past thirty
years have significantly improved the income security of current
workers and future retirees. This development has been encouraged
by tax incentives. In 1985, the Social Security retirement and dis-
ability programs paid over $186 billion in benefits to over 37 million
beneficiaries. Over 820,000 employer-based pension programs pro-
vided coverage to approximately 52 million workers and paid about
$129 billion in benefits to more than 15 million beneficiaries. Med-
icare provided $70 billion in health protection, and privately admin-
istered group health insurance plans provided $106 billion.
Employer-Provided Pensions
Tax deferral of employer pension contributions and individual re-
tirement savings provides an important incentive for employers and
workers to provide for retirement income. Between 1950 and 1983,
employee participation in employer-sponsored pensions rose by nearly
300 percent. Since 1960, 20 to 30 percent of the increase in employer
pension contributions can be attributed to favorable tax incentives
and the growth of real marginal tax rates (the amount of tax paid for
each additional $1 of income, adjusted for inflation).
The increasing importance of pensions as a source of income for
future retirees is the direct result of past growth in pension plan
participation among workers. The future rate of pension recipiency
among today's young workers (ages 25 to 34) is projected to be nearly
50 percent more than that of workers who are retiring today. Forty-
eight percent of those now retiring (ages 55 to 64) who have families
receive an average pension benefit of $7,100, whereas about 71 per-
cent of today's young workers who have (or will have) families will
receive an average pension benefit of about $13,000 (in inflation-
adjusted dollars calculated using 1985 as the base year).
Employer-Provided Health Insurance
Employer group health insurance coverage for workers and their
dependents has become the most common benefit offered to employ-
ees in the United States. Insurance coverage for major health care
expenses and access to health care services has risen steadily among
the U.S. population since 1960. In 1985, almost 132 million nonelderly
civilian, nonagricultural workers and their family members reported
coverage from an employer group health insurance plan, excluding
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people employed in agriculture or the military and members of their
families. Congress has made extensive private health insurance cov-
erage a public policy goal.
Eliminating tax preferences for employer health insurance contri-
butions might dramatically reduce coverage rates among low-income
workers and their families, among workers and their dependents who
experience unemployment during the year, and among persons who
are eligible for Medicaid or Medicare.
An Employee Benefit Research Institute (EBRI) simulation of the
probable pattern of coverage loss suggests that tax preferences for
employer health insurance contributions strongly benefit low-income
workers and their dependents, provide important economic security
for workers with fragmented employment histories, and reduce the
cost of public health care entitlement programs.
Tax preferences for employer health and pension contributions and
individual saving for retirement are critical factors in determining
worker participation and coverage. Nondiscrimination provisions in
the tax code make tax benefits contingent on the breadth of the plan's
coverage; that is, both high- and low-income workers must be in-
cluded and receive comparable benefits from tax-qualified plans.
Employee Benefits Available at All Earnings Levels
Employee benefits are widely distributed among workers and their
families at all income levels. In the United States, most workers have
low and middle incomes. Reflecting this pattern, most workers who
participate in employer pension and health insurance plans are low-
or middle-income workers. In 1983, 76 percent of all wage and salary
workers covered by an employer pension plan and 80 percent of work-
ers covered by an employer group health plan earned less than $25,000.
The distribution of IRA savings among income groups also suggests
distribution of IRA tax advantages at every income level. In 1982, 18
percent of all new IRA accounts and 14 percent of all additional IRA
contributions were made by households with adjusted gross incomes
less than $20,000. More than a third of all IRA contributions (34
percent) were made by households with adjusted gross incomes of
less than $30,000. The share of total IRA contributions by lower- and
middle-income workers will probably increase in the future, because
of new restrictions on the eligibility of higher-paid workers contained
in the Tax Reform Act of 1986.
Employer sponsorship increases availability of employee benefits.
But there is no evidence that tax preferences for employer- and
employee-based employee benefits favor only highly paid workers.
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Pensions Provide Savings
Pension coverage constitutes the major source of savings for more
than half of current pension participants. Of the 38.8 million persons
(40.5 percent of the labor force) who had little or no savings of their
own in 1983, 18.2 million (almost half) were covered by employer
pensions. Since these persons had incomes just over half the size of
those with some savings, it follows that employer-provided pensions
distribute wealth more equally than would be the case in their ab-
sence. Federal tax law has been effective in encouraging retirement
savings at lower income levels. Without such law, this lower-income
saving could not otherwise be expected.
Total Cost of Employee Benefits
According to EBRI tabulations of U.S. Chamber of Commerce data,
private- and public-sector employer contributions to fully taxable,
tax-exempt and tax-deferred employee benefits exceeded 35.2 percent
of wages and salaries in 1985. Nearly two-thirds of this figure (23.0
percent of wages and salaries) represented: (1) legally required em-
ployer payments (8.2 percent of wages and salaries); and (2) voluntary
employer payments (14.8 percent of wages and salaries) that are fully
taxable. Legally required employer payments include contributions
for Social Security, unemployment compensation, workers' compen-
sation and a variety of smaller public insurance programs.
Total voluntary employer contributions to benefits (i.e., taxable and
tax-favored benefits) in the Chamber of Commerce data represented
27.0 percent of wages and salaries in 1985. Of this amount, over half
(55 percent) were fully taxable both by Social Security and by the
individual income tax. The fully taxable benefits reported in the data
include employer payments for time not worked (paid vacations, hol-
idays and sick leave) as well as paid rest periods, lunch periods and
other paid employee time not directly spent in production. About
one-third of the total level of employee benefits reported in the data
(34.5 percent) represent voluntary tax-favored benefits paid by em-
ployers. In 1985, all tax-favored benefits totaled 12.2 percent of wages
and salaries.
Size of Tax-Favored Benefits
Employer contributions to tax-favored benefits (those that are not
taxed as current income to the employee) can be divided into two
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groups: benefits on which taxes are deferred and benefits that are tax-
exempt.
(1) Tax-deferred benefits primarily include employer contributions to pri-
vate and public retirement income and profit sharing plans. These
constituted about 7.2 percent of wages and salaries in 1985. Taxation
of these benefits is deferred until the employee withdraws funds from
the plan.
(2) Tax-exempt benefits include employer contributions to group health
plans, life insurance (up to $50,000 face value) and a variety of smaller
benefits that include dental insurance, dependent care, merchandise
discounts and employer-provided meals. These benefits constituted 5.0
percent of wages and salaries in 1985.
Failure to distinguish among the growth of legally required em-
ployer payments, fully taxable employee benefits, tax-deferred ben-
efits and tax-exempt benefits has greatly distorted the perception of
the tax-base erosion that can be attributed to tax-favored and tax-
exempt benefits.
The size of tax-favored benefits as a proportion of wages and salaries
is much smaller than is commonly perceived. As shown in chart 1,
voluntary, tax-favored employee benefits for private- and public-
sector employees equal only 12.2 percent of wages and salaries.
Growth of Tax-Favored Benefit Costs
Over the past thirty years, tax-favored employee benefit costs have
grown more rapidly than wages and salaries, and slightly faster than
legally required employer payments. Consequently, tax-favored ben-
efits have absorbed a rising share of total compensation. Although
there have been increasing tax incentives for tax-favored employee
benefits, the growth of these benefits as a share of total compensation
has been remarkably slow. Additionally, the rise in cost of tax-favored
benefits appears to be slowing. Employers are increasingly concerned
about controlling benefit and other costs that affect their competitive
position in the marketplace.
Data compiled by the U.S. Department of Commerce indicate that
employer contributions to all voluntary benefits as a fraction of wages
and salaries increased at an average annual rate of 6.3 percent be-
tween 1960 and 1985.
The relatively faster growth of 15 percent a year in the early 1970s
reflects several factors. The growth of pension contributions can be
attributed to the slow growth of wages both before and during the
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Chart 1
Employer Spending for Employee Benefits
as a Percent of Wages and Salaries, 1985
Legally Required
Payments
Voluntary Taxable
Benefits
Voluntary Tax-
Favored Benefits
Percent: o
Source: EBRI tabulations of U.S. Chamber of Commerce data.
1973-75 economic recession; employer efforts to improve pension
funding in anticipation of-and in response to-the enactment of the
Employee Retirement Income Security Act (ERISA) in 1974; and net
growth in pension plan participation. The growth of health contri-
butions can be attributed to growth in health plan participation and
sudden increases in the employer cost of group health insurance ben-
efits. The recent slower growth of employer pension contributions
appears likely to continue, according to employer surveys.
Employer contributions to group health insurance are the fastest
growing employee benefits. The expansion of worker and dependents'
coverage under employer group health plans, the enhancement of
benefits under these plans and persistent high inflation in health care
costs have all contributed to the growth of employer contributions
to health insurance as a share of compensation. Between 1950 and
1980, employer health insurance contributions as a percent of wages
and salaries have risen at an average annual rate of 7.4 percent.
Reflecting continued high inflation in health care costs since 1980,
employer contributions to health insurance have continued to grow
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at an average annual rate 4.2 percent faster than the growth of wages
and salaries.
Benefit Cost Variation by Employer
The value of voluntary employee benefits varies significantly from
employer to employer. During 1985, total value ranged from 10.7 to
34.4 percent of total compensation among Fortune 500 firms, and the
expenditure would be lower for very young and small businesses.
Significant variation is also found in industries. Among industries in
1985, average value ranged from 14.8 percent in retailing to 24.8
percent of total compensation in banks.
Benefit Cost Variation by Employee Age
Employee benefits, such as defined benefit pensions and health
insurance, are almost always discussed as a flat-dollar cost per em-
ployee or as a level percentage of pay per employee. Employee rep-
resentatives, employees, and employers have been content with this
approach since the actual distribution of cost does not affect either
the taxes to be paid by the employee or the employer. As a result,
the only attention given to individual employee cost variation has
been undertaken very recently to assess: (1) approaches to health care
cost management; and (2) possible disincentives to hiring or retaining
e older workers. These recent studies show very significant cost vari-
ation by age. Workers age 30 to 44 cost the employer 80 percent of
the average medical cost, whereas those age 55 to 59 cost 125 percent
and those 65 to 69 cost 225 percent of the average medical cost.
New Forms of Employee Benefits
The growth of new tax-favored employee benefits has come under
close scrutiny due to concern that these benefits might represent
further erosion of the tax base. In fact, employers often have inde-
pendent motivations for setting up these plans. The growth of new
benefits-in particular, section 401(k) salary reduction arrangements
and section 125 cafeteria plans2-generally represents an effort by
employers to contain the employer cost of tax-favored employee ben-
efits. Introduction of child care programs is an accommodation to
the growing number of working mothers, particularly single heads
'For more information on section 401(k) arrangements and cafeteria plans, see chapters
X and XXXI, respectively.
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of households, who could not work if such programs were not avail-
able.
Rising employer pension costs have prompted several innovations
in the design of retirement income plans. Section 401(k) arrange-
ments, authorized by the Revenue Act of 1978, have become an in-
creasingly popular tool for controlling employer retirement plan costs.
Employees are able to supplement employer contributions to a sec-
tion 401(k) arrangement with tax-deferred contributions of their own.
Section 401(k) arrangements-and other defined contribution plans-
represent a way to provide employees with some inflation protection
in retirement at a substantially lower cost to employers. Unlike de-
fined benefit plans, which promise a fixed benefit, defined contri-
bution plans are, in effect, better protected against inflation. The
dollar value of the assets in the individual's account tends to rise
along with the general price level.
Section 401(k) arrangements also meet the demand for retirement
income security among mobile workers and workers with irregular
labor force participation. Employee contributions to section 401(k)
arrangements are, by law, fully and immediately vested.
The growth of cafeteria (or section 125) plans also reflects employ-
ers' efforts to control the cost of employee benefits. Generally, the
primary motive of employers in establishing a cafeteria plan is the
containment of employer contributions to health insurance and to
make workers more sensitive to health costs. Cafeteria plans encour-
age employees-to elect less generous health insurance coverage and
substitute other benefits-both tax-favored and fully taxable bene-
fits-for generous health insurance coverage. As do section 401(k)
arrangements, cafeteria plans enable employers to meet the benefit
needs of an increasingly diverse work force-including young work-
ers, dual income families and single employees-while controlling
total benefit costs.
Impact of Tax Reform
The recently enacted tax reform legislation makes dramatic changes
in employee benefits both through the numerous provisions directly
affecting benefits and through the overall reduction in individual
income tax rates.
The changes in the pension and welfare benefit area are intended'
to produce more comparable employee benefit coverage of rank-and-
file employees and of highly compensated employees. Pension changes'
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will increase the number of vested workers through faster vesting
schedules, increase pension amounts for rank-and-file employees by
limiting the coordination with Social Security benefits, and mandate
broader and more comparable coverage of rank-and-file employees.
Higher-paid employees, however, suffer potential losses in benefits:
restrictions on 401(k) salary reduction contributions ($7,000 cap, tigh-
ter nondiscrimination rules and inclusion of all after-tax contribu-
tions as annual additions under the section 415 limits); a new limit
of $200,000 on the amount of compensation that may be taken into
account under all qualified plans; a new excess benefit tax of 15
percent on most annual distributions over $112,500; and sharply re-
duced maximum benefits payable to early retirees under defined ben-
efit plans.
Changes in welfare benefit areas aim for the same effect: an in-
tended broadening of benefits because of tighter nondiscrimination
rules that also could reduce tax-favored benefits payable to the higher
paid. Government staff has argued that reduced tax-favored benefits
for the highly paid employees may be viewed as more comparable
coverage of rank and file and highly paid when considered in terms
of dollars, versus percent of compensation.
In all, the employee benefit changes are far less punitive than those
originally contained in the 1984 Treasury proposal. Favorable tax
treatment is retained for most benefits, except education assistance,
group legal services and van pooling, which lose the income tax ex-
clusion. Also, nondiscrimination rules for medical and group life in-
surance coverage are much more flexible than the original Treasury
proposal, and permit a greater disparity between highly paid and
rank-and-file employees.
Still, dramatic effects may be anticipated. The reduction in mar-
ginal tax rates will remove a significant force that historically con-
tributed to the growth in employee benefits, and future growth will
be slowed; coverage may not improve and may actually decline in
the small business sector, where a top rate of 28 percent for the owners
and a 15 percent rate for 80 percent of taxpayers may make cash
more attractive than benefits, which are also more difficult to ad-
minister under the new rules. The desirability of deferring compen-
sation for nonretirement purposes under qualified plans is also called
into question, because of new penalties on early withdrawals and the
expectation that future tax rates may be higher than current rates.
Finally, because of the new restrictions on the higher paid, many
employers will face the option of removing the higher paid from their
general qualified benefit plans, which could result in deterioration
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in benefits for rank-and-file employees. As more of their compensation
is provided through nonqualified plans, the higher compensated might
"lose their stake" in the general benefit plan. Obviously, whether
nondiscrimination rules cause expanded and more comparable cov-
erage of rank-and-file employees, or reduce tax-favored benefits for
the highly paid, will differ from employer to employer.
Employee benefits will remain an important piece of total com-
pensation, but the changes in their tax effectiveness may prompt a
reevaluation of overall benefits and a return to the basic purposes
employee benefits were intended to fulfill: the promotion of economic
security and human resource needs.
Importance of Employee Communications
The recent, massive changes in the tax rules governing employee
benefits brought about by tax reform will, among other things, re-
quire employers to communicate more to employees about the recent
changes and the effects of the new rules.
The importance of effective communication to employees cannot
be overstated. Focus groups consisting of older workers, in discussions
sponsored by EBRI and the American Association of Retired Persons
(AARP), emphatically demonstrated that most older workers delay
their financial and retirement planning until age 50 or later, when
it is more difficult to accumulate the additional savings needed for
a comfortable and secure retirement. Most of the individuals lacked
detailed knowledge of their benefit provisions, particularly the pen-
sion provisions, and some had made serious miscalculations of what
their retirement income would be.
Among workers generally, a lack of understanding of employee
benefit costs and provisions contributes to a lack of appreciation for
what is provided by employers and the vast sums of money involved
in providing economic security to workers. Clearly, employers and.
employees would both have much to gain if the full dimensions of
employee benefits were better known and appreciated by employees.
Likewise, public policy decisions, which are often made by legislators
with an eye on the size of the potential constituency for these pro-
grams, would also more accurately reflect the widespread provision
of benefits through the work place.
Fortunately, employers have increasingly begun to see the need for
more effective employee communication on benefit issues, and some
are taking bold new steps to enhance employee understanding. Com-
prehensive communication and education routinely take place, for
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example, when a firm establishes a flexible compensation plan, and
employees have to be educated in order to make the choices required
of them as participants of a flexible benefit plan. Also health care
cost management, which is now practiced by the vast majority of the
nation's large employers, also requires education and communication
to employees about elements in the redesign of health plans, and
how, for example, reimbursement levels can vary depending on the
type of plan selected and the type of provider.
Because financial planning has become more important (and more
complicated), some employers are creating computerized benefit
communications programs to make it easier for employees to plan
their future. This advanced new communications practice helps em-
ployees understand the true value of all employee benefits offered,
and it equips them with the information needed to make the many
choices common in today's benefit packages.
Easy-to-use computer terminals and computer programs allow an
employee access to his or her personal benefits record. They could
show, for example, account balances in savings plans; covered ser-
vices under health plans; life insurance available; and accrued pen-
sion benefits. And they could indicate whether any of the savings
account balance is available for borrowing and how much loan re-
payment will affect take-home pay.
In flexible benefit arrangements, employees can visualize how dif-
ferent choices of benefits might work. The system could project what
their future pension and Social Security benefits might be. It could
also compare current taxable income and future retirement income
if a specific percentage of salary is set aside in the company's savings
plan. Repeating the same exercise with different contribution amounts
can help employees decide how much of current pay can be used to
meet future needs. Computerized communication systems promise
to make financial planning through employee benefits simpler and
more reliable.
Whether or not an employer can install computerized or videotaped
employee communications packages depends a great deal on the size
of the employer and the resources available for this purpose. But
regardless of the method of communication chosen, more-and more
effective-employee commmunication and education will represent
a continuing trend in the future. Frequent changes in laws and reg-
ulations governing employee benefits, the desire of more employers
to accommodate the request for a greater range of benefit choices by
employees, and the continuing efforts of employers to redesign their
employee benefit packages in the most cost-effective manner, all con-
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tribute to make comprehensive employee communication an essen-
tial ingredient in virtually all employee benefit activities.
Conclusion
Tax laws favoring employee benefits were enacted in the belief that
extensive coverage of workers and their families is desirable social
policy. The growth of worker coverage by pensions and health in-
surance, in particular, has been strongly encouraged by the tax ad-
vantages given these plans and by the the needs of workers and their
families for economic security. As we have seen, pensions and health
insurance are broadly distributed among lower- and middle-income
workers.
Women are gaining pension entitlement in greater numbers than
ever before. Among those women meeting ERISA standards for plan
participation, coverage expanded by 2.2 million workers between
1979 and 1983, and nearly 1.3 million more women became entitled
to pension benefits at retirement.
This government policy to encourage employee benefits has been
a success. This book describes the many different types of benefits
that exist. Each must be carefully evaluated by workers, employers
and the federal government. The favorable tax treatment may not be
crucial to the existence of some benefits-but it is essential to the
provision of employee benefits at all income levels.
Other nations now seek to duplicate the success of this nation in
developing a true public- and private-sector partnership in meeting
economic security needs. Were employer-sponsored benefits to dis-
appear, one could expect higher rates of poverty among the elderly,
greater demands on social programs, heightened strife among gen-
erations and tens of millions of surprised and disappointed Amer-
icans.
Additional Information
Employee Benefit Research Institute. America in Transition: Benefits for the
Future. Washington, DC: EBRI, 1987.
. "Tax Reform and Employee Benefits." EBRI Issue Brief 59 (October
1986).
. "Long-Term Effects of Tax Reform on Retirement Income: Many Un-
answered Questions." EBRI Issue Brief 64 (March 1987).
Hosay, Cynthia K., Ph.D. "Communicating Health Care Options and Cost
Management Programs." Employee Benefits Journal (June 1986): 10-14.
Watters, Deborah A. "New Technologies for Benefits Communication."
Personnel Administrator (November 1986): 110, 112, 114.
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H. Social Security
Introduction
Congress passed the Social Security Act in 1935, and it became
effective on January 1, 1937. The original legislation has been amended
many times since then, and has become a complex set of laws, rules
and regulations governing and influencing the lives of all Americans
in one way or another. This chapter represents a brief overview of
Social Security, its benefits and its costs-present and future.
What Is Social Security?
Mention Social Security to a dozen people and they will conjure
up a dozen different ideas-and for good reason. The Social Security
Handbook, published by the federal government, contains close to
400 pages of explanation on the Social Security Act and refers the
reader to thousands of additional pages of explanation contained in
other volumes. In describing Social Security, the Handbook states:
The Social Security Act and related laws established a number of
programs which have the basic objectives of providing for the ma-
terial needs of individuals and families, protecting aged and disabled
persons against the expenses of illnesses that could otherwise ex-
haust their savings, keeping families together, and giving children
the opportunity to grow up in health and security. These programs
include:
(1) Old-Age Insurance (frequently referred to as Retirement insurance);
(2) Survivors Insurance;
(3) Disability Insurance;
(4) Medicare for the Aged and Disabled;
(a) Hospital Insurance (HI)-Part A;
(b) Supplementary Medical Insurance (SMI)-Part B;
(5) Black Lung Benefits;
(6) Supplemental Security Income;
(7) Unemployment Insurance;
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(8) Public Assistance and Welfare Services;
(a) aid to needy families with children;
(b) medical assistance;
(c) maternal and child-health services;
(d) services for crippled children;
(e) child welfare services;
(f) food stamps;
(g) energy assistance.
The federal government operates the first six programs listed above.
The remaining programs are operated by the states with the federal
government cooperating and contributing funds.
This chapter limits itself to a discussion of the first four programs:
Old-Age, Survivors, Disability and Medicare, and refers to them col-
lectively as Social Security. This is partly for simplicity, but largely
because these four programs are: (1) financed primarily by the Social
Security payroll taxes paid by employees, employers and self-
employed persons; and (2) usually thought of by the public as Social
Security. An exception to this financing method is the Supplementary
Medical Insurance program, Part B, of Medicare. This program is
financed by premiums paid by those electing to be covered by SMI
and by general revenues.
Participation
Who is covered by Social Security; thus, who is eligible for Old-
Age, Survivors, Disability and Medicare benefits? When Social
Security took effect in 1937, it applied only to workers in industry
and commerce-about 60 percent of all working persons. Since then,
there has been a steady movement toward covering all workers.
The Social Security Act originally excluded all state and local gov-
ernment employees from Social Security coverage because of the
question of whether the federal government could legally tax state
employers. Workers for certain nonprofit organizations that are tra-
ditionally exempt from income taxes were also excluded. Federal
government employees were excluded because of the existence of the
Civil Service Retirement System established in 1920.
Coverage was extended substantially in the early 1950s to most
self-employed, farm and household workers, and to members of the
armed forces.
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Legislation enacted in 1950 (and later) provided that employees of
state and local governments and nonprofit organizations could be
covered by Social Security on a voluntary basis under certain con-
ditions. The Social Security Amendments of 1983 changed the law to
require the coverage of employees of all nonprofit organizations. This
legislation also mandated that state and local governments, which
elected to become covered by Social Security, could not later with-
draw from the program. Additionally, beginning in 1984, new federal
government employees became covered by Social Security.
Mandatory coverage now extends to private-sector workers, non-
profit-sector workers, military personnel, 10 percent of all federal
civilian employees who joined the government before 1984 and all
federal civilian employees hired after December 31, 1983. Social Se-
curity presently covers about 95 percent of all United States workers.
Benefits
Because of the complexity of Social Security, this section gives only
an overview of the program's benefits. For specific information con-
cerning benefits that would be payable in a particular case, it is best
to contact a local Social Security Administration office.
To assure that covered earnings are appropriately recorded on
Social Security records, workers should review their past earnings
records every three years. This can be accomplished by submitting
Form SSA-7004 (Request for Statement of Earnings). This form is avail-
able through local Social Security Administration offices. A response
usually takes six weeks.
In a nutshell, Social Security replaces a portion of covered earnings
that are lost as a result of a person's old age, disability or death; and
it pays a portion of the medical expenses of aged and disabled persons.
Social Security provides a much wider variety of benefits than is
generally recognized. In fact, monthly cash benefits to retired workers
represented about 50 percent of total Social Security benefits in-
cluding Medicare for calendar year 1985.
Old-Age, Survivors and Disability Insurance-The benefits that are
provided under the Old-Age, Survivors and Disability Insurance
(OASDI) programs are:
(1) monthly benefits to those workers who are at least 62 years old and
retired or partially retired; in addition, monthly benefits to their eli-
gible spouses and dependents;
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(2) monthly benefits to disabled workers, their eligible spouses and de-
pendents;1
(3) a lump-sum death payment and monthly benefits to eligible survivors
of deceased workers.
Any person who is at least 62 years old in 1987 and who has earned
at least 36 quarters of coverage in his or her lifetime, working at a
job subject to the Social Security tax, is eligible to retire and receive
a Social Security monthly benefit.
Persons age 62 or over who do not have a sufficient earnings record
to get benefits on their own can, nevertheless receive a spouse's ben-
efit, provided the husband or wife is entitled to benefits on the basis
of his or her earnings record and is drawing benefits. The spouse's
benefit adds an extra 50 percent to the primary retiree's benefit if
the spouse is 65 or over, but somewhat less if the spouse is between
62 and 65.
In cases where an individual is entitled to a benefit on the basis of
his or her own lifetime earnings and also to a spousal benefit, the
effect is that the person gets whichever is greater.
Starting in 1985, there was a new provision for divorced spouses.
In the past, a divorced woman, for example, could get a spouse's
benefit if she had been married at least ten years to her former
husband, but only if he had retired and started receiving benefits
of his own. This created severe problems in cases where the former
husband did not retire; the ex-spouse could not get any bene-
fit. Now, even if the former husband is not retired, the ex-spouse
can receive the benefit if they both are at least 62, were married
10 years, have been divorced at least 2 years and the former
husband worked under Social Security long enough to qualify for
benefits.
Receipt of spouse's benefits by a former spouse does not take any-
thing from a current spouse. Each could receive a spouse's benefit,
although the current spouse would have to wait until the benefit
earner retired.
The 1983 Social Security Amendments made significant changes
in benefit eligibility. While reduced benefits will continue to be paid
at age 62, the age for receiving full benefits, now available at age 65,
will be increased in the future. The full benefit age will increase by
two months a year for people reaching age 62 between the years 2000
`For more information on Social Security Disability Insurance, see chapter XXVII.
2For more information on Social Security survivor benefits, see chapter XXVI.
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and 2005. The full benefit age will remain at 66 for people reaching
age 62 in the years 2006 through 2016. The full benefit age will in-
crease again by two months a year for people reaching age 62 between
2017 and 2022. It will remain at 67 for those who reach age 62 after
2022.
The early retirement benefit amount, which is payable at age 62,
will be reduced over this period. The maximum reduction for early
retirement benefits will increase from its present 20 percent to 30
percent for those who reach age 62 in 2022 or later.
Monthly benefit amounts are related to the average earnings on
which a worker pays Social Security taxes throughout his or her
career years. When computing benefits, a worker's average earnings
are indexed to changes that have taken place in national average
earnings over the worker's career years. To assist in achieving a social
adequacy goal, benefits are higher (relative to preretirement earnings)
for persons with low career earnings than for persons with high av-
erage earnings. Also, benefits are reduced or withheld altogether, if
a participant under age 70 works after retiring and earns income that
exceeds specified amounts.
Once monthly benefits begin, they are generally adjusted auto-
matically each December to take into account Consumer Price Index
(CPI) changes. Prior to 1986, these adjustments generally occurred
only if the CPI increased by 3 percent or more since the last automatic
adjustment. In 1986, Congress passed legislation that removed the 3
percent trigger for automatic adjustments, so that cost-of-living ad-
justments are tied to the rate of inflation.
Social Security benefits were not subject to federal, state or local
income taxes (or to Social Security tax) prior to the 1983 Amend-
ments. Beginning in 1984, however, up to one-half of Social Se-
curity benefits are included in taxable income for: (1) single taxpayers
whose income exceeds $25,000; (2) married taxpayers filing jointly
with a combined income of $32,000; and (3) all married taxpayers
who lived with their spouses anytime during the tax year and file
separately. For purposes of calculating these income levels, income
includes: adjusted gross income, plus nontaxable interest income,
plus one-half of Social Security benefits. For more details, please
review Internal Revenue Service tax form instructions.
Social Security was not designed to meet all the financial needs
that arise from a person's old age, disability or death. It is necessary
to supplement Social Security with private savings and employer-
sponsored retirement plans. This applies particularly to persons who
earn higher than average incomes during their working years because
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of the covered earnings limitation and the benefit formula which
favors lower-paid workers.
During 1987, about 38 million persons in the United States will
receive a Social Security OASDI benefit payment. In the same year,
total cash benefit payments will reach about $205 billion.
Hospital Insurance and Supplementary Medical Insurance-The
Medicare program has two parts: Hospital Insurance and Supple-
mentary Medical Insurance. The Hospital Insurance program is au-
tomatic for those covered by Social Security or the Railroad Retirement
plan. Additionally, all federal civilian employees were covered by HI
beginning in 1983 and state and local government employees hired
after March 31, 1986 were covered by HI beginning April 1, 1986. HI
provides benefits for individuals: (1) age 65 or older; (2) receiving
Social Security disability benefits for more than 24 consecutive months;
and (3) disabled by chronic kidney disease that requires dialysis or
a transplant. Those who are not automatically covered by Social
Security may elect to be covered by the HI program at their own
expense. HI helps to pay for inpatient hospital care and for certain
follow-up care after leaving the hospital.
During 1987, approximately 28.4 million persons age 65 and over
will be covered under HI (i.e., they will be eligible for HI benefits in
the event of illness). This represented more than 95 percent of all
persons age 65 and over in the United States and its territories. An-
other 3 million disabled persons under age 65 will be covered by HI.
The Supplementary Medical Insurance program is voluntary; it
is offered to almost all persons age 65 and over and to those under
age 65 who are covered by HI. Those who participate must pay a
premium. Individuals not covered by Social Security or the Rail-
road Retirement program who elect HI must also pay for SMI. SMI
coverage, however, can be elected independent of HI coverage. SMI
helps to pay for doctor services and outpatient hospital services,
as well as many other medical items and services not covered by
HI.
Approximately 28 million persons age 65 and over were covered
under SMI in 1987. Again, this represented over 95 percent of all
persons age 65 and over in the United States and its territories.
Another 3 million disabled persons who were under age 65 were
covered by SMI.
Total Medicare benefit payments in 1987 are projected in Social
Security's 1986 Annual Report at $76.2 billion; this represents ap-
proximately 50 percent of the total medical expenses of those par-
ticipating in the two programs.
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How Social Security Is Funded
Social Security is financed primarily by payroll taxes paid by em-
ployees, employers, and the self-employed. These taxes are held by
special Social Security trust funds and can be used only to pay Social
Security benefits and administrative expenses of the program. Any
trust fund assets not needed to meet current costs are invested in
U.S. government securities.
In 1987, participating workers pay Social Security taxes of 7.15
percent of earnings (subject to maximum taxable earnings of $43,800).
The employer matches this amount. Payroll taxes account for about
97 percent of the total income for the Old-Age, Survivors, Disability
and Hospital Insurance programs. Approximately 1 percent of the
income for these programs comes from interest earnings on the trust
funds; 0.4 percent is from general revenues and is used to finance
special benefits. Beginning in 1984, OASDI began receiving income
from the taxation of some Social Security benefits. General revenues
from taxation benefits account for the remaining 1.6 percent of the
total income for OASDI and HI. The general revenue contribution,
however, will increase in the future as a result of the 1983 Amend-
ments, which include a provision for shifting amounts equal to tax
liabilities on Social Security benefits from the general fund to the
Social Security trust funds. Also, general revenues will contribute
amounts equal to the employer share of the Social Security tax with
respect to coverage of federal employment.
The 1983 Social Security Amendments increased tax rates for em-
ployers, their employees and the self-employed. To lessen the burden
of the tax increases, income tax credits (against Social Security tax
liability) were provided to employees (in 1984 only) and to self-
employed persons in 1984 to 1989.
The tax rates for employees and employers are scheduled to in-
crease from 7.15 percent in 1986-1987, to 7.51 percent in 1988-1989
and 7.65 percent in 1990. The maximum taxable earnings will in-
crease in future years at the same rate as the average earnings of all
the nation's workers. This maximum is $43,800 in 1987.
Self-employed persons have the same maximum taxable earnings
base as other workers; but they pay higher tax rates, since they do
not have an employer with whom to share the total tax. The self-
employed tax rate will be 14.3 percent in 1986-1987, 15.02 percent
in 1988-1989, and 15.30 percent in 1990. An income tax credit of 2.0
percent in 1986-1989 is allowed the self-employed, offsetting their
Social Security tax liability. Beginning in 1990, self-employed per-
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sons will pay Social Security taxes on a reduced earnings base; in
addition they will be allowed to deduct 50 percent of their Social
Security tax as a business expense. To assess your eligibility for such
tax treatment, check your income tax form instructions.
The 1983 Amendments were designed to improve the financial
soundness of the Old-Age and Survivors Insurance program. That
goal will be accomplished if the economic and demographic as-
sumptions used by Congress prove to have been correct. The Medicare
program, however, is in need of reform. Without changes, the pro-
gram is projected to have insufficient funds around the turn of the
century.
Unlike the other Social Security programs we have discussed, SMI
is not financed by payroll taxes. The cost of SMI was originally taken
care of through premiums imposed on participants and matching
payments from general revenues. At the present time, however, about
75 percent of SMI's total cost is paid from general revenues because,
by law, premiums have not been permitted to rise as rapidly as pro-
gram costs.
Outlook
Social Security's development is a continuing process. The program
is a product of the decisions made by policymakers living in an ever
changing social and economic environment.
Men and women under age thirty-nine comprise over 60 percent
of today's population. When the bulk of these young persons approach
retirement some 30 to 50 years from now, social and economic con-
ditions are likely to be quite different than they are today or than
they have been in the past. Accordingly, it is reasonable to expect
society to begin now to make the changes necessary to assure that
the Social Security program will be appropriate for the future social
and economic environment.
Public understanding or misunderstanding will play a more im-
portant role in determining the future shape of the program than it
did in the past when Social Security taxes were relatively low and
the average worker was less questioning. One problem confronting
Social Security is a lack of public understanding about the program-
its basic rationale, the type and level of benefits it provides, the
tenuous relationship between individual taxes paid and individual
benefits received, its method of financing and the significance of its
projected high future costs. The better we understand Social Security,
the greater are our chances that the program will be modified to
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coincide with our desires. Public acceptance will be necessary for a
program that is scheduled to pay benefits, and to require tax collec-
tions amounting to trillions of dollars during the next 10 years.
The Social Security Administration has expanded its efforts to ed-
ucate the public. In addition, a number of advisory groups and com-
missions regularly study the various aspects of Social Security. This
attention and scrutiny may result in a certain amount of turmoil; in
the long-run, however, it will improve the Social Security program.
Conclusion
The recent changes in Social Security legislated in 1983 have re-
solved the immediate financial difficulties that plagued the system.
The latest actuarial estimates by the Social Security Board of Trust-
ees generally project that OASDI benefits can be paid on time well
into the next century, although some experts believe the system will
still encounter difficulties in the long-term, as the large "baby boom"
generation reaches retirement age.
The inadequate financing of the Medicare program is currently the
major concern of the elderly and of public policymakers in general.
Social Security and Medicare are large, well established and rec-
ognized as an integral part of the national socioeconomic structure.
Will the Social Security program and Medicare continue to grow?
Will they grow in a way that best reconciles beneficiaries' economic
needs and taxpayers' financial abilities? Or, will they be curtailed
because of heavy financial burdens? The answers to these questions
depend largely upon the dialogue among an informed citizenry.
Additional Information
For further information, contact your local Social Security office.
Ackenbaum, W. Andrew. Social Security: Visions and Revisions. New York,
NY: Cambridge University Press, 1986.
Boskin, Michael J. Too Many Promises. Homewood, IL: Dow Jones-Irwin,
1986.
Lubove, Roy. The Struggle for Social Security, 1900-1935. 2nd Edition. Pitts-
burgh, PA: University of Pittsburgh Press, 1986.
U.S. Department of Health and Human Services, Social Security Adminis-
tration. Social Security Handbook, 1986. Washington, DC: U.S. Government
Printing Office, 1986.
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III. Employee Retirement Income
Security Act
Introduction
The Employee Retirement Income Security Act (ERISA) was signed
by President Ford on Labor Day, September 2, 1974. It is the most
comprehensive employee benefits legislation ever enacted in the United
States. ERISA affects millions of working Americans who are covered
by private-sector employee benefit programs. Although the law is
frequently referred to as the Pension Reform Act, it affects almost all
types of employee benefit plans.
ERISA has a long history. In 1962, President Kennedy appointed
a committee to study corporate pension plans. The committee's report
was released in 1965; it dealt with areas such as labor mobility,
vesting, funding and the financial aspects of private retirement plans.'
One of the committee's conclusions was that "private pension plans
should continue as a major element in the nation's total retirement
security program. Their strength rests on the supplementation they
can provide to the basic public system." This report led to a series
of investigations by various congressional committees and subcom-
mittees, which resulted in the introduction of numerous bills to reg-
ulate private pension plans.
Congress found that the number of benefit plans was substantial,
and that these plans were important to the well-being and security
of millions of American workers and their dependents. Congress de-
termined that there was insufficient employee information and there
were inadequate safeguards for employee benefit plans. ERISA was
passed because Congress believed that "minimum standards [should]
be provided assuring the equitable character of such plans and their
financial soundness."
Studies and congressional hearings leading to the passage of ERISA
showed that most plans were operated for the benefit of participants
and beneficiaries. However, the small proportion of exceptions were
not to be tolerated. ERISA represents a strong commitment to pro-
tecting the rights of plan participants. This legislation has created a
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greater awareness of the need to: (1) provide continuing attention to
employee benefits; (2) protect plan participants and beneficiaries;
and (3) realize employee benefit plan goals.
Employee benefit plan sponsors must design and administer their
plans according to legal standards. Employees and beneficiaries must
be given a summary plan description (SPD) and they must have access
to plan financial information. These requirements are part of ERISA's
reporting and disclosure provisions. Reporting requirements were ex-
panded under ERISA to include almost all types of employee benefit
plans. These requirements are intended to provide the information
needed to determine whether participants' rights and benefits are
protected.
Retirement plans must meet minimum standards in areas such as
participation, vesting and benefit accrual. Certain retirement plans
are subject to minimum funding standards, which are designed to
ensure that money is available to pay benefits when participants
retire.
ERISA's fiduciary standards apply to most plans. These standards
require those who conduct the plan's business (i.e., fiduciaries) to do
so for the exclusive benefit of plan participants and beneficiaries.
One of the most important features of ERISA is plan termination
insurance. Through this insurance, the government guarantees some
benefits if certain types of retirement plans terminate. The Pension
Benefit Guaranty Corporation (PBGC) was established to administer
the termination insurance program.
ERISA originally set limits on the benefit amounts that retirement
plans could provide. Under defined benefit plans-these plans prom-
ise to pay a stated monthly benefit-the initial maximum benefit
amount was $75,000 per year. Under defined contribution plans-
these plans specify an employer contribution rather than a fixed ben-
efit-the limit applies to the amount of money that can be contributed
to a participant's account in any year.2 The initial contribution limit
was $25,000. Before 1983, the maximum benefit and contribution
limits were adjusted annually to reflect increases in the cost of living.
The 1982 Tax Equity and Fiscal Responsibility Act (TEFRA), however,
imposed new benefit and contribution limits beginning in 1983, and
2For more information on defined benefit and defined contribution plans, see chapter
VI.
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froze them at these levels until 1985. The Deficit Reduction Act of
1984 (DEFRA) extended the freeze on cost-of-living adjustments until
1988. The Tax Reform Act of 1986 (TRA) made further changes. The
annual benefit limit under a defined benefit plan is the lesser of
$90,000 or 100 percent of the employee's average compensation for
his or her three highest earning years; and the annual contribution
limit under a defined contribution plan is the lesser of $30,000 or 25
percent of an employee's compensation. Under TRA, all employee
after-tax contributions must be counted as part of annual additions.
The defined contribution limit will remain unchanged until the de-
fined benefit limit, which is indexed to the Consumer Price Index
beginning in 1988, reaches $120,000. This 4:1 ratio will then be main-
tained in the future.
Certain plans are also required to use more accelerated vesting and
to provide minimum benefits in years when the plan primarily ben-
efits key employees 3
In addition to its impact on employee benefit plans, ERISA affected
workers who were not covered by employer retirement plans. It cre-
ated a means for such workers to save pretax earnings toward their
own retirement (and their spouse's retirement) through individual
retirement accounts.
Scope of ERISA
Although ERISA primarily applies to private retirement plans, al-
most all employee benefit plans are subject to some provisions of the
act. The legislation affects welfare plans, such as those providing
health insurance, group life insurance, sick pay and long-term dis-
ability income; and retirement plans, such as pension plans, profit
sharing plans, thrift plans and stock bonus plans. There are no general
exclusions based on employer or plan size. Other groups that sponsor
benefit plans, for example, associations and labor organizations, are
also affected.
Reporting and Disclosure
ERISA's extensive reporting and disclosure requirements are rooted
in a belief that availability of information serves two important needs.
First, adequate communications about the plan to participants can
3Key employees are company officers or other individuals meeting specified ownership
and earnings criteria.
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lead to realistic employee expectations of their benefits. Second,
periodic government reporting enables officials to monitor legal
compliance.
Reporting to Participants/Beneficiaries-The summary plan descrip-
tion is probably the most important document provided to plan par-
ticipants and beneficiaries. It is required for all plans that are subject
to ERISA. This summary must be:
(1) written so the average participant can understand it;
(2) accurate and detailed enough to reasonably inform participants and
beneficiaries of their rights and obligations.
The law does not dictate the exact form the summary description
should take. It does, however, require inclusion of specific informa-
tion. For example, among other things, an SPD must include:
(1) the name and address of the employer or employee organization main-
taining the plan;
(2) the name and/or title and business address of each trustee;
(3) plan requirements for participation and benefit accrual eligibility;
(4) a description of provisions for nonforfeitable pension benefits;
(5) information regarding credited service and breaks in service;
(6) a description of situations that may result in disqualification, denial,
loss or forfeiture of benefits.
In addition to the summary plan description, each participant and
beneficiary must have access to financial information about the plan.
This information is provided in summary form; it is the summary of
a more extensive annual report filed with the Internal Revenue Service
(IRS). Such information enables participants and beneficiaries to gain
an awareness of the plan's financial status and the types of financial
transactions engaged in during the preceding year.
Participants are also entitled to see certain documents relating to
the plan (e.g., complete annual report, personal pension benefits state-
ment). A participant who requests such material and does not receive
it within 30 days may file suit in a federal court. The court may
require the plan administrator to furnish the materials, and it may
impose a fine of up to $100 a day until the materials are received.
Certain events may generate the need for other reports. For ex-
ample, a plan participant who terminates service with vested benefits
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must be given a statement showing the amount of accrued and vested
benefits. Once a year, participants and beneficiaries may request a
written statement of accrued and vested benefits.
Government Agencies and Reports-Three government agencies ad-
minister ERISA: the Internal Revenue Service, the Department of
Labor (DOL) and the Pension Benefit Guaranty Corporation. The IRS
is concerned primarily with qualified retirement plans-those offer-
ing employers and employees favorable income tax treatment under
a special section of the tax law. DOL's main responsibility is to protect
participants' rights. If a defined benefit plan terminates, PBGC in-
sures that guaranteed benefits are paid to participants.
Plan sponsors must file an annual report with the IRS. The IRS
then sends the report to DOL. Additionally, some information from
the report is sent to the PBGC. The report provides detailed infor-
mation on the number of plan participants, distributions made to
participants and beneficiaries, and the amount and nature of the
plan's assets. (This information is available to participants and ben-
eficiaries in the form of a summary referred to earlier.) Other reports
must be filed when certain events occur. DOL, for example, must be
notified when a new plan is established (the summary plan descrip-
tion serves this purpose). PBGC must be notified when defined benefit
plans are terminated. Again, the reports are intended to help the
government ensure that plans are operated according to the law and
that participants' rights are protected.
Minimum Standards
Under ERISA, both the DOL and IRS are responsible for enforcing
retirement plan participation, vesting and benefit accrual standards.
The law also created funding standards for defined benefit pension
plan sponsors, intended to protect plan participants. These standards
represent minimum requirements; employers may adopt plans with
more liberal provisions.
Participation-ERISA does not require employers to provide pen-
sion plans to all their employees. It is permissible, for example, to
design retirement plans covering only hourly employees. If an em-
ployer sponsors a plan for all employees or for a specific group of
employees, such employees must be covered by the plan after satis-
fying minimum age and service requirements.
In most situations, employees become eligible to participate in
retirement plans when they reach age 21 and have completed one
year of service. (Before the Retirement Equity Act of 1984 (REA)
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became law, ERISA's minimum age requirement was 25.) An excep-
tion applies to plans with immediate vesting; such plans may require
three years of service. In plan years beginning after December 31,
1988, the maximum service requirement is lowered to two years.)
These minimum standards have made it possible for more employees
to participate in retirement plans.
Vesting-Vested benefits are those that are earned by an employee
and cannot be revoked by an employer. Employees attain vested rights
to benefits after satisfying specific service, or age and service require-
ments. (REA reduced the age at which an employee begins earning
vesting credits from 22 to 18.) Once vested, an employee's benefit
rights cannot be revoked, even if employment with the plan sponsor
is terminated. In some cases, participants who terminate employment
after they are vested may receive their benefits immediately. In other
cases, they may receive the vested benefits at some future date when
they retire.
With respect to benefits attributed to employer contributions, pen-
sion plans generally must satisfy one of three alternative vesting
formulas:
(1) Ten-Year Service Rule-An employee must receive nonforfeitable rights
to all accrued pension benefits after 10 years of service.
(2) Graded 15-Year Service Rule-An employee must receive nonforfeitable
rights to 25 percent of accrued pension benefits after five years of
service. Vested rights must then increase by 5 percent in each of the
next five years and 10 percent in each of the following five years. Thus,
the employee is 25 percent vested after 5 years, 40 percent vested after
8 years, 50 percent vested after 10 years and 100 percent vested after
15 years of service with any one private plan sponsor.
(3) `Rule of 45"-An employee gains nonforfeitable rights to 50 percent
of accrued pension benefits by satisfying one of two conditions: (a) 10
years of service with the plan sponsor; or (b) five or more years of
service and age and length of service totaling 45 (e.g., age 37 with 8
years of service). After the employee has vested 50 percent, he or she
will vest another 10 percent in each of the next 5 years 4
4Additionally, a different rule may apply to defined contribution money purchase,
profit sharing and thrift plans where plans provide class-year vesting. Class-year vest-
ing occurs when each year's contribution is vested after some period has expired (the
law allows a five-year maximum). Under the class-year approach, the employee may
not fully vest and may forfeit some employer contributions in the years prior to
termination. In plan years beginning after December 31, 1988, class-year vesting that
does not meet either of the two new minimum vesting schedules will not be permitted.
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In plan years beginning after December 31, 1988, the 1986 Tax
Reform Act requires employer contributions to vest according to
one of two schedules: (1) 100 percent after five years of service or
(2) 20 percent after three years of service and 20 percent after each
subsequent year of service until 100 percent at the end of seven
years of service. These vesting rules are applicable for employer
contributions to private-sector, single-employer pension plans.
Multiemployer plans can use different vesting schedules, but under
TRA must fully vest employer contributions after a maximum of
10 years.
Full vesting also occurs at normal or early retirement and, in some
plans, at death or disability. Loss or suspension of benefits occurs in
some situations, however. If a participant and spouse have both waived
the preretirement survivor option, the spouse will not be entitled to
the vested benefit of the participant should he or she die before re-
tirement. Additionally, benefits to retired participants may be sus-
pended during reemployment. And, participants who take their own
contributions out of the plan may-if they are not sufficiently vested-
lose their rights to employer plan contributions.
In many cases, an employee who is not vested can have a break in
service without losing credit for previous service. The break-in-service
rules under REA require prior service to be reinstated unless the break
is equal to, or exceeds, the greater of five years or the number of prior
years of service.
Joint and Survivor Annuities-ERISA mandates that private em-
ployer retirement plans provide a qualified joint and survivor an-
nuity option for retired married participants as the normal method
of benefit payment. This provides the surviving spouse with a
monthly income equal to at least half the amount of the employee's
benefit. In return for this protection, the employee's benefit usually
is reduced. In order to select a pension paid over the duration of
the participant's life only, both the participant and the spouse must
refuse the joint and survivor option in writing. (The spouses' sig-
natures must be notarized or made before a plan administrator.)
Private employer plans may, but are not required to, make death
benefits available to vested participants in the form of a life insurance
contract or a cash distribution.
Preretirement Survivor Annuities-Prior to 1985, preretirement
survivor benefits were available only after the participant was el-
igible for early retirement. Under REA, all spouses of vested par-
ticipants who die before retirement are eligible for preretirement
survivor benefits, payable at the plan's earliest retirement date.
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Both the signature of the participant and spouse are required to
opt out of this benefit.
These survivor benefit provisions must be explained to plan par-
ticipants in detail. They are intended to assist a participant in as-
suring that the surviving spouse is provided with a pension at retirement
age.5
Benefit Accrual-ERISA also imposes a standard for the rate at
which benefits are accrued (i.e., earned) by participants. In general,
benefits must be earned evenly over the period of a worker's plan
participation. The law focuses only on the rate of benefit accrual; it
does not specifically consider benefit levels.
Funding-To ensure that plans have the money necessary to pay
benefits when participants retire, ERISA established minimum fund-
ing standards for defined benefit plans. Employers who sponsor these
plans must make at least the minimum required plan contribution
each year. If they do not make the necessary contribution without
prior IRS approval, they are subject to a tax on the unpaid amount.
Employers are able to get IRS funding waivers only in limited cir-
cumstances.
Fiduciary Standards
Employers who sponsored retirement plans before ERISA were
subject to one general fiduciary standard: plans had to be operated
for the exclusive benefit of participants and beneficiaries. ERISA ex-
panded this principle and established fiduciary standards that apply
to almost all employee benefit plans. Fiduciaries are defined as: (1)
those who exercise control or discretion in managing plan assets; (2)
those who provide investment advice to the plan; and (3) those who
have discretionary authority in administering the plan. ERISA's fi-
duciary standards apply to most professionals who are involved in
plan operation. For example, in an individual employer plan, the
trustee, the plan administrator and the employer are normally con-
sidered fiduciaries.
Basic Standards-Plan fiduciaries must meet certain basic stan-
dards in fulfilling their responsibilities. A fiduciary must: (1) act in
the exclusive interest of plan participants and plan beneficiaries; (2)
manage the plan's assets to minimize risk of large losses; and (3) act
in accordance with documents that govern the plan.
'For more information on survivor benefits under pension plans, survivor income plans
and Social Security, see chapter XXVI.
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Fiduciaries must act also "with the care, skill, prudence and dili-
gence under the circumstances then prevailing that a prudent man
acting in a like capacity and familiar with such matters would use
in the conduct of an enterprise of a like character and with like aims."
This standard is frequently referred to as ERISA's prudent man rule.
Because the performance standard is so high, the prudent man rule
can be translated to require the actions that a prudent expert would
take. Fiduciaries must meet this test in performing all aspects of plan
operation-from selecting the individual or institution that will han-
dle plan asset investment, to setting investment objectives. Invest-
ments that were once acceptable may carry an element of risk that
is too large to be considered prudent under current regulations.
Impact of Fiduciary Standards-A fiduciary who violates ERISA's
standards is personally liable to cover any losses resulting from fail-
ure to meet responsibilities, and he or she must return any personal
profits realized from his or her actions. Additionally, fiduciaries may
be liable for the misconduct of other fiduciaries, if they know about
such misconduct.
Enforcement of fiduciary standards permits certain penalties. Loss
of favorable tax treatment may apply to some plans, but more ex-
tensive remedies are available to the government as well as to plan
participants and beneficiaries. In some situations, the IRS may tax
the person, such as the employer, who engages in a prohibited trans-
action; or the DOL may bring suit on behalf of participants in plans
that do not satisfy ERISA's fiduciary standards.
Additional Employee Protection
Plans must provide an appeals procedure to participants whose
claims are partially or completely denied. The reason for claim denial
must be provided in writing to the participant, and the participant
must have the right to request a reconsideration of the decision. If
the claim is denied again, the participant can file suit in federal or
state court to enforce his or her benefit rights.
ERISA prohibits anyone, including the employer, from discrimi-
nating against a participant who has exercised his or her legal rights.
If a participant is fired or otherwise discriminated against for exer-
cising his or her rights, he or she may seek assistance from the DOL,
or may file suit in federal court.
Plan Termination Insurance
Plan termination insurance is probably ERISA's most innovative
change. The Pension Benefit Guaranty Corporation, a governmental
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body created by ERISA, insures payment of certain pension plan
benefits in the event a covered plan terminates with insufficient funds
to pay promised benefits. Employers (and jointly managed funds)
with private, defined benefit plans are required to pay annual pre-
miums to the PBGC to provide funds from which guaranteed benefits
can be paid.
ERISA set the premium for single-employer plans at $1 per plan
participant per year. The rate, which can only be raised after congres-
sional approval, was raised to $2.60 for plan years beginning in 1978
and was raised again to $8.50 per plan participant for plan years after
December 31, 1985. In 1987, PBGC again requested a premium in-
crease. Multiemployer premium rates, originally set at $.50 per plan
participant per year were raised by the 1980 Multiemployer Pension
Plan Amendments Act (MPPAA) to $1.40 and are scheduled to increase
to $2.60 over a nine-year period. PBGC can designate a more rapid
multiemployer premium increase to protect the termination insur-
ance program's financial soundness; however, premiums cannot be
raised in excess of $2.60 without congressional approval.
Termination Policy-Terminations of single-employer plans are re-
stricted to two cases: a "standard" termination and a "distress" ter-
mination. A standard termination is permitted only if the plan holds
sufficient assets to pay all "benefit commitments" under the plan.
Benefit commitments are defined as all PBGC guaranteed benefits,
all benefits that would be guaranteed if not for maximum benefit
limits or phase-in rules, and early retirement supplements and plant-
closing benefits that were vested before termination. Thus, benefit
commitments include virtually all accrued basic benefits vested be-
fore termination and some accrued nonbasic benefits vested prior to
termination. Although under ERISA all accrued benefits become vested
at termination, benefit commitments do not include benefits that
become vested solely due to plan termination.
A plan that lacks sufficient assets to pay benefit commitments may
be terminated only when the employer is in financial "distress." To
terminate a plan in a distress situation, the plan administrator must
show that: (1) a petition has been filed in bankruptcy or other state
insolvency proceedings seeking liquidation of the employer; (2) a sim-
ilar petition has been filed seeking reorganization of the employer
and the bankruptcy court has approved the termination; (3) the em-
ployer will be unable to pay its debts when due; or (4) pension costs
have become unreasonably burdensome due to a declining work force.
For multiemployer plans, which cover the workers of two or more
unrelated companies under a collective bargaining agreement, PBGC
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provided insurance coverage on a discretionary, plan-by-plan basis
to participants of terminating plans until 1980. However, MPPAA
established significant benefit guarantee provisions for all collec-
tively bargained plans contributed to by "more than one employer."6
Covered Plans and Benefits-PBGC guarantees the retirement, death
and disability benefits of those who are private-sector, defined benefit
plan beneficiaries should a plan terminate. It also guarantees the
vested retirement benefits of those who are private-sector, defined
benefit plan participants should a plan terminate. Benefit guarantees
are expressed in terms of straight life annuities that begin at age 65.
There are certain restrictions on the monthly benefit amount PBGC
will pay. In general, payment is limited to a maximum dollar amount
that is adjusted annually to reflect the increasing average wages of
American workers ($1,857.95 in 1987). The limit applies to all plans
in which a participant is covered-it is not possible to receive sep-
arate insurance protection under several plans and, thus, to increase
the total guaranteed benefit.
For single-employer, defined benefit plans, insurance on new ben-
efit provisions (i.e., benefits resulting from newly established plans
or recent plan amendments) is phased in at 20 percent per year.
Therefore, full insurance coverage applies only to benefit provisions
that have been in effect for five consecutive years prior to plan ter-
mination. The guarantee pertains exclusively to benefits earned while
the plan is qualified for favorable tax treatment. Additionally, ben-
efits are guaranteed up to the stipulated maximum.
For multiemployer plans, MPPAA established a level of guaranteed
benefits that is generally lower than single-employer plan benefit
guarantees. No portions of multiemployer plan benefits are guaran-
teed until they have been in effect for five years; and the maximum
amount guaranteed per year of service is 100 percent of the first $5
in monthly benefit rate plus 75 percent of the lesser of the next $15
or the accrual rate in excess of $5. Where plans seeking guarantees
are insolvent, the guarantee's second tier is reduced from 75 percent
to 65 percent.
Employer Liability to PBGC-In a distress termination, the termi-
nating employer is liable to PBGC and to plan participants for un-
funded benefit commitments up to a maximum limit, which is the
6Under ERISA's 1974 provisions, certain plans that were maintained by "more than
one employer" were treated as single-employer plans. MPPAA allowed these plans to
irrevocably elect-within one year of MPPAA enactment-to remain classified as
single-employer plans.
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sum of: (1) the full amount of unfunded PBGC guaranteed benefits
up to 30 percent of net worth; (2) 75 percent of unfunded PBGC
guaranteed benefits in excess of 30 percent of net worth; and (3)
interest on the amount due calculated from the termination date.
The employer is additionally liable to plan participants for a por-
tion of unfunded, nonguaranteed benefit commitments. That liability
is limited to the lesser of: (1) 75 percent of the unfunded, nonguar-
anteed vested benefit commitments or (2) 15 percent of total vested
benefit commitments.
Different rules apply for certain types of multiemployer plans. Be-
cause employers signatory to a multiemployer plan may withdraw
from the plan-or reduce contributions to the plan-without ter-
mination, MPPAA imposes liability upon an employer for withdrawal
from the plan. Withdrawal liability is a legal obligation requiring an
employer, who discontinues or sharply reduces contributions to a
multiemployer plan, to pay for its share of the plan's unfunded vested
benefits. The employer must continue to make annual payments for
20 years or until the liability is satisfied, whichever occurs first.
Under MPPAA, full withdrawal occurs when an employer's contri-
bution obligation to a plan permanently ceases, or if all of an em-
ployer's covered operations under a plan permanently cease. Partial
withdrawal occurs when there is a gradual reduction in an employer's
contribution base (i.e., if there is a 70-percent decline in the number
of contribution units-for example, hours worked) continuing for three
years. Partial withdrawal also results when an employer is no longer
obligated to contribute: (1) under one of two or more collective bar-
gaining agreements even though work continues that previously re-
quired contributions; or (2) because one or more (but not all) of an
employer's facilities withdraws from a plan, although work continues
at the withdrawing facility. PBGC assumes liability only when the
entire plan is in financial difficulty. Thus, for multiemployer plans,
plan insolvency, rather than plan termination, is the insured event.
Plan trustees are responsible for: (1) identifying withdrawing em-
ployers; (2) calculating the amount of the withdrawal liability; and
(3) collecting this liability.
Multiemployer plan trustees can: (1) adopt one of four methods set
forth by PBGC for computing the employer's share of the unfunded
vested benefits; or (2) develop their own computation method subject
to PBGC approval. If plans do not choose a method themselves, MPPAA
requires that withdrawing employers use the presumptive rule. This
rule may be more complicated and more costly than some of the
other calculation rules. Plan trustees, therefore, should carefully eval-
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uate each of the withdrawal liability calculation methods to decide
which is most practical for their individual circumstances.
Some limited exemptions from withdrawal liability apply to the
building, construction, entertainment, trucking, moving and ware-
housing industries. A de minimis rule may also be used; under this
rule, withdrawal liabilities may be waived for an employer whose
share is less than $50,000 or .75 percent of the plan's total unfunded
liability, whichever is smaller.
Unlike a single-employer plan termination where the employer's
liability is limited to 30 percent of net worth, there is no limit on net
worth for multiemployer plan withdrawal liability.
Conclusion
Since ERISA became law, thousands of plans have been amended
to comply with its requirements. As areas that were initially over-
looked or treated inadequately are identified, additional changes can
be anticipated. The PBGC insurance program is a good example of a
provision of ERISA that has undergone significant change. More
changes can be expected, particularly for the single-employer ter-
mination insurance program.
Additional Information
The ERISA Industry Committee
1726 M Street, NW
Washington, DC 20036
U.S. Department of Labor
Pension and Welfare Benefits Administration
200 Constitution Avenue, NW
Washington, DC 20210
Coleman, Barbara J. Primer on Employee Retirement Income Security Act.
Washington, DC: Bureau of National Affairs, Inc., 1985.
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IV. Pension Plans
In 1759, the first pension plan was established in the United States
to benefit widows and children of Presbyterian ministers. The first
pension plan was established for United States' workers a century
later when New York City created a fund for retired policemen. Only
15 percent of all privately employed nonfarm workers were covered
by pension programs in 1930. Pension plans began to play a promi-
nent role in providing retirement income security to American work-
ers in the years after World War II. By 1983, employer-sponsored
pension and profit sharing plans covered about 52 million people-
more than half of the nation's work force.
Before the second World War, private pensions were considered to
be employer gifts in recognition of long and faithful service. Typically,
employers did not assume an obligation to provide retirement ben-
efits to either retired or active employees. The employer gratuity phi-
losophy evolved gradually into a theory of human depreciation. Since
the employee's value as a worker depreciated over his or her working
life, employers were thought to have a moral obligation to provide
for employees when they were too old (and nonproductive) to con-
tinue in the labor force. The human depreciation theory has been
supplemented by another theory holding that pensions represent de-
ferred employee wages. Under this theory, an employee group is viewed
as having a choice between immediate wage increases and a pension
plan-if the employees choose the pension plan, the pension benefits
are regarded as a form of deferred wages. Although this theory has
some weaknesses, it is growing in popularity and has become the
most prevalent view.
Qualified Plans
The Internal Revenue Code (IRC) was amended in 1942 to incor-
porate general guidelines for the design and operation of pension
plans (as well as profit sharing and stock bonus plans). The amend-
ments were intended to prevent discrimination in favor of the pro-
hibited group (i.e., shareholders, officers and highly paid employees)
with regard to pension plan coverage, benefits and financing. The
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amendments were also intended to protect federal revenues against
excessive tax deductions for contributions to these employee benefit
plans. Except in the areas of participation, vesting and minimum fund-
ing, the 1974 Employee Retirement Income Security Act (ERISA) did
not change significantly these basic plan qualification requirements.
The 1986 Tax Reform Act (TRA), however, made further changes
in these rules, which are described in a later section, for plan years
beginning after December 31, 1988.
A tax-qualified plan offers advantages to both employers and em-
ployees: (1) the employer can claim an immediate income tax de-
duction for contributions to the plan; and (2) plan participants are
not subject to current income taxation on employer contributions
and the investment earnings on plan assets until benefits are received.
Also, plan assets are held in tax-exempt trust funds, which do not
pay taxes on the trust's investment earnings.
Additionally, a terminating employee who receives a lump-sum
distribution from an employer pension plan may, within 60 days, roll
over all or part of the distribution to another qualified plan or an
individual retirement account (IRA). If the rollover occurs, the em-
ployee is not taxed on the amount transferred to the other plan or
the IRA.1
The primary requirements for tax qualification are:
(1) The plan's provisions must be delineated in a written document.
(2) The plan must be established with the intent of being a permanent
and continuing arrangement.
(3) The plan must provide coverage to employees in general-not just to
a select group of employees.
(4) The plan's assets must be held separate from the employer's general
assets.
(5) The plan contributions and benefits must not discriminate in favor of
the prohibited group.
Numerous changes have been made to the tax treatment of qual-
ified pension plans. TRA: (1) phased out capital gains treatment for
lump-sum distributions over 6 years beginning on January 1, 1987;
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and (2) eliminated 10-year forward averaging for taxable years be-
ginning after December 31, 1986, and instead, permitted a one-time
election of 5-year forward averaging for a lump-sum distribution re-
ceived after attainment of age 59 1/2. Forward averaging is the ability
to pay taxes on lump-sum distributions at a certain fraction of the
marginal rate. Under a transition rule, a participant who attained
age 50 by January 1, 1986, is permitted to make one election of 5-
year forward averaging or 10-year forward averaging (at present-law
rates) with respect to a single lump-sum distribution without regard
to attainment of age 59 1/2, and to retain the capital gains character
of the pre-1974 portion of such a distribution. Under the transition
rule, the pre-1974 capital gains portion is taxed at a rate of 20 percent.
TRA provides significant penalties for most early distributions from
qualified retirement plans. It applies a 10 percent additional income
tax to all early distributions includible in gross income, regardless
of the character of the contribution to which the distribution relates,
from a qualified plan, qualified annuity plan, tax-sheltered annuity
or IRA, made before death, disability or attainment of age 59 1/2 in
taxable years beginning after December 31, 1986; but it does not apply
to sec. 457 plans, which are plans commonly used by state and local
governments.
The 10 percent additional tax does not apply to certain distribu-
tions: (1) in the form of an annuity payable over the life or life ex-
pectancy of the participant (or the joint lives or life expectancy of
the participant and the participant's beneficiary); (2) made after the
participant has attained age 55 and separated from service; (3) used
for payment of medical expenses to the extent deductible under fed-
eral income tax (i.e., in excess of 7.5 percent of adjusted gross income);
(4) received from an employee stock ownership plan (ESOP) before
January 1, 1990; (5) received in a lump sum prior to March 15, 1987,
if made on account of separation from service in 1986 if the recipient
elects to be taxed on the distribution in 1986; or (6) made to or on
the behalf of an alternate payee pursuant to a qualified domestic
relations order (QDRO).
Employers may elect to sponsor non qualified pension plans, which
do not meet the requirements of the IRC and, as a result, suffer dis-
advantages from a tax standpoint. These plans, however, are not
discussed in this chapter.
Plan Design
Pension plans can be classified into two major types: (1) single-
employer plans; and (2) multiemployer plans. Single-employer plans
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generally are established by the employer. Multiemployer plans gen-
erally cover union employees and are established by the participating
employees and the union through the collective bargaining process.
In both types of plans, there are certain decisions to be made. For
example: Who will be covered? What benefits will the plan provide?
Who will administer the plan? How will the plan be financed? All of
these decisions will be made within the constraints of the employer's
budget; and under the deferred wages theory of pensions, they are
subject to trade-offs between retirement income and current wages.
Coverage-Even though ERISA and the IRC set minimum partic-
ipation standards, there is some flexibility in deciding who will be
eligible for plan membership. If an employee is in the group covered
by a plan, once the employee reaches age 21 and completes one year
of service, the employee must be eligible to participate in the plan
(although there are some exceptions to this rule). More liberal stan-
dards may be set (e.g., employers could establish plans that cover all
employees immediately).
Coverage may be extended to particular employee groups, provided
certain restrictions of the IRC are satisfied. For example, the covered
group may be defined in one or more of several ways: (1) on a pay
basis (i.e., hourly or salaried employees); (2) according to job location
(i.e., employees in certain divisions, plants or subsidiaries); or (3) on
the basis of whether employees are union or nonunion. Employees
may be required to make contributions in order to be covered. Some
plans allow employees to elect not to participate.
In defining the covered employee group, the plan must not dis-
criminate in favor of the prohibited group, and it must be established
exclusively for the participants' benefit-rather than for the employ-
er's benefit.
TRA provides new coverage rules for qualified plans that require
one of the following tests to be satisfied:
(1) Seventy percent of all nonhighly compensated employees are covered
by the plan.
(2) The percentage of nonhighly compensated employees covered by the
plan is at least 70 percent of the percentage of highly compensated
employees covered.
(3) The group of employees covered by the plan satisfies the present-law
classification test, and the average benefit provided to all nonhighly
compensated employees (as a percentage of compensation), including
those not covered by the plan, is at least 70 percent of the average
benefit provided to highly compensated employees (as a percentage of
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compensation), including those not covered by the plan. In applying
the third test, all plans maintained by the employer, including elective
deferrals under a qualified cash or deferred arrangement, are taken
into account.
The provisions of TRA are generally effective for plan years beginning
after December 31, 1988. A special effective date applies to plans
maintained pursuant to a collective bargaining agreement.
Under TRA, a plan is not qualified unless it benefits no fewer than
the lesser of: (1) 50 employees or (2) 40 percent or more of all em-
ployees of the employer. The requirement may not be satisfied by
aggregating comparable plans. In the case of a cash or deferred ar-
rangement or the portion of a defined contribution plan to which
employee contributions or employer matching contributions are made,
for purposes of tests (1) and (2) above, an employee is treated as
benefiting under the plan if the employee was eligible to make con-
tributions to the plan.
TRA also provides a new uniform definition of the group of em-
ployees in whose favor discrimination is prohibited ("highly com-
pensated employees") that generally applies for purposes of the
nondiscrimination rules for qualified plans and statutory employee
benefit plans (such as medical and group term life insurance). The
new definition became effective for years beginning in 1987, except
to the extent that the substantive rule to which it relates is effective
at a later time (e.g., for 401(k) arrangements it is effective in 1987,
but for minimum coverage rules it is effective in 1989).
An employee is treated as highly compensated with respect to a
year if, at any time during the year or the preceding year, the em-
ployee: (1) was a 5 percent owner of the employer; (2) earned more
than $75,000 in annual compensation from the employer; (3) earned
more than $50,000 in annual compensation from the employer and
was a member of the top-paid group of employees, the top 20 percent
of employees by pay during the same year; or (4) was an officer of
the employer and received compensation greater than 150 percent of
the dollar limit on annual additions to a defined contribution plan
($45,000 in 1987). If for any year no officer of the employer received
compensation in excess of 150 percent of the defined contribution
plan dollar limit, then the highest-paid officer of the employer is
treated as a highly compensated employee.
A special rule applies to new hires and to those with increases in
compensation in the current year. Under this special rule, an em-
ployee who would be treated as highly compensated because the
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employee meets one of these last three tests stated above is not in-
cluded in the highly compensated group until the year after the year
in which the employee satisfies one of these tests. This one-year delay
does not apply in the case of a participant who is in the top 100 in
pay of the employer.
Defined Contribution Plans-Under defined contribution plans, em-
ployers pay a specific amount into the pension fund for each partic-
ipant. These payments accumulate, along with investment and interest
earnings, in separate participant accounts. Employer contributions
may be defined in some manner, such as either a percentage of salary
or profits. Defined contribution plans may also provide for employee
contributions, which may be either voluntary or mandatory. The re-
tirement benefit under these plans is determined by the amount in
the participant's account at retirement. As a result, the level of re-
tirement benefits cannot be calculated exactly in advance. There are
several types of defined contribution plans: (1) money-purchase pen-
sion plans; (2) profit sharing plans (including 401(k) arrangements);
(3) thrift plans; and (4) ESOPs.2
Defined Benefit Plans-These plans differ from defined contribution
plans. In defined benefit plans, the benefit is determined in advance,
based on a benefit formula. The benefit formula is one of three general
types: (1) a flat-benefit formula; (2) a career-average formula; or (3)
a final-pay formula.
(1) Flat-Benefit Formulas-These formulas pay a specific dollar amount
for each year of service recognized under the plan. They are most often
seen in collectively bargained plans or plans covering hourly paid em-
ployees; sometimes flat-benefit formulas are used to provide a mini-
mum benefit in plans covering salaried employees.
(2) Career-Average Formulas-There are two types of career-average for-
mulas. Under the first type, participants earn a percentage of the pay
recognized for plan purposes in each year they are plan participants;
the normal retirement benefit is the sum of the yearly benefit amounts.
The second type of career-average formula totals and then averages
the participant's yearly earnings over his or her period of plan partic-
ipation. At retirement, the benefit equals a percentage of the career-
average pay, multiplied by the participant's number of years of service.
Sometimes, the percentage used in the calculation will be higher for
career-average pay over a given pay breakpoint. Pay breakpoint for-
mulas produce a more generous benefit where higher earnings are
2Profit sharing, thrift, 401(k) arrangements and employee stock ownership plans are
discussed in greater detail in chapters VIII, IX, X and XI.
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available during later years, which offset lower earnings in earlier
years.
(3) Final-Pay Formulas-These plans base benefits on average earnings
during a specified number of years at the end of a participant's career;
this is presumably the time when an employee's earnings are highest.
Benefits equal a percentage of the employee's final average earnings,
multiplied by number of years of service. This formula provides the
greatest inflation protection to the participant, but it also represents
the greatest cost to the employer.
Career-average and final-pay formulas are most common in plans cov-
ering nonunion employees.
Under pay-related formulas, an employer has some discretion in
defining pay for plan purposes. He may choose to: (1) recognize all
compensation; (2) restrict the definition to base pay; or (3) choose a
definition that is a compromise between (1) and (2). Under ERISA's
minimum standards, there is also some leeway in determining what
employment period will be recognized in the benefit formula. The
benefit may reflect only the plan participation period; or it may be
based on the entire employment period.3
Contribution Limits-ERISA originally set limits on the benefit
amounts that retirement plans could provide. Under defined benefit
plans, the initial maximum benefit amount was $75,000 per year.
Under defined contribution plans, the limit applies to the amount of
money that can be contributed to a participant's account in any year.
The initial contribution limit was $25,000. Before 1983, the maximum
benefit and contribution limits were adjusted annually to reflect in-
creases in the cost of living. The 1982 Tax Equity and Fiscal Respon-
sibility Act (TEFRA), however, imposed new benefit and contribution
limits beginning in 1983, and froze them at these levels until 1985.
The Deficit Reduction Act of 1984 (DEFRA) extended the freeze on
cost-of-living adjustments until 1988. The Tax Reform Act of 1986
(TRA) made further changes. The annual benefit limit under a defined
benefit plan is the lesser of $90,000 or 100 percent of the employee's
average compensation for his or her three highest earning years; and
the annual contribution limit under a defined contribution plan is
the lesser of $30,000 or 25 percent of an employee's compensation.
Under TRA, all employee after-tax contributions must be counted as
part of annual additions. The defined contribution limit will remain
unchanged until the defined benefit limit, which is indexed to the
3Defined benefit and defined contribution plans are discussed in greater detail in
chapter VI.
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Consumer Price Index beginning in 1988, reaches $120,000. This 4:1
ratio will then be maintained in the future.
Pension Plan Integration-Social Security benefits replace a greater
proportion of preretirement earnings for lower-paid employees than
for higher-paid employees. This is caused by two factors. Social Se-
curity taxes and benefits are based on earnings up to the taxable wage
base, rather than on all earnings. In addition, the Social Security
benefit formula produces higher benefits-relative to earnings-for
lower-paid employees. Pension plan benefits can be coordinated with
Social Security benefits to reflect the tilt in Social Security's benefit
formula. Thus, to help compensate for Social Security's benefit tilt,
employers are permitted to provide proportionately higher pension
benefits to higher-paid employees than to lower-paid employees.
This benefit coordination, known as pension plan integration, can
be accomplished in one of two ways: (1) by subtracting a portion of
the Social Security benefit from the pension plan benefit; or (2) by
providing a higher benefit on earnings above a stated amount and a
lower benefit on earnings below that amount. The integration meth-
ods described here pertain to defined benefit plans and the integration
rules for defined benefit and defined contribution plans have been
substantially changed by TRA, effective for plan years beginning after
December 31, 1988.4
Vesting-Pension plans are required to satisfy ERISA's minimum
vesting provisions. Vesting occurs when a plan participant has earned
a right to his or her benefit that is not dependent on additional re-
quirements, such as continued employment. If a participant is vested
and terminates employment, he or she retains the right to pension
plan benefits. These benefits may be paid immediately or at some
future date. As a result of the Retirement Equity Act of 1984 (REA),
the vesting age has been reduced from 22 to 18.5
The vesting schedule may provide for: (1) immediate full vesting;
(2) full vesting after a certain number of years of service; (3) accrual
of a certain vesting percentage for each year of service; or (4) full
vesting after the sum of service years, plus the participant's age, equal
a specified amount. For plan years beginning after December 31, 1988,
TRA shortens vesting schedules for most plans. Under the new sched-
ules, a private-sector, single-employer plan must meet one of two
tests: (1) 100 percent vesting after five years of service; or (2) 20
4Pension plan integration methods for defined benefit and defined contribution plans,
as well as TRA changes, are discussed in chapter VII.
5ERISA's vesting requirements are discussed in greater detail on pages 32-33.
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percent after three years of service, with an additional 20 percent for
each subsequent year of service until 100 percent vesting is achieved
at the end of seven years of service. A special rule is provided in the
case of a multiemployer plan to require 100 percent vesting after 10
years of service.
Class-year vesting that does not meet either of the two new mini-
mum standards is not permitted for plan years beginning after De-
cember 31, 1988, effectively repealing the special class-year vesting
rule.6
TRA also provides that the current maximum waiting period for
plan participation of three years for plans with full and immediate
vesting is reduced to two years of service. If a plan requires an em-
ployee to complete more than one year of service as a condition of
participation, the employee must be 100 percent vested when the
benefit is accrued.
The above provisions of TRA are generally applicable for plan years
beginning after December 31, 1988, with respect to participants who
perform at least one hour of service after the effective date. A special
effective date applies to plans maintained pursuant to a collective
bargaining agreement.
Additionally, the 1982 Tax Equity and Fiscal Responsibility Act
requires certain plans to use more accelerated vesting provisions once
the plan becomes top-heavy (i.e., the plan primarily benefits key em-
ployees) .7
Loans-Some plans permit employees to borrow a portion of their
vested benefits. Generally, the employee repays the loan according
to a specified repayment schedule. If loans are permitted, they must
be: (1) available to all participants on a comparable basis; (2) ade-
quately secured; and (3) made by the plan (i.e., not by a third party
such as a bank). Loans from thrift plans must bear a reasonable
interest rate. Recent legislation has placed further restrictions on
loans.
(1) Loans for more than $10,000 may not exceed one-half of the present
value of the employee's nonforfeitable accrued benefit, subject to an
overall loan maximum of $50,000.
(2) Loans must be repaid under a level amortization schedule within 5
years, with payments at least quarterly.
6For a definition of class-year vesting, see footnote on p. 32.
7Key employees are individuals meeting specified ownership and earnings criteria.
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(3) The only allowable exception to the 5-year repayment rule is to acquire
a primary residence of the employee.
Other Features-Many pension plans pay benefits when events other
than normal retirement occur, e.g., early retirement, disability or
death. Pension benefits may also be distributed to former spouses
and children upon divorce under qualified domestic relations orders.
Most of these additional benefits are not mandatory. The amount of
such benefits is usually based on the participant's accrued benefit at
the time of the event. ERISA generally requires that participants earn
benefits evenly over their plan participation periods. (Some plans,
however, use all periods of employment to satisfy the benefit accrual
rules.) The accrued benefit is the benefit amount a participant has
earned at a particular date. It may be either the full benefit produced
by the benefit formula, or it may be a prorated benefit reflecting that
a participant has not reached normal retirement age.
(1) Early Retirement-Early retirement benefits are generally payable when
a participant satisfies certain age and service requirements. Less often,
they are available based on age alone, years of service alone, or when
the combination of age and service totals a required sum.
The early retirement benefit is usually the accrued benefit, reduced to
reflect a participant's increased length of benefit receipt. Sometimes,
to encourage early retirement, subsidized early retirement benefits are
paid until the participant is eligible for Social Security benefits. This
type of benefit may be limited to participants with long service or to
those who are retiring because of a plant shutdown or staff reduction.
TRA requires that maximum benefits payable from a defined benefit
plan must be actuarially reduced for retirees who claim benefits before
the Social Security normal retirement age.
(2) Disability Benefits-Disability benefits may also be tied to age and/or
service requirements, and they are usually contingent on satisfying the
plan's definition of disability. For plan purposes, disability may be
linked to the definition of disability under Social Security.
The benefit may be a flat-dollar amount that continues until the par-
ticipant's normal retirement date (assuming he or she remains dis-
abled); then, at normal retirement date (usually age 65), the normal
retirement benefit would become payable. Or, the plan may pay the
participant the unreduced, accrued benefit during the period before
he or she reaches normal retirement age. Under yet a different method,
the plan may reduce the participant's accrued benefit to reflect that
benefits are paid before normal retirement. In some plans, disabled
participants continue to accrue benefits from the time they become
disabled, through their normal retirement age. Where an employer
also provides a long-term disability (LTD) plan, the pension plan ben-
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efit is usually postponed until the LTD benefit stops, to avoid duplicate
payments .8
(3) Late Retirement Benefits-Amendments to the Age Discrimination in
Employment Act prohibit employers from forcing employees to retire
because of age. The majority of pension plans specify 65 as the normal
retirement age for plan participants; these plans must reflect how
benefits will be calculated for participants who remain employed be-
yond age 65. As a result of legal changes and recent court decisions, a
plan must now recognize earnings and/or service after age 65 for pen-
sion contribution and benefit purposes.
(4) Death Benefits Before Retirement-There is a considerable amount of
flexibility in designing death benefit provisions under pension plans.
Where plans offer early retirement benefits, REA requires that partic-
ipants must be provided with an early survivor annuity. Written spousal
consent is needed to elect out of the coverage. Such an annuity would
be payable to a surviving spouse, if the worker dies before retirement.
The annuity must be equal to at least half of the participant's accrued
benefit at the time of his or her death. To reflect the cost of providing
survivor protection, the law permits employers to provide a lower
benefit to the participant.
(5) Death Benefits After Retirement-ERISA requires that retirement ben-
efits to married persons must be paid as a qualified joint and survivor
annuity, unless the participant gets written spousal consent to receive his
or her benefits in some other form. Under a joint and survivor annuity,
the participant receives a benefit during retirement years; benefits then
continue to be paid, after his or her death, in the same amount or in
a lesser amount to the surviving spouse. The participant's benefit is
usually reduced to reflect the cost of survivor protection. Some plans,
however, pay an unreduced amount to the participant.
Typically, any employee contributions are refunded to a beneficiary
if a participant dies before receiving his or her benefits.'
Plan Administration
Under ERISA, an employer must name a plan administrator. Ad-
ministrative responsibilities are frequently delegated to an admin-
istrative committee. Administrative committees are typically made up
of representatives from personnel, finance and top management, as
well as union representatives if the plan is collectively bargained.
Record keeping for the plan may be incorporated into the personnel
8For more information on disability benefits under pension plans, disability plans and
Social Security, see chapter XXVI.
9Death benefits under pension plans, survivor income plans and Social Security are
discussed in chapter XXVI.
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function, or it may be assigned to another area. Responsibilities of
the administrative committee may include:
(1) filing the various governmental reports necessary for legal compliance;
(2) ensuring that reports to participants and beneficiaries are prepared
and distributed;
(3) determining eligibility for plan participation;
(4) determining eligibility for and calculation of plan benefits;
(5) explaining plan provisions to employees;
(6) interpreting plan provisions;
(7) making investment decisions regarding plan assets.
The committee should keep a written record of its meetings and
actions. Since the plan may not discriminate in favor of the prohibited
group, a written record is helpful-it can assist in ensuring nondis-
criminatory treatment.
The plan administrator, the administrative committee and certain
other parties involved in the plan's operation are considered to be
fiduciaries. Under the law, a fiduciary must:
(1) act solely in the interest of plan participants and beneficiaries, and for
the exclusive purpose of providing benefits and defraying reasonable
administrative expenses;
(2) manage the plan's assets to minimize the risk of large losses;
(3) act in accordance with the documents governing the plan.
In some instances, violation of fiduciary standards will cause the
pension plan to lose IRS qualified status. The Department of Labor
may bring suit on behalf of participants in plans that are not operated
according to ERISA's fiduciary standards. Other penalties also exist.
Funding
To be eligible for IRS tax-qualification provisions, plan assets must
be held apart from the employer's general assets. A plan may be
funded through one of a number of vehicles. For example, a trust
agreement with a bank or similar institution may be used. In this
case, the trustee holds the plan's money in a separate account, and
the employer does not have access to the funds.
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Under another arrangement, a plan may be funded through an
insurance company. The funding may be through either an allocated
or unallocated funding instrument. If an allocated arrangement is
used, separate accounts are established for each plan participant and
total contributions are divided among participants. Under an unal-
located arrangement, a pool of funds is established and benefits are
paid from this pool. Pension plans may also be funded through in-
dividual policies issued on each participant's life.
Combinations of trust funds and insured plans may be used to gain
a greater degree of flexibility in plan funding.
To ensure that pension plans have the funds to pay benefits when
participants retire, ERISA established minimum funding standards.
These funding standards are generally more applicable to defined
benefit plans than to defined contribution plans. ERISA requires that
a minimum contribution must be made each year. If funding require-
ments are not met, a penalty tax may be imposed on plan sponsors.
In limited situations, the IRS may issue a funding waiver enabling
the employer to postpone his annual contribution.
Pension plans retain the services of actuaries (i.e., individuals skilled
in the mathematics of pension plans and insurance) to determine the
amount of the minimum contribution. The actuary certifies that plan
contributions are sufficient to satisfy the minimum funding stan-
dards. The Financial Accounting Standards Board (FASB) is an in-
dependent, private authority that establishes U.S. accounting principles
and guidelines, which often affect calculations of pension assets and
liabilities.
Plan Termination
Even though pension plans are established with the intent that
they will be permanent, employers can and do reserve the right to
terminate their plans. ERISA introduced plan termination insurance
to protect participants' benefit rights in the event of plan termination.
The Pension Benefit Guaranty Corporation (PBGC) is a govern-
mental body that insures payment of plan benefits when qualified
defined benefit plans terminate without sufficient assets to pay cer-
tain of their promised benefits. Defined benefit pension plan sponsors
pay annual premiums to PBGC. These premiums are used to provide
the funds needed to pay guaranteed benefits.
There are certain restrictions and limitations on the benefit amounts
PBGC will guarantee. In general, payment is limited to a dollar amount;
this amount is adjusted annually to reflect the increasing average
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wages of the American work force. To be fully insured, benefits must
have been vested before the plan terminated; and the benefits must
be attributable to plan provisions that have been in effect for five
years.10
Conclusion
Over the last 30 years, the number of employer pension plans has
grown dramatically. This historical growth, combined with the in-
creasing labor-force participation of women and the maturing of baby
boom workers, suggests that employer plans will continue to play an
increasing role in providing retirement income security.
Additional Information
Financial Accounting Standards Board
High Ridge Park
Stamford, CT 06905
American Council of Life Insurance, Pension Facts. Washington, DC: ACLI,
1984/1985, 1986 Update.
Andrews, Emily S. The Changing Profile of Pensions in America. Washington,
DC: Employee Benefit Research Institute, 1985.
Employee Benefit Research Institute. "Tax Reform and Employee Benefits."
EBRI Issue Brief 59 (October 1986).
"Pension Vesting Standards: ERISA and Beyond." EBRI Issue Brief
51 (February 1986).
Korczyk, Sophie. Retirement Security and Tax Policy. Washington, DC: Em-
ployee Benefit Research Institute, 1984.
10For more information on pension plans and government regulations affecting these
plans, see chapters IV, VI and VII.
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V. Multiemployer Plans
Introduction
A multiemployer plan is an employee benefit or pension plan that
covers the workers of two or more unrelated companies, in accor-
dance with a collective bargaining agreement. Contributions to sup-
port such plans are negotiated at the initiative of a labor union or a
group of labor unions representing the workers of a number (fre-
quently hundreds) of employers in a given geographic area. The work-
ers are usually engaged in the same kind of employment (e.g., a skilled
craft like carpentry or acting).
Multiemployer plans are generally of two types. The first, a benefit
or welfare plan, may provide group life insurance, disability insur-
ance and coverage for hospitalization, surgical and medical costs.
The other, a pension plan, provides retirement income security. The
multiemployer concept can also be used to provide other benefits;
its collective approach has been used effectively in areas such as
employee training.
Multiemployer plans are governed by employer and union repre-
sentatives who comprise the plan's board of trustees. Employer rep-
resentatives must equal the number of union representatives on the
board.
The first multiemployer plan was probably an employer-sponsored
pension plan initiated in 1929 by Local 3 of the Brotherhood of Elec-
trical Workers and the Electrical Contractors Association of New York
City. Subsequently, certain negotiated plans developed in the 1930s
and 1940s in industries such as the needle trades and coal industries.
True growth of multiemployer pension plans did not begin until after
World War II. By 1950, negotiated multiemployer pension plans cov-
ered one million people. Coverage under these plans rose to 3.3 mil-
lion workers in 1960, and an estimated 7.2 million active workers
were participating in 1979.
Multiemployer Plan Characteristics
Number of Plans-There are an estimated 2,500 multiemployer pen-
sion plans; these plans cover an estimated 8.5 million active and
retired participants and involve over 700,000 employers. There is
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probably an equal number of multiemployer welfare plans, which
provide life, medical, dental and disability insurance to employees
and their dependents. There is also a growing number of multiem-
ployer plans that provide annuity funds, supplementary unemploy-
ment insurance and legal benefits.
Of the nation's 8.5 million multiemployer pension plan partici-
pants, the majority are covered by large plans. In 1982, the latest
year for which data are available, there were 149 plans with 10,000
or more active participants, covering 4.2 million persons. All the other
plans provided combined coverage for only 4.3 million participants.
The United States Department of Labor (DOL) has produced figures
indicating that each of ten unions-Carpenters, Electrical Workers
(IBEW), Food and Commercial Workers, Hotel and Restaurant Em-
ployees, Laborers, Ladies Garment Workers, Mine Workers, Operat-
ing Engineers, Plumbers and Teamsters-had over 250,000 members
covered by multiemployer pension plans in 1979.
Industries Covered by Multiemployer Plans-Multiemployer plans
tend to be found in certain industries. With some exceptions, they
are common in industries where there are many small companies,
each too small to justify an individual plan. They are also found in
industries where, because of seasonal or irregular employment and
high labor mobility, few workers would qualify under an individual
company's plan (if one were established). For example, construction
workers are commonly hired by a given contractor for only a few
weeks or months. When the job is completed, the worker may be
unemployed until another contractor needs his particular skills or
talent.
Substantial numbers of multiemployer plans exist in the following
manufacturing industries, as defined by the Labor Department:
food, baked goods and kindred products;
apparel (or needle trades) and others;
printing, publishing and allied industries;
finished textile products;
leather and leather products;
lumber and wood products;
furniture and fixtures;
metalworking.
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In nonmanufacturing industries, multiemployer plans are common
in:
(1) mining;
(2) construction;
(3) motor transportation;
(4) wholesale and retail trades;
(5) services;
(6) entertainment;
(7) communication and public utilities.
Construction is the industry with the most multiemployer plans.
In 1979, construction accounted for about 1,500 multiemployer pen-
sion plans or roughly one-half of all multiemployer pension plans in
the United States. In addition, construction accounted for nearly 28
percent of all employees participating in multiemployer pension plans.
Multiemployer plans also appear among companies and in indus-
tries where single-employer plans are feasible. Breweries, dairies,
large bakeries and metal fabricating companies are some typical ex-
amples.
Benefits-According to the Pension Benefit Guaranty Corporation,
in 1976, multiemployer plans paid benefits totalling $2.5 billion to
about 1.3 million retirees. In the same year, multiemployer retire-
ment plan assets exceeded $21.6 billion. Multiemployer pension plan
benefit payments increased to $4.5 billion by 1981, according to DOL,
while the number of retirees grew to about 1.8 million. Multiemployer
retirement fund assets are estimated to have been $56.8 billion in
1981, and $107.4 billion as of September 30, 1986.
Investment Performance of Plan Funds-According to the Employee
Benefit Research Institute's (EBRI) Quarterly Pension Investment Re-
port (QPIR), for four years ending September 30, 1986, multiemployer
retirement plan investment portfolios produced an average annual
rate of return of 16.6 percent, based on market value. This overall
result reflected annual earnings of 23.3 percent on equities and 16.1
percent on fixed income holdings. These equity and fixed income
results compared favorably with broad stock and bond market av-
erages over the four-year period. In the first three quarters of 1986
alone, the funds earned 13.8 percent overall, with 16.0 percent and
15.0 percent on the equity and fixed income portions, respectively.
These rates reflect the bulk of the funds' assets but exclude certain
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nonmarketable holdings, such as insurance company investment con-
tracts.
As of September 30, 1986, the invested assets covered by QPIR were
27 percent invested in equities (i.e., common stocks and convertible
securities), 45 percent in bonds, 5 percent in cash and 23 percent in
other investment vehicles. Multiemployer fund trustees tend to follow
conservative investment policies; this is at least partly because plan
contributions are fixed by collective bargaining agreements.
Funding
Plan contributions are normally made by the employers partici-
pating in the collective bargaining agreement. Occasionally, employ-
ees are required or permitted to make additional contributions to
welfare plans (e.g., during short unemployment periods). The em-
ployer's contribution amount is determined through negotiations (e.g.,
$1 for each hour worked by each employee). All the contributions are
pooled in a common fund that pays for the benefits provided. In-
vestment earnings augment the fund. A multiemployer plan, by virtue
of its size, often can undertake certain forms of investment that are
not available to a small fund or a plan established by a single com-
pany employing only a few workers.
Companies participating in the same multiemployer plan usually
make equal contributions. However, some large, national multiem-
ployer plans provide several levels of benefits that require different
levels of employer contributions. As a result of special circumstances,
a company may be required to make higher contributions than other
participating companies or its employees may receive lower benefits.
For example, a company with a large number of older workers may
join an established multiemployer pension plan. Such a company
might be required to make higher contributions because of the sub-
stantial past service liabilities of its older workers who are approach-
ing retirement.
Establishing the Plan
Once a union and various companies agree to set up a multiem-
ployer plan, the first step is usually to negotiate how much each
employer will contribute to the plan. Then, employer and union rep-
resentatives, with an attorney's assistance, adopt a trust agreement
(equivalent to a constitution) that: (1) establishes a board of trustees;
(2) defines the board's powers and duties; and (3) covers the affairs
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of both the trustees and benefit or pension plan. An attorney and an
accountant will assist in establishing a trust fund to accept company
contributions. Benefit and actuarial consultants will assist the trust-
ees in working out plan details and determining a supportable benefit
level. The trustees will probably retain a professional investment
advisor or portfolio manager to ensure competent fund management.
The trustees will also hire a salaried plan administrator and staff-
or retain an outside administration firm-to manage the plan and
handle day-to-day details, such as: (1) the collection of employer con-
tributions; and (2) employee claims, payments and inquiries. Finally,
the trustees must publish a booklet in lay language informing em-
ployees of plan benefits, eligibility rules and procedures for filing
benefit claims.
Administrative Differences Between Multiemployer and Single-
Employer Plans-The administration of a multiemployer plan differs
from that of a single-employer plan. Multiemployer plans must es-
tablish procedures for obtaining information from all contributing
employers. A central system for collecting contributions and main-
taining employee records must be set up, and procedures must be
established to flag delinquent contributors. For pension plans, a method
of verifying all creditable past service must be devised.
Like a corporation's board of directors, a board of trustees sets
overall plan policy and gives direction to the plan's activities. As
previously mentioned, the trustees employ an administrator and var-
ious advisors (e.g., lawyers, accountants, actuaries and consultants)
to assist them. These experts provide the technical information that
the trustees need to make informed policy decisions.
Trustees are responsible for proper fund management. Trustees
may delegate certain of their duties and functions, including the man-
agement of plan funds; but they bear ultimate responsibility for all
actions taken in their names. Fund management is a serious respon-
sibility, since vast sums of money may be involved and pensions or
other benefits of hundreds or thousands of people are at stake. Trust-
ees are bound by rigid rules of honesty and performance. They are
required by law to act on behalf of plan participants as any prudent
person familiar with such matters (i.e., financial affairs) would act.
These same requirements apply to any advisors who manage plan
funds.
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Industry Practices
There is frequently more than one multiemployer plan within each
large industry. Multiemployer plans may cover industry employees
on a national, regional or local basis.
Transferral of Pension Credits-Normally, pension credits cannot be
transferred from one multiemployer plan to another in the same in-
dustry, unless the trustees of the various plans have negotiated re-
ciprocity agreements. Under such agreements, a worker can shift from
employer to employer and among different plans without losing pen-
sion credits.
About 75 percent of the workers covered by health, welfare and
pension programs in the construction industry were covered by re-
ciprocity agreements in 1983. Many other multiemployer plans are
also industrywide in nature. Still others are adopting reciprocity
agreements at an accelerating rate as international unions continue
to encourage these arrangements.
Multiemployer plans generally have benefit patterns that are sim-
ilar to the patterns negotiated by large international unions like the
United Auto Workers or Steelworkers. Benefits are normally defined
in terms of a dollar amount that is related to an employee's length
of service (e.g., $15 per month, per year of service). Often there is a
maximum on the number of years of service credited (e.g., twenty-
five or thirty years). In the example cited, a thirty-year employee
would be entitled to $450 per month (i.e., $15 x 30).
About 75 percent of multiemployer plans (with 65 percent of mul-
tiemployer plan workers) base benefits on length of service and do
not base benefits on earnings level. This is partly because the range
of earnings for workers covered by multiemployer plans tends to be
narrower than for workers covered by single-employer plans. Under
multiemployer plans, the need to keep individual earnings records is
eliminated; the contribution rate for all employees is usually iden-
tical.
Vesting-The provision in the Tax Reform Act of 1986 that requires
either five-year vesting or seven-year graded vesting, effective in 1989,
makes an exception for multiemployer plans. Instead, multiemployer
plans are only required to provide 10-year cliff vesting.
Normal Retirement Age Under Multiemployer Plans-A DOL study
disclosed that about 98 percent of those covered by multiemployer
plans must reach a specific age to qualify for a retirement benefit.
Nearly 75 percent were in plans where normal retirement was at age
65; nearly 20 percent were in plans where normal retirement was
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before age 65. Five out of eight participants were in plans that allowed
retirement after 15 years of service, providing participants also met
the age requirements.
Early Retirement Options-Virtually all multiemployer plans pro-
vide an option for early retirement. Employees who choose this option
will usually receive a reduced pension benefit. A few multiemployer
plans allow workers to retire after working a stated length of service,
such as 30 years, regardless of age. A person whose coverage under
a service plan begins at 24 could, therefore, be eligible to retire with
full benefits at 54-an earlier age than under a conventional mul-
tiemployer or single-employer plan.
Restrictions-Most multiemployer plans restrict retirees in their
jurisdictions from working in the same trade or industry while re-
ceiving pensions. The restriction is to prevent retirees from competing
for jobs with active workers or practicing their skills in the nonunion
sector of the industry. Under rules issued by the DOL, a multiem-
ployer plan may suspend benefits for a retiree who completes forty
or more hours of service in a month:
(1) in an industry where other employees covered by the plan were em-
ployed and accrued benefits under the plan, at the time benefit pay-
ments commenced or would have commenced, if the retired employee
had not returned to employment;
(2) in a trade or craft where the retiree was employed at any time under
the plan;
(3) in the geographic area covered by the plan, at the time benefit pay-
ments commenced or would have commenced, if the retired employee
had not returned to employment.
Advantages of Multiemployer Plans
Employee Advantages-Multiemployer plans provide certain ad-
vantages to employees. First, because so many companies contribute
to multiemployer plans, they are less likely to terminate than single-
employer plans. Consequently, multiemployer plans may provide
greater assurance of permanence than single-employer plans. More-
over, recent legislation requires generally that employers continue
contributions to multiemployer pension plans, even if the employers
withdraw from the plan. Withdrawing employers may have to pay
for a prorata portion of any unfunded vested benefits.'
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Second, multiemployer plans offer attractive portability features.
Employees may carry pension credits with them as they move from
company to company. Thus, they can earn pensions based on all
accumulated credits, even if some of their former employers have
gone out of business or stopped making plan contributions. Similarly,
continuity of coverage can be assured for other benefits (e.g., medical
insurance) when the worker switches jobs within the same
industry.
Third, multiemployer plans provide an incalculable advantage to
employees of small companies; these employees might not receive
benefits if multiemployer plans did not make benefit programs af-
fordable for small employers.
Fourth, the favorable tax treatment of health and pension benefits
under single-employer plans also applies to the benefits employees
receive under multiemployer plans. In many cases, single-employer
plans cannot achieve the same results as multiemployer plans. Con-
sider a highly mobile industry such as entertainment. An actor might
work for the same employer for weeks or months, but probably not
for the years needed to qualify for a pension. If the actor's various
employers contributed toward a multiemployer pension fund, their
contributions would eventually finance his or her pension coverage.
Single-employer plans cannot accomplish this.
Employer Advantages-There are several advantages for employers
who participate in multiemployer plans. First, economies can be
achieved through group purchasing and simplified administration.
Second, benefit and labor costs throughout a region or even an in-
dustry may be stabilized. This can help reduce employee turnover,
because workers will not be attracted to other jobs by the promise
of better benefits elsewhere. As with all benefit plans qualified by the
Internal Revenue Service, company contributions to a multiemployer
plan are tax deductible.
The economies for administration and group purchasing are sub-
stantial. If a single, small company were to sponsor a plan, the ad-
ministrative costs might be 15 to 20 percent of total costs. For a
typical multiemployer plan, the administrative costs generally amount
to less than 5 percent. In addition to lowering administrative costs,
a multiemployer plan reduces the per capita costs for consulting,
actuarial, legal, accounting and investment advisory services.
Sometimes, competing companies participate in the same mul-
tiemployer plan. In fact, it is more common for competitors to par-
ticipate in such plans than it is for miscellaneous firms. In certain
highly competitive industries, such as garment manufacturing, par-
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ticipation in a multiemployer plan is considered a distinct advantage
to each company.
There is no maximum limit on the number of companies or workers
who can participate in a multiemployer plan. There must be at least
two companies and at least two employees, but there is no upper
limit. Multiemployer plans may cover a small number of employees
or as many as 500,000 employees; there may be thousands of partic-
ipating companies.
Some plans are industrywide within a region (e.g., several states,
a city or a county), and some cut across several related industries
(e.g., crafts or trades in just one geographic area). Industrywide plans
often cover a trade or craft rather than a national industry. However,
some plans that embrace whole industries or a large part of an in-
dustry include those of the American Federation of Television and
Radio Artists, Communication Workers of America, National Mari-
time Union, International Ladies Garment Workers Union, United
Paperworkers International Union and Amalgamated Clothing Work-
ers.
Nonnegotiated Plans-There is also a nonnegotiated multiemployer
plan. These plans have been established by certain employers who
have chosen on their own initiative to provide their employees with
a benefit package. Nonnegotiated plans are quite common in the
nonprofit area among religious, charitable and educational institu-
tions.
Conclusion
Multiemployer plans have grown: (1) to meet the needs of people
who seek pension security; (2) to assist in paying the medical expenses
associated with illness or off-the-job accidents; and (3) to provide
financial protection against untimely death. The years of explosive
multiemployer plan growth are probably over. In the future, only
incremental coverage growth will occur with relatively small num-
bers of new workers coming under multiemployer plan protection.
Multiemployer plans can be expected to grow, however, in certain
industries. Dynamic industries such as entertainment, where em-
ployees work irregularly, offer favorable prospects for multiemployer
plan growth. Additionally, small manufacturers, the retail trades and
transportation-particularly mass transit-may experience substan-
tial growth. Over the long term, service industries also offer potential
opportunities for multiemployer plan expansion. In addition, some
authorities have suggested that government unions might negotiate
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benefits under a multiemployer plan setup that includes small mu-
nicipalities.
There are also a few industries where the number of multiemployer
plans is declining. Since passage of the 1974 Employee Retirement
Income Security Act, some plans have terminated in the millinery,
printing and milk delivery industries.
Additional Information
National Coordinating Committee for Multiemployer Plans
815 16th Street, NW
Suite 603
Washington, DC 20006
Employee Benefit Research Institute. EBRI Quarterly Pension Investment Re-
port, published 4 times a year.
. "Reciprocity and Multiemployer Plans." Employee Benefit Notes (Feb-
ruary 1987), pp. 5-7.
Martin E. Segal Company. 1986 Survey of the Funded Position of Multiemployer
Plans (New York, NY: Martin E. Segal Company, 1986).
U.S. General Accounting Office. 1980 Multiemployer Pension Amendments:
Overview of Effects and Issues. HRD-86-4. Washington, DC: U.S. Govern-
ment Printing Office, February 1986.
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VI. Defined Benefit and Defined
Contribution Plans: Understanding
the Differences
Introduction
Employers generally try to meet the retirement income needs of
their employees by adopting either a defined benefit plan, a defined
contribution plan or both.
Defined Benefit-In this type of plan, each employee's benefit is
predetermined by a specific formula. Usually, the promised benefit
is tied to the employee's earnings, length of service or both. For ex-
ample, an employer may promise to pay each vested participant a
pension equal to 1 percent of the employee's final five-year average
salary, times number of years of service at retirement.'
Defined Contribution-There are several types of defined contri-
bution plans (e.g., money-purchase pension, profit sharing (including
401(k) arrangements), savings or thrift and employee stock ownership
plans) 2 In these plans, the employer's plan contributions are prede-
termined each year and allocated to individual accounts for employ-
ees. The allocation is usually determined by a percentage of each
employee's earnings. The benefit payable at retirement is based on
money accumulated in each employee's account. Such accumulated
money will reflect employer contributions, employee contributions
(if any) and investment gains or losses. The accumulated amount may
also include employer contributions forfeited by employees who leave
before they become fully vested, to the extent such contributions are
reallocated to the accounts of employees who remain.
To illustrate the basic differences between the two approaches, the
following discussion will focus on the major considerations involved
in an employer's selection of the type of plan to be used.
'For a definition of vesting, see pages 32-33.
2For more specific information on profit sharing, thrift, 401(k) and employee stock
ownership plans, see chapters VIII, IX, X and XI.
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The Major Differences
The important factors for understanding the differences between
defined benefit and defined contribution plans include:
(1) achievement of retirement income objectives;
(2) plan cost;
(3) ownership of assets and investment risk;
(4) ancillary benefit provisions;
(5) postretirement benefit increases;
(6) employee acceptance;
(7) employee benefits and length of service;
(8) plan administration;
(9) taxes.
Achievement o f Retirement Income Objectives-Many (perhaps most)
employers feel that the primary objective in adopting a retirement
plan is to provide future retirement income to employees. In addition,
they have an interest in seeing that retirement income programs help
to maintain organizational efficiency and vitality. Such goals require
plans to be available for long periods of benefit accumulation. For
career employees who do not change jobs frequently, the defined
benefit plan provides a known result without employee risk. Defined
benefit plans calculate the employee's ultimate retirement benefit
based upon formulas. Examples of such formulas are:
(1) Flat-Benefit Formula-$12 a month per year of service;
(2) Career-Average Formula-1 percent of the employee's earnings up to
the Social Security taxable wage base, plus 2 percent of earnings in
excess of the Social Security taxable wage base for each year of service
(or plan participation);
(3) Final-Pay Formula-1.5 percent of the employee's final five-year av-
erage earnings, times years of service (or plan participation), minus
one-half of his or her primary Social Security benefit.'
Flat-benefit formulas are most frequently found in union-
negotiated plans. Career-average and final-pay formulas are more
'For more information on these benefit formulas, see pages 46-47; also, see chapter
VII.
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often found in plans for salaried employees. Today, final-pay formulas
are the most commonly used.
Employer-sponsored retirement plans do not guarantee that each
employee's benefits will be sufficient to fully support the employee
and/or his or her dependents throughout retirement. Defined benefit
plans, however, provide employers with the ability to design plans
that attempt to satisfy stated retirement income objectives.
Defined contribution plans are not designed specifically to provide
stated retirement benefit levels. Instead, they prescribe the rate of
employer and/or employee contributions and how these contributions
are to be allocated to individual employee accounts. Such plans may
rely totally upon employer contributions, or they may include the
combined contributions of employees and employers. Here are some
representative examples:
(1) Defined Contribution Savings or Thrift Plan-The employee may con-
tribute up to 6 percent of his or her earnings each year, and the em-
ployer contributes an additional amount equal to one-half of the
employee's contributions.
(2) Defined Contribution Profit Sharing Plan-Each year, the employer's
total plan contribution is based on profits. This contribution is divided
among employees in proportion to their respective earnings.
(3) Defined Contribution Money-Purchase Pension Plans-The employer
contribution to the plan is stated as a percentage of employee salary.
The plan may be integrated with Social Security by stating a lower
percentage of salary up to the taxable earnings base, and a higher
percentage above the base.
Under defined contribution plans, there is no way of knowing in
advance the exact amount of assets that will be in the employee's
account at retirement. The size of the account will be affected by the
amounts contributed, the impact of investment gains or losses and
the value of reallocated benefit forfeitures.
Employers adopt defined contribution plans:
(1) as a step toward achieving employees' retirement income security;
(2) to supplement an existing defined benefit plan;
(3) to avoid the long-term funding and liability commitments, as well as
the more burdensome regulations of defined benefit plans;
(4) to create a program that provides benefits for short-term workers;
(5) as a tool to attract qualified employees or to control an excessive em-
ployment turnover rate.
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Plan Cost-The employer who adopts a defined benefit plan accepts
an unknown cost commitment. Numerous factors determine the cost
of promised benefits, including the: (1) rates of return on investment;
(2) number of employees working until retirement; (3) nature of future
government regulatory changes; and (4) future employee pay levels.
The unknown cost aspect of defined benefit plans is often consid-
ered a deterrent. Employers minimize the unknown cost by projecting
future interest earnings, mortality rates, personnel turnover and sal-
ary increases; thus, they attempt to establish a reasonably level fund-
ing pattern. Moreover, the plan's assets and liabilities are evaluated
periodically (usually annually), and contribution adjustments can be
made on a regular basis. Within legal limits, the employer is per-
mitted to vary contributions from year to year. Therefore, defined
benefit plan sponsors have a certain contribution flexibility; however,
flexibility is not as great as it is under certain defined contribution
plans 4
Defined contribution plan sponsors generally know the plan's true
cost on a yearly basis. The employer pays an established amount on
a regular basis; he does not have to be concerned about future costs.
This cost control feature appeals to many employers-particularly
to newer and smaller employers and to nonprofit educational insti-
tutions. Additional funding flexibility is possible by basing employer
contributions on profits (i.e., through a defined contribution profit
sharing plan) and, thus, permitting the employer to forego contri-
butions in times of economic hardship.
Ownership of Assets and Investment Risk-The ownership of plan
assets differs between defined benefit and defined contribution plans.
In a defined contribution plan, contributions can be viewed as a
deferred wage once an employee has become vested. The full vested
value of each participant's account can be considered owned by the
employee. Vested benefits are often distributable to employees upon
employment termination. Defined contribution plan sponsors may
be committed only to paying a stipulated contribution each year. It
is the employee who bears the investment risk thereafter. Favorable
investment results will increase benefits; unfavorable results will de-
crease benefits.
In a defined benefit plan, vested benefits can again be viewed as a
deferred wage. It is here, however, that the difference in risk becomes
important. Defined benefit plan sponsors assume an obligation for
paying a stipulated future benefit. Consequently, the employer ac-
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cepts any investment risk involved in meeting this obligation. If the
pension fund established to provide promised benefits earns a lower-
than-expected yield, or if it suffers capital losses, the employer will
have to make additional contributions. Because defined benefit plan
sponsors are at risk for paying promised benefits, regardless of in-
vestment gains or losses, the employers can be viewed as owning the
plan assets.
Ancillary Benefit Provisions-Although retirement plans are in-
tended first and foremost to provide retirement income, they must,
by law, make some provision for paying benefits in the event of a
participant's death or preretirement termination. Most plans provide
early retirement and disability benefits as well. To receive ancillary
benefits, employees may be required to satisfy certain eligibility re-
quirements; the law places limits on such requirements.
Under most plans, employees must work a specified length of time
before they qualify for vesting. Defined benefit plans normally require
longer waiting periods than defined contribution plans. Defined con-
tribution thrift and profit sharing plans usually pay a vested em-
ployee's individual account balance in full upon death, employment
termination, retirement or disability. Defined benefit and defined
contribution pension plans frequently distribute the vested benefit
as a stream of level monthly payments for life beginning at the time
the employee retires-early, at the normal age or later.
Defined benefit plans can coordinate ancillary benefits with similar
benefits from other types of plans. For example, if the employer has
a three-times-pay group life insurance plan, or a long-term disability
plan providing 60 percent pay continuance, a defined benefit pension
plan can be designed to reflect such life insurance and disability
protection.
Defined contribution plans also can be coordinated with other plans;
but coordination is more difficult, and the total benefit in any given
circumstance may be more or less than is intended or needed.
Postretirement Benefit Increases-During periods of inflation the
pensioner's financial plight is brought into sharp focus. In such pe-
riods, retired employees living on fixed pensions, or on incomes de-
rived from investing lump-sum retirement distributions, have been
affected by the dollar's declining value. Automatic Social Security
benefit increases have helped; but they frequently have not provided
total retirement income increases comparable to inflationary in-
creases for above-average earners.
Most employers are concerned about their retired workers' finan-
cial problems. Few, however, can afford to provide automatic cost-
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of-living adjustments under their plans. Where automatic cost-of-
living increases are provided, the initial benefit is generally reduced
to balance the indexing feature's cost. If resources are available, many
employers are willing to voluntarily grant periodic benefit increases
after retirement to help offset inflationary effects; such ad hoc ad-
justments generally can be made easily.
Defined contribution thrift and profit sharing plan sponsors usually
provide for lump-sum distributions at retirement, and defined con-
tribution money-purchase pension plans may require that pension
benefits be taken in the form of a fixed and/or variable annuity. Where
lump-sum distributions are provided for, the employees may pur-
chase fixed and variable annuities, or partially indexed annuities,
with the latter usually requiring a reduction in the initial benefit
amount.
Employee Acceptance-By nature, defined benefit plans are com-
plex. Numerous government regulations-intended to protect em-
ployee rights-have added to the complexity.' Ironically, as a result
of the complexity, many employees do not understand their plans;
therefore, they do not value or appreciate them. Promised benefits
often seem remote, and the current dollar value of benefits is not
apparent.
As employees approach retirement, however, they may come to
understand and appreciate their defined benefit plans. In some cases,
though, employers conclude that defined benefit plans are too ex-
pensive; and they do not generate a fair return in terms of overall
employee motivation and retention.
Defined contribution plans can also be complex. However, their
complexity is less apparent. Defined contribution plan participants
have individual accounts; their accounts have known values ex-
pressed in dollars-rather than benefit formulas. Benefit accumu-
lations under thrift and profit sharing plans are usually payable in
lump sums upon a vested participant's death, disability, employment
termination or retirement. Instinctively, employees may prefer a
$50,000 lump-sum cash payment to a $400 monthly benefit pay-
ment-even though the latter form of payment may produce an equal
or greater value than the lump-sum payment. Defined contribution
plans also offer flexibility. They can permit the employee to choose
his or her benefit distribution among a variety of options (e.g., an
annuity, a cash payment or a combination of both).
'For more information on such regulations, see chapters III and VII.
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Employee Benefits and Length of Service-Defined contribution plans
offer distinct benefit advantages to employees who change jobs
frequently. Vesting provisions in these plans are generally liberal.
Defined contribution plans usually provide at least partial vesting
after two or three years of service. Additionally, vested benefits
under thrift and profit sharing plans are normally paid in a lump
sum at employment termination, but under pension plans may be
required to be taken as a lifetime annuity. Prudent employees will
be able to avoid the 10 percent additional income tax on prere-
tirement distributions by rolling over the lump-sum distribution
into an individual retirement account or another qualified retire-
ment plan.
Alternatively, defined benefit plan participants usually do not be-
come fully vested until they have completed 5 to 10 years of service.
Instead of receiving vested benefits at employment termination, they
receive deferred monthly income after they retire. The benefit amount
is usually frozen at termination, and the employee is exposed to future
inflationary effects.
Vesting provisions for private-sector, single-employer plans were
changed, however, under the Tax Reform Act of 1986 (TRA) for plan
years beginning after December 31, 1988. TRA requires faster vesting
schedules for private-sector, single-employer plans. A plan can choose
to meet one of two tests: (1) 100 percent vesting after five years of
service; or (2) 20 percent after three years of service, with an addi-
tional 20 percent for each subsequent year of service until 100 percent
vesting is achieved at the end of seven years of service.
Defined benefit plan benefit formulas frequently anticipate late-
age hirings; some are designed to provide adequate retirement ben-
efits for employees with as few as 20 or 25 years of service. This offers
an advantage for the employee making a permanent job commitment
relatively late in his or her career years (e.g., at age 40 or 45). Under
defined contribution plans, employees hired at age 40 or 45 are less
likely to accrue adequate benefits.
Plan Administration-Both defined benefit and defined contribu-
tion plans can be complex to administer; they usually require trained
internal staffs as well as outside advisors. Defined contribution plans
offer some administrative advantages over defined benefit plans. First,
defined benefit plans require the use of complicated actuarial tech-
niques, but defined contribution plans do not.
Second, provisions of the tax code and the Employee Retirement
Income Security Act (ERISA) have less effect on defined contribution
plans than on defined benefit plans. For example:
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(1) Defined benefit plans must satisfy minimum funding standards. Gen-
erally, defined contribution plans do not have to satisfy these stan-
dards.
(2) Defined benefit plans must calculate and pay insurance premiums to
the Pension Benefit Guaranty Corporation (PBGC) to protect employee
benefits in the event of plan termination. Defined contribution plans
are by nature fully funded; therefore, they do not present the risks of
defined benefit plans and are not subject to the pension insurance
program. This also makes it administratively easier to terminate a
defined contribution plan because approval by the PBGC is not nec-
essary.
(3) Defined benefit plans usually must provide more detailed and com-
plicated actuarial disclosure reports than defined contribution plans,
although now many defined contribution filings are as detailed and
complex. Individual recordkeeping, especially where loan and with-
drawal rights exist, can also pose complications for defined contri-
bution plan administration.
Since the passage of ERISA, the administrative advantages of de-
fined contribution plans have been considered significant by many
employers and have influenced their selection of a defined contri-
bution plan.
Taxes-For employers, the tax considerations under defined benefit
and defined contribution plans are essentially the same. Under either
plan, employer contributions-subject to certain statutory limits-
are a deductible business expense in the year paid or accrued .6
For employees, too, the tax considerations associated with each
plan are essentially the same. Employees do not pay taxes on em-
ployer contributions, investment income or capital gains of retire-
ment plan assets until they receive benefits.
Employees, however, have traditionally paid taxes on their own
plan contributions in the year such income was earned. Most private-
sector, defined benefit plans do not require employee after-tax con-
tributions, but public-sector, defined benefit plans commonly do re-
quire employee after-tax contributions.
Employee elective deferrals to qualified 401(k) salary reduction
arrangements generally are not treated as current income to the em-
ployee and are not taxed until distribution. In such plans, an em-
ployee may take a pretax reduction in salary up to the plan's maximum
allowable deferral (in no case more than $7,000), contribute the amount
to the plan and thus reduce his or her gross income by the amount
6For more information on the statutory contribution limits, see pages 28-29.
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of the deferral. Where a 401(k) arrangement also accepts employee
after-tax contributions in addition to elective deferrals, the after-tax
contributions are treated differently for tax purposes.
Under defined benefit and defined contribution plans, benefits are
subject to tax when received by the employee.
If employees receive benefits in the form of monthly income-this
is typical under defined benefit plans-ordinary income tax rates
apply. The advantage here is that traditionally the employee has been
in a lower-income tax bracket when retired than during his or her
working years although this has become less likely under tax reform's
two tax brackets (15 percent and 28 percent).
For employees receiving lump-sum distributions-this is more typ-
ical under defined contribution plans-the tax options have changed.
TRA: (1) phases out capital gains treatment for lump-sum distribu-
tions over six years beginning on January 1, 1987; and (2) eliminates
10-year forward averaging for taxable years beginning after Decem-
ber 31, 1986, and instead, permits a one-time election of 5-year for-
ward averaging for a lump-sum distribution received after attainment
of age 59 1/2. Forward averaging is the ability to pay taxes on lump-
sum distributions at a certain fraction of the marginal rate. Under a
transition rule, a participant who attained age 50 by January 1, 1986,
is permitted to make one election of 5-year forward averaging or 10-
year forward averaging (at 1986 rates) with respect to a single lump-
sum distribution without regard to attainment of age 59 1/2, and to
retain the capital gains character of the pre-1974 portion of such a
distribution. Under the transition rule, the pre-1974 capital gains
portion would be taxed at a rate of 20 percent. TRA also imposes a
15 percent excise tax on distributions to an individual in excess of
specified limits (currently up to $150,000 in a year, or $750,000 if a
lump sum).
The tax consequences depend on the form of benefit payment-not
on the type of plan. Lump-sum distributions are treated the same,
for example, whether paid from a defined benefit or a defined con-
tribution plan.
Income distributions that are attributable to employee contribu-
tions are not taxed in retirement if such contributions were made
from after-tax income.
Conclusion
In the past, defined benefit plans were generally adopted as the
primary vehicle for meeting employees' retirement income needs.
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More recently, due to changes in legislation, in public attitudes and
in the economy, the emphasis appears to be shifting to defined con-
tribution plans. An increasing number of employers believe that the
most effective retirement program combines the two types of plans-
making maximum use of the particular cost and benefit advantages
of each.
An employer could, for example, adopt a defined benefit plan that
provides a modest level of benefits and supplement these benefits
with a defined contribution thrift, profit sharing or salary reduction
plan. The employer's cost risk under the defined benefit plan is min-
imized, while the two plans combine benefits to satisfy income
adequacy standards.
An employer with a defined contribution plan could adopt a defined
benefit plan; the latter plan would guarantee a minimum level of
retirement benefits (e.g., 40 percent of final pay). In this case, the
defined benefit plan is called a floor plan. Its purpose is to counteract
potential benefit deficiencies in the primary plan (i.e., the defined
contribution plan). Under this approach, minimum benefit objectives
can be-met with certainty, but cost control is reduced. Slight defi-
ciencies in expected benefit levels under the defined contribution plan
can result in sharp cost increases under the floor plan.
Employers might also choose just one plan that incorporates char-
acteristics of both defined benefit and defined contribution plans. For
example, cash balance pension plans are defined benefit plans offer-
ing features common to defined contribution plans, and target benefit
plans are defined contribution plans doing just the opposite.
Defined benefit and defined contribution plans offer distinct ad-
vantages for employers and employees. Individual circumstances will
determine which type of plan is adopted.
Additional Information
Andrews, Emily S. The Changing Profile of Pensions in America. Washington,
DC: Employee Benefit Research Institute, 1985.
Atkins, G. Lawrence. Spend It or Save It? Pension Lump-Sum Distributions
and Tax Reform. Washington, DC: Employee Benefit Research Institute,
1986.
Employee Benefit Research Institute. "1985-86 Estimates Show More Pen-
sion Plans." Employee Benefit Notes (September 1986).
McGill, Dan M. Fundamentals of Private Pensions. Homewood, IL: Richard
D. Irwin, Inc., 1984.
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VII. Integrating Pension Plans With
Social Security*
Introduction
The majority of private pension plans and a significant number of
public plans coordinate their benefits with Social Security. This co-
ordination is known as integration. Through integration, employers
can design pension formulas that: (1) take into account Social Se-
curity benefits; and (2) produce a combined pension and Social Se-
curity benefit that attempts to replace a desired portion of preretirement
income.
The requirements for integrated plans will change substantially for
plan years beginning after 1988. This chapter describes the integra-
tion of plans prior to that time. A final section describes the 1989
requirements under the Tax Reform Act of 1986 (TRA).
Table 1 shows Social Security benefits for workers at four earnings
levels. It also gives these workers' Social Security replacement rates
(i.e., the portion of final year's gross income that is replaced by Social
Security benefits).
The Social Security benefit formula is weighted to favor low-in-
come workers. This produces the higher replacement rates shown for
the lower earners in table 1. The replacement rate is 52 percent for
workers with final average annual earnings of $8,000; it is 22 percent
for those with final average annual earnings of $37,500. Integrated
pension formulas are designed to help close such replacement rate
gaps. For example, some pension plans use an offset integration
formula.
Offset Plans
Offset integration formulas are used with defined benefit plans. In
offset plans, employers: (1) calculate an employee's pension benefit
based on the plan's benefit formula; and (2) subtract an amount (tra-
ditionally a portion of the employee's Social Security benefit) from
*This chapter draws heavily from James H. Schulz and Thomas D. Leavitt, Pension
Integration: Concepts, Issues and Proposals (Washington, DC: EBRI, 1983).
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TABLE 1
Social Security Benefits and Replacement Rates
for Workers Retiring at Age 651
Average Annual
Earnings2
Final Year's
Earnings
Social Security
Benefit
Social Security
Replacement
Rate3
Worker A4
$ 8,000
$ 8,958
$4,644
52%
Worker B4
16,000
17,916
7,284
41
Worker C5
37,500
42,000
9,228
22
Worker D6
112,500
126,000
9,228
7
Source: Donald S. Grubbs, Jr., F.S.A., Grubbs and Company, Inc., Silver Spring, MD.
Assumed to retire at the beginning of 1987.
2 Average of highest five years of earnings, which in these hypothetical examples are
the last five years.
3 Benefit divided by final year's earnings.
4 Annual earnings are assumed to increase at a rate of 6 percent per year.
5 Worker earns the taxable wage base in all years.
6 Worker earns three times the taxable wage base in all years.
his or her calculated pension benefit. This determines the actual em-
ployee pension.
Table 2 illustrates an offset plan's impact on long-term workers. It
uses a benefit formula that first calculates a benefit equal to 50 per-
cent of final average earnings. In a second step, the formula subtracts
50 percent of the employee's Social Security benefit from the pension
benefit calculated in the first step.
The offset's effect is apparent in column (5). As earnings increase,
the pension plan replaces a greater portion of preretirement earnings.
Note, however, that the combined Social Security and pension benefit
replacement rate-shown in column (7)-remains significantly higher
for lower-income workers.
All replacement ratios shown in this chapter are based on the final
year's gross pay. If these replacement ratios were adjusted for taxes
to determine the percentage of after-tax pay that is replaced, all per-
centages would be higher and the differences between the high-paid
and low-paid employees would be less.
Under pre-1989 Internal Revenue Service (IRS) regulations, a work-
er's normal retirement benefit may be reduced by a maximum offset
of 83 1/3 percent of his or her Social Security primary insurance
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amount (the benefit payable at age 65 with no reductions for early
retirement). The most commonly used offset, however, is 50 percent.
Sometimes, offset formulas result in no pension benefits below certain
earnings levels.
Employers can also integrate pension benefits with Social Security
benefits by using excess and step-rate excess integration formulas.
Excess formulas are used with both defined benefit and defined
contribution plans. Unlike offset plans, excess plans do not directly
deduct Social Security benefits in calculating pension benefits. In-
stead, in determining employer benefit accrual or contribution rates,
pure excess plans give no credit to lower earnings. This is intended
to counteract the effects of Social Security, which gives more credit
to lower earnings than to higher earnings. Pure excess plans do not
provide pension benefits for workers with earnings below a certain
level. Benefits are based on a percent of earnings above the maximum
integration level. Pure excess plans will not be permitted after 1988.
Maximum Integration Level-The maximum integration level is the
highest earnings level that the IRS will allow a qualified pension plan
to exclude for benefit accrual or contribution purposes. This level
increases each year with changes in the taxable wage base. The taxable
wage base is the maximum amount of earnings on which Social Se-
curity taxes and benefits are paid. For pension plans that base benefits
on a percentage of each year's actual annual compensation, the max-
imum integration level is the current Social Security taxable wage
base. The 1987 taxable wage base is $43,800. In defined benefit plans
that base benefits on a percentage of final average salary, the maxi-
mum integration level is known as covered compensation. For each
employee, covered compensation is the average of taxable wage bases
beginning in 1959 (or age 30 if later) and ending with the year the
employee reaches age 64. In this case, the maximum integration level
is $15,732 for persons reaching age 65 in 1987. The IRS also allows
rounding of the covered compensation level to the nearest multiple
of $600. In 1987, this alternative produces a maximum integration
level of $15,600, which is used in the examples in this chapter.
The integration level may be static or dynamic. If it is static, it
remains at a fixed level despite changes in the taxable wage base. If
it is dynamic, it changes in response to increases in the taxable wage
base. In inflationary times, plans with static integration levels be-
come less integrated each year. This happens because the benefit
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accrual or contribution rate is applied to a greater portion of earnings
each year.
Integration Percentage-The integration percentage is the percent
applied to earnings above the integration level, which is used to cal-
culate benefits or contributions in an excess or step-rate excess plan.
IRS imposes a maximum limitation on integration percentages.
Defined Benefit Excess Plans-Two types of excess formulas are used
in defined benefit plans: (1) Flat-Benefit Excess; and (2) Unit-Benefit
Excess.
(1) Flat-Benefit Excess Plans-Flat-benefit excess plans must be based on
an average earnings period. Originally, five years was the minimum
period that could be used in averaging earnings. It is now permissible
to use four or three consecutive years for averaging earnings. The max-
imum integration percentage, however, must then be reduced by 5 and
10 percent, respectively.
In flat-benefit excess plans, up to 371/2 percent of average earnings
above the integration level may be paid to participants with at least
fifteen years of service. For participants with less than 15 years of
service, the maximum percentage is 21/2 percent for each year of service.
Thus, the maximum for a participant with twelve years of service is
30 percent (i.e., 12 x 0.025 = 0.30).
Table 3 shows pension and total replacement rates produced by a fully
integrated flat-benefit excess formula for four hypothetical workers.
Since this plan does not provide benefits to people with average earn-
ings below $15,600, Worker A receives no pension benefit. As with fully
integrated offset plans, however, total replacement rates decline with
increasing average earnings.
(2) Unit-Benefit Excess Plans-Unit-benefit excess plans determine benefit
accrual in terms of each year of credited service. Benefits may be based
on actual earnings each year. In this case, up to 1.4 percent of earnings
above the integration level may be paid to a participant. Alternatively,
benefits may be based on average earnings. If benefits are based on
earnings averaged over at least five years, up to 1 percent of earnings
above the integration level may be paid. Table 4 illustrates benefits
for 30-year workers in a fully integrated unit-benefit excess plan, which
uses average earnings.
For a worker with 371/2 years of credited service, the unit-benefit for-
mula used for table 4 becomes equivalent to the flat-benefit formula
in table 3. However, these formulas produce markedly different results
for workers with fewer years of service. For example: A worker with
20 years of service, who participates in the unit-benefit excess plan,
will receive a benefit equal to 20 percent of average earnings above
the integration level. If the same worker participates in the flat-benefit
excess plan, he or she will receive a benefit equal to 371/2 percent of
average earnings above the integration level.
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Plan sponsors may, therefore, choose among integration formulas
in order to achieve particular business and social goals. A sponsor
interested in retaining skilled workers for the longest possible period
may prefer to use a unit-benefit excess formula. He or she may choose
this formula because it provides a higher percentage of average earn-
ings for each additional year of service. On the other hand, a sponsor
interested in quickly maximizing benefits to higher-paid workers may
choose a flat-benefit excess formula. This formula can provide full
benefits after just 15 years of service.
Defined Contribution Excess Plans-In a defined contribution excess
plan, benefits are based on the accumulated value of employer
and/or employee contributions. Employer contributions to these plans
cannot exceed 5.7 percent of an employee's earnings above the in-
tegration level. The limit is based on the Old-Age, Survivors and
Disability Insurance (OASDI) payroll tax rate. This rate equals the
Social Security (FICA) tax (7.15 percent in 1987) minus the amount
attributable to Medicare Hospital Insurance, which is 1.45 percent
in 1987.
Step-Rate Excess Plans
Step-rate excess plans are similar to the excess plans just described.
Unlike pure excess plans, however, the benefits of step-rate plans may
accrue or contributions may be made on earnings below as well as
above the integration level. In step-rate excess plans, all participants
receive a pension benefit.'
In one sense, a step-rate excess plan is two plans: (1) it is a non-
integrated plan providing proportionately equal benefits to all work-
ers with earnings below the integration level; and (2) it is an excess
plan providing additional benefits to those with earnings above the
integration level. Restrictions on benefit accrual and contribution
percentages apply only to the excess part of the formula. They are
related to the limits in pure excess plans.
In flat-benefit step-rate formulas, the accrual rates on average earn-
ings above the integration level may be up to 371/2 percent more than
the accrual rates on average earnings below the integration level.
Similarly, maximum accrual rates on earnings above the integration
level may be up to: (1) 1.0 percent greater than accrual rates on
earnings below the integration level in unit-benefit plans using av-
'Even a pure excess plan would provide benefits to all participants if they all had
earnings above the integration level.
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erage earnings; (2) 1.4 percent greater than accrual rates on earnings
below the integration level in unit-benefit plans using each year's
actual annual compensation; and (3) 5.7 percent (OASDI rate) greater
than contribution rates on earnings below the integration level in
defined contribution plans.
Table 5 shows benefits and replacement rates for workers at various
earnings levels in a fully integrated, unit-benefit step-rate excess plan,
using average earnings.
Adjustments to Maximum Integration Percentages
In deriving maximum integration percentages and offsets, the IRS
has assumed that the employer-funded portion of Social Security
benefits (i.e., primary and ancillary) is equal to 371/2 percent of final
earnings for workers at the Social Security taxable wage base. The
basic assumption underlying the concept of integration is that an
employer should be able to fund a proportionate annuity for workers
whose earnings are above the taxable wage base. However, the pro-
visions of many integrated plans-if used in conjunction with max-
imum integration percentages-would raise the value of benefits above
the 371/2 percent limit. Consequently, the use of these provisions re-
quires downward adjustment of maximum integration percentages.
Six types of provisions require such adjustment:
(1) normal retirement at ages lower than 65;
(2) early retirement with benefit reductions that are less than actuarial
reductions;
(3) integrated disability benefits payable before age 65;
(4) employer-paid, integrated preretirement death benefits;
(5) normal forms of annuities other than straight life;
(6) earnings periods that are averaged over less than five years in excess
plans.
Upward adjustment of maximum integration percentages for excess
plans is allowed if the plan has integrated employee contributions.
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Top-Heavy Plans
Top-heavy plans must provide minimum, nonintegrated benefits or
contributions to plan participants who are not key employees 2 The
minimum benefit for nonkey employees in defined benefit plans is 2
percent of average annual compensation for each year of service-
not to exceed 20 percent of average annual compensation. The min-
imum contribution for nonkey employees in defined contribution plans
is the lesser of 3 percent of compensation or the highest contribution
rate for a key employee.
Tax Reform Act of 1986
TRA changes all of the rules for integrated plans for benefits earned
in 1989 and later. The general thrust of the changes is to reduce the
permitted disparity between the percentage of benefits or contribu-
tions for higher-paid and lower-paid employees.
For defined contribution plans, in addition to the old limit of 5.7
percent (the OASDI rate) in the contribution level above and below
the integration level, there is a new requirement. The contribution
percentage below the integration level must be at least half the con-
tribution percentage above the integration level. Thus, pure excess
plans will no longer be permitted. Also, the additional contribution
percentage above the integration level is limited to the greater of the
Social Security Old Age Insurance payroll tax rate at the beginning
of the plan year (less than 5 percent in 1987) or 5.7 percent.
At the time of this writing, several aspects of the new requirements
for integration of defined benefit plans depend upon technical cor-
rections or regulatory clarification.
For defined benefit excess plans, the benefit percentage below the
integration level must be at least half the benefit percentage above
the integration level. In addition, the difference between the per-
centages of benefits above and below the integration level may not
exceed 0.75 percent of pay times years of service (maximum 26.25
percent after 35 years). But this maximum allowable integration at
age 65 is reduced for participants born after 1937, so that the 0.75
2Defined benefit plans are considered top-heavy when the present value of accumulated
accrued benefits for key employees exceeds 60 percent of the present value of accu-
mulated accrued benefits for all employees. Defined contribution plans are top-heavy
when the sum of key employees' account balances exceeds 60 percent of all employees'
account balances. Key employees are company officers or other individuals meeting
specified ownership and earnings criteria.
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percent factor becomes 0.65 percent for participants born in 1960 and
later. The maximum integration level is limited to the Social Security
wage base ($43,800 in 1987), with the maximum allowable integration
being further reduced if the plan's integration level exceeds covered
compensation.
For offset plans, the changes are more radical, and there is more
uncertainty about the exact requirements at the time of this writing.
The amount of allowable offset will no longer be determined as a
percent of the Social Security primary insurance amount, but will
be 3/4 percent of three-year-final-average pay for each year of service.
The allowable percentage will vary with the level of compensation.
In addition, the maximum allowable offset may not exceed one-half
the amount of the benefit prior to the offset.
Unlike prior law, no adjustment in the maximum allowable inte-
gration is required to account for the form of annuity, death benefits,
disability benefits or employee contributions. However, adjustments
must still be made for early retirement if less than the actuarial
reductions is applied.
Conclusion
With the escalating costs of employee benefits, Social Security and
public assistance programs, concern over integration has expanded.
The public has become more aware of private and public benefit
program costs and their effects on our national productivity. Concern
now focuses on equity, affordability and efficiency issues as well as
on benefit adequacy.
Most employers believe integration is necessary to: (1) control total
employer retirement income costs; and (2) design efficient retirement
income programs that help correct overpensioning and underpen-
sioning problems.
Additional Information
Schulz, James H., and Thomas D. Leavitt. Pension Integration: Concepts,
Issues and Proposals. Washington, DC: Employee Benefit Research Insti-
tute, 1983.
U.S. General Accounting Office. How Large Defined Benefit Plans Coordinate
Benefits With Social Security. HRD-86-118BR. Washington, DC: U.S. Gov-
ernment Printing Office, July 1986.
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VIII. Profit Sharing Plans
Introduction
A profit sharing plan is a type of defined contribution plan;' it plays
a unique role in filling employee benefit planning objectives. Through
these plans, employees share in their companies' profits; this may
provide a strong incentive for increased employee productivity. De-
pending on plan design, profit sharing arrangements can provide
supplemental income to employees and their families at death, dis-
ability, retirement, employment termination or at other times for
personal use. This flexibility is another very attractive feature of profit
sharing.
About 100 years ago, Pillsbury Mills and Procter & Gamble each
established a cash (defined below) profit sharing plan. In 1916, Harris
Trust & Savings Bank (Chicago) established the first deferred (defined
below) profit sharing plan. In 1939, legislation clarified the tax status
of deferred plans. This legislation and the World War II wage freeze
resulted in rapid growth of profit sharing plans in the 1940s. Another
major increase in the growth of profit sharing plans was caused by
the 1974 Employee Retirement Income Security Act (ERISA). Since
ERISA imposed less burdensome regulations on profit sharing plans
than on pension plans, there was a substantial increase in pension
plan terminations and in profit sharing plan creations.
Today, profit sharing plans continue to increase in popularity. The
Profit Sharing Research Foundation estimates that by 1984, there
were approximately 360,000 companies practicing deferred or com-
bination profit sharing. Deferred plans cover approximately 20 per-
cent percent of private, nonfarm employment. Plans exist in
approximately 25 percent of manufacturing companies, 30 percent
of retailing and wholesaling companies and in about 40 percent of
banks 2 Qualified deferred plans cover about 20 million employees;
cash plans cover about 2 million employees. A substantial portion of
deferred plans provide for some direct cash payments to participants.
'Defined contribution plans are discussed in chapter VI.
TThis includes thrift plans, which share many characteristics of profit sharing plans.
Thrift plans are discussed in chapter IX.
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Types of Profit Sharing Plans
There are three basic types of profit sharing plans:
(1) Current or Cash Plan-At the time profits are determined, benefits are
paid directly to employees in the form of cash, checks or stock. (Typ-
ically, benefits are paid at the end of a fiscal year.)
(2) Deferred Plan-Contributions are credited to employee accounts and
paid out as benefits at retirement or at the time of other specified
events (e.g., death, disability or employment termination).
(3) Combination Plan-A portion of the benefit is paid in cash and another
portion is placed in an account until the employee's retirement or other
specified event.
For tax purposes, Internal Revenue Service (IRS) qualification of
profit sharing plans is restricted to deferred or combination profit
sharing plans. Therefore, the remainder of this chapter will focus
primarily on these two types of profit sharing arrangements.
Plan Design
To satisfy government regulations3 and employee benefit objec-
tives, profit sharing plans must be designed with the following ques-
tions in mind: Who is covered? How will employer contributions be
determined? How will contributions be allocated? How and when
will benefits be paid?
Vesting-Deferred profit sharing plans must define employee vest-
ing rights. The Tax Reform Act of 1986 (TRA) requires that profit
sharing plans satisfy one of two vesting rules: (1) 100 percent vesting
after five years of service, or (2) 20 percent after three years of service,
with an additional 20 percent for each subsequent year of service
until 100 percent vesting is achieved at the end of seven years of
service.
TRA also provides that the current maximum waiting period for
plan participation of three years for plans with full and immediate
vesting will be reduced to two years of service. If a plan requires an
employee to complete more than one year of service (aside from a
waiting period that a plan may require prior to an enrollment date)
as a condition of participation, the employee must be 100 percent
vested when the benefit is accrued.
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Plans with class-year vesting4 will not meet qualification standards
of TRA unless, under the plan schedule, the participant's total accrued
benefit becomes nonforfeitable as rapidly as under one of the previ-
ously described two vesting schedules.
All of the tax reform provisions discussed above are generally ap-
plicable for plan years beginning after December 31, 1988, with re-
spect to participants who perform at least one hour of service after
the effective date. A special effective date applies to plans maintained
pursuant to a collective bargaining agreement.5
Coverage-Qualified profit sharing plans that have age and service
requirements must meet ERISA's minimum standards (i.e., the plan
must cover all employees who are age 21 with one or more years of
service). Depending on plan characteristics, participation may be lim-
ited to specific employee groups, providing it satisfies nondiscrimi-
nation requirements that have been revised under TRA.6
Employer Contributions-When employers establish profit sharing
plans, they must intend for the plan to be permanent. Although em-
ployers can amend or terminate plans, if a plan is terminated shortly
after its inception for other than business reasons, IRS may construe
that the plan was not established for the benefit of all employees.
This could result in tax consequences.
Allocation of Employer Contributions
Plans must define how employer contributions will be allocated to
employee accounts. The allocation formula is generally based on com-
pensation. Allocations may be determined by calculating the pro-
portion of each employee's compensation, relative to the total
compensation of all plan participants. For example, if the employee
earns $15,000 annually and total annual compensation for all par-
ticipants is $300,000, he or she will receive 5 percent of the employer's
annual contribution.
Some plans base their allocations on compensation and service
credits. These plans must be very careful to assure that the wage/
service formula does not result in discrimination in favor of the pro-
4See footnote on page 32 for a definition.
5Under a collective bargaining agreement ratified before March 1, 1986, the amend-
ments are not effective for plan years beginning before the earlier of: (1) the later of
(a) January 1, 1989, or (b) the date on which the last of the collective bargaining
agreements terminates; or (2) January 1, 1991. Extensions or renegotiations of the
collective bargaining agreement, if ratified after February 28, 1986, are disregarded.
6See chapter IV for coverage rules.
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hibited group. Whether a plan uses compensation or compensation
and service in determining allocations depends on an employer's ob-
jectives. If employee retention is a primary goal, this can be reflected
in a pay-and-service allocation formula. Allocation formulas may be
integrated with Social Security, within prescribed limits.
For the present, dollar limits under section 415-the lesser of $30,000
or 25 percent of compensation for annual additions to defined con-
tribution plans-along with combined plan limits, have been re-
tained under TRA. TRA modified the provision of tax law that regulates
the maximum amount that an employer may contribute for employ-
ees and deduct for federal tax purposes. If a company has both a
profit sharing and a defined benefit pension plan covering the same
employees, the combined tax-deductible contributions to both plans
generally cannot exceed 25 percent of all covered employees' com-
pensation.
Also, an employer's contribution to a profit sharing plan for plan
years beginning after December 31, 1985, is not limited to the em-
ployer's current or accumulated profits (this provision applies with-
out regard to whether the employer is tax-exempt, although tax-exempt
employers who did not adopt a cash or deferred arrangement before
July 2, 1986, are no longer allowed to do so under TRA). Treasury
may require defined contribution plans to contain provisions that
specify whether they are pension or discretionary contribution plans.
TRA repeals the limit carryforward for profit sharing and stock
bonus plans effective for employer tax years beginning in 1987. Ac-
cordingly, if an employer's contribution for a particular year is less
than the maximum amount for which a deduction is allowed, the
unused limit may not be carried forward to subsequent years as under
prior law. TRA does not change the rules relating to deduction car-
ryforwards of contributions in excess of the deduction limit for a
particular year. Any amount paid into a profit sharing or stock bonus
trust in excess of the 15 percent deduction limit for the year may be
deductible in succeeding taxable years to the extent allowed. Such
contributions, however, may subject to the 10 percent nondeductible
excise tax that TRA imposes on excess contributions to a tax-qualified
pension, profit sharing, stock bonus, or annuity plan for employer
taxable years beginning after December 31, 1986. Excess contribu-
tions are defined as the sum of: (1) total amounts contributed for the
taxable year over the amount allowable as a deduction for that year;
and (2) the amount of excess contributions for the preceding year,
reduced by amounts returned to the employer during the year, if any,
and the portion of the prior excess contribution that is deductible in
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the current year. In other words, if an excess contribution is made
during a taxable year, the excise tax would apply for that year, and
for each succeeding year to the extent that the excess is not elimi-
nated. Excess contributions for a year are determined at the close of
the employer's taxable year and the tax is imposed on the employer.
Employee Contributions
Pure profit sharing plans do not require employee contributions,
but many profit sharing plans do permit voluntary employee contri-
butions. Employee contributions in the form of a salary reduction
arrangement are becoming increasingly popular. This is a result of
the 1978 Revenue Act (and subsequent regulations in 1981) that per-
mit employee contributions with pretax income to profit sharing plans.'
TRA makes extensive changes in what can be contributed to qualified
plans, although for most low- and moderate-income individuals sav-
ing for retirement, these changes will not have a major effect. For
highly compensated individuals, they could have a major effect.
Again, the maximum amount of combined tax-deductible contri-
butions that may be made to defined contribution plans generally
cannot exceed the lesser of 25 percent of compensation for the year,
or $30,000. Also, any after-tax employee contributions now count
dollar-for-dollar as annual additions under this limit; they also must
comply with special nondiscrimination rules.8 Adjustments to the
$30,000 limit will begin when the current defined benefit dollar limit
of $90,000 has been increased, due to cost-of-living increases, to
$120,000.
A new limit for most plans on includible compensation will have
the effect of isolating a greater portion of executives' benefit expec-
tations from those of the rank and file. TRA imposes a limit of $200,000
on the amount of compensation that can be used to determine allow-
able contributions and benefits, and for the nondiscrimination rules
starting in 1989. The $200,000 limit will be indexed to track the
defined benefit plan limits beginning in 1990.
7Profit sharing plans that utilize the salary reduction approach are known as 401(k)
arrangements. Salary reductions are treated as employer contributions for tax pur-
poses and must satisfy Internal Revenue Code regulations applicable to such arrange-
ments.
'The special nondiscrimination rules for employee after-tax contributions are the same
as the nondiscrimination rules for 401(k) arrangements (see chapter X).
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Profit sharing funds may be invested in a wide variety of vehicles
including corporate-stocks, bonds, real estate, insurance products and
mutual funds. Unlike qualified pension plans, profit sharing plans
may invest more than 10 percent of their assets in employer securities.
Therefore, contributions are frequently invested in employer secu-
rities. This practice may give participants an increased interest in
the firm's success.
Plan assets can be held in one fund or in several funds. The plan
sponsor usually has responsibility for developing broad investment
policies. The trustee (e.g., bank) is usually responsible for the actual
investment of plan assets.
Investment risk is assumed by the participant since employers do
not guarantee benefit levels in profit sharing plans. Some employers
permit participants to select among two or more investment options.
Retirement, Disability and Death Benefits-The law requires that
participants' account balances fully vest at retirement. In addition,
plans generally provide for full benefits upon death and disability.
The plan's vesting provisions determine whether an employee will
receive full or partial benefits upon other types of employment ter-
mination. However, if the plan is contributory (i.e., employees make
contributions), the employee will always receive the benefits that are
attributable to his own contributions.
Profit sharing plans typically give retiring participants and bene-
ficiaries of deceased participants a choice of up to three benefit pay-
ment options: (1) annuities; (2) installments; or (3) lump-sum
distributions. Usually, those who terminate employment for reasons
other than retirement, death or disability receive lump-sum distri-
butions, although if the benefit exceeds $3,500, the participant cannot
be forced to take an immediate lump-sum distribution.
Withdrawals-Although withdrawal provisions are more common
in thrift plans, some profit sharing plans provide for partial account
withdrawal during active employment. Plans allowing participants
to elect account withdrawals impose certain conditions; these con-
ditions vary widely. Withdrawal provisions must be designed with
care, or they may defeat the plan's major objectives (e.g., whether
the plan is intended to provide for retirement income or capital ac-
cumulation). Permissible withdrawal amounts are usually the value
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of employee contributions or employee and vested employer contri-
butions. Withdrawal provisions are also likely to change because of
the recent modification of their tax treatment, and, in particular, the
pro rata recovery of employee contributions discussed below.
TRA phases out capital-gains treatment for lump-sum distributions
over five years beginning January 1, 1987, and eliminates 10-year
forward averaging, replacing it with a one-time election of five-year
forward averaging for lump-sum distributions received after attain-
ment of age 591/2.
TRA provides significant penalties for early distributions from
qualified plans. It applies a 10 percent additional income tax to most
early distributions made before death, disability, or attainment of
age 591/2. The 10 percent additional tax does not apply to certain
distributions: (1) in the form of an annuity or installments payable
over the life or life expectancy of the participant (or joint lives or life
expectancy of the participant and the participant's beneficiary); (2)
made after the participant has separated from service on or after age
55; (3) used for payment of medical expenses deductible under federal
income tax rules; (4) received in a lump-sum before March 15, 1987,
if made on account of separation of service in 1986 if the recipient
elects to be taxed on the distribution in 1986; or (5) made to or on
the behalf of an alternate payee pursuant to a qualified domestic
relations order. A distribution rolled over to an IRA or to another
qualified plan will not be subject to additional tax.
Minimum distribution rules were also established under TRA, whereby
distributions must begin by April 1 of the calendar year following the
calendar year in which the individual attains age 701/2. There are also
rules about the minimum distribution required during a taxable year.
A 50 percent nondeductible excise tax will be imposed in any taxable
year on the excess of the amount that should have been distributed over
the amount that actually was distributed. The tax will be imposed on
the individual required to take the distribution.
Additionally, there are certain legal restrictions on withdrawal pro-
visions. For example, employees cannot generally make withdrawals
of employer contributions that have been held in the fund for less
than two years. Profit sharing plan sponsors must design withdrawal
provisions that consider administrative costs, satisfy IRS qualifica-
tion requirements and comply with the new tax law.
TRA imposes a 15 percent excise tax on the aggregate amount of
annual distributions (excluding basis recovery and rolled-over amounts)
to an individual in excess of $112,500 in 1987, or 1.25 percent of the
indexed defined benefit plan limit. Under a complex transition rule, the
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tax will either not apply to "excess" benefits accrued before August 1,
1986, or the applicable dollar threshold will be increased to $150,000.
A separate limit is used for a lump-sum distribution where 5-year or
10-year forward averaging treatment is used for income tax purposes.
For such a lump sum, a 15 percent excise tax applies if the lump sum
exceeds five times the annual threshold in effect the year in which the
distribution is received (e.g., 5 x $150,000 = $750,000).
TRA also: (1) modifies present-law basis recovery rules for amounts
distributed prior to a participant's annuity starting date to provide pro
rata recovery of employee contributions; this means employees can no
longer withdraw nontaxable employee contributions only; (2) elimi-
nates the special three-year basis recovery rule of present law; (3) mod-
ifies the general basis recovery rules for amounts paid as an annuity to
provide that each distribution is treated in part as recovery of employee
contributions and in part as payment of taxable employee contribu-
tions; and (4) restricts rollovers of partial distributions to distributions
due to separation from service. The new basis recovery rules do not
apply to employee contributions made prior to January 1, 1987, to the
extent that, on May 5, 1986, such contributions were available for dis-
tribution under a plan before separation of service.
TRA also includes a "separate contract rule" that applies to plans
accepting both pretax and after-tax contributions. The rule allows
the employee's after-tax contributions, and the earnings on those
contributions, to be treated as a separate "plan" for purposes of the
pro rata rule. Thus, only the percentage represented by earnings on
the after-tax contribution would be taxable.
Loans-Some plans permit employees to borrow a portion of their
vested benefits. In general under TRA, the employee must repay the
loan according to a level amortization schedule with payments made
at least quarterly. If loans are permitted, they must be available to
all participants on a comparable basis, and they must bear a reason-
able interest rate. (The 1982 Tax Equity and Fiscal Responsibility
Act included additional loan requirements for qualified profit sharing
plans, and TRA precludes a deduction for loan interest paid on loans
made to a key employee.)9
In general, taxation of distributions from qualified profit sharing
plans is the same as taxation of distributions from qualified pension
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plans.10 Employer contributions are tax deductible to the employer.
Employer contributions and investment earnings or gains on em-
ployee/employer contributions are not taxed to the employee until
actually received. Employee contributions may be made from after-
tax or pretax income.
There are also limits on the amounts that an employer can con-
tribute annually for individual participants. These limits only affect
highly paid employees. tt
Integration of Profit Sharing Benefits With Social Security
Benefits
Profit sharing plan benefits can be integrated (i.e., coordinated)
with Social Security benefits through one of two methods: (1) a pure
excess formula; or (2) a step-rate excess formula.12 In an excess formula,
contribution allocations are provided only to employees who earn
income above the maximum Social Security taxable wage base ($43,800
in 1987). In a pure excess formula, the maximum allowable employer
contribution is currently 5.7 percent of each participant's compen-
sation above the taxable wage base. Employer contributions, as well
as the reallocation of benefits forfeited by nonvested terminating par-
ticipants, must be included in the 5.7 percent maximum.
Under a step-rate excess formula, all employees participate in the
profit sharing plan, but a larger percentage of compensation is al-
located relative to earnings above the integration level than to earn-
ings below the taxable wage base. The maximum difference in the
permitted contribution to the two groups is 5.7 percent. For example,
if an employer contributes 5 percent of each participant's earnings
below the taxable wage base, the maximum contribution that can be
made on each participant's earnings above the wage base is 10.7
percent. In a step-rate excess plan, the reallocated benefits forfeited
by terminating employees are not included in the 5.7 percent con-
tribution differential.
When the contribution formula is expressed as a percentage of
profits, rather than of compensation, a variation of the excess or step-
rate excess integration methods is used. Additionally, if an employer
has a profit sharing and a pension plan, the combined integration
under the two plans cannot exceed 100 percent of the permitted in-
10For information on taxation of pension plan distributions, see pages 42-43.
"See discussion on ERISA's contribution limits for defined contribution plans, pages
28-29.
12For a more detailed discussion of these integration formulas, see chapter VII.
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tegration of one plan. Integrated profit sharing plans, however, are
rare.
For plan years beginning after December 31, 1988, TRA provides
that a plan is not to be considered discriminatory merely because
the contributions and benefits under the plan favor highly compen-
sated employees, if the plan meets new disparity limits. Under TRA,
the contribution percentage below the integration level must be at
least half the contribution percentage above the integration level.
Thus, pure excess plans will no longer be permitted. For step-rate
excess plans, a defined contribution plan meets the disparity limits
for integrated plans only if the excess contribution percentage above
the integration level does not exceed the base contribution by more
than the lesser of either (1) the base contribution percentage, or (2)
the greater of 5.7 percentage points or the percentage equal to the
Social Security Old Age Insurance payroll tax rate (currently less
than 5 percent).
Conclusion
From the employee's point of view, a cash profit sharing plan is a
form of contingent bonus. If profits are good, benefits are paid. Plan
sponsors should understand, however, that after several years of suc-
cessful plan performance, there is some danger employees could view
their benefits as a certainty and spend anticipated benefits before
they materialize.
Deferred plans are more complex. They are generally intended to
supplement other benefit plans. They sometimes attempt to fill many
needs; and in doing so, they may not succeed in satisfying specific
goals. For example, a plan that permits liberal withdrawals can result
in modest capital accumulation or retirement benefits.
Profit sharing provides unique incentives for employee productiv-
ity. It helps raise employee awareness about the importance of profits;
thus, employees may work harder and more effectively to enhance
the company's success. Profit sharing plans may create a favorable
attitude among employees, greater job satisfaction and work force
stability.
In profit sharing plans, employer costs need be incurred only when
(and to the extent that) profits are substantial enough to justify ben-
efits. In deferred plans, the company's financial commitment ends
with its contribution and with prudent investment of plan assets.
Because of their advantages to both employees and employers, profit
sharing plans will continue to play an important role in employee
benefits planning.
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Additional Information
Profit Sharing Council of America
20 N. Wacker Drive
Chicago, IL 60606
Weitzman, Martin L. The Share Economy. Cambridge, MA: Harvard Univer-
sity Press, 1984.
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IX. Thrift Plans
Introduction
A thrift plan is a type of defined contribution plan.' The Internal
Revenue Code (IRC) considers thrift plans to be a type of profit sharing
plan.2 Thus, what are commonly called profit sharing plans and thrift
plans are very similar. Differences between the two plans include:
(1) Thrift plans generally require employees to make contributions in order
to be a participant-profit sharing plans do not.
(2) Since thrift plans often require employee contributions, they normally
cost the employer less than profit sharing plans.
Employees generally make periodic contributions to thrift plans.
Employee contributions are often matched (completely or in part) by
employer contributions. These contributions are placed in a trust
fund and invested. For record-keeping purposes, each participant's
savings and investment earnings are assigned to an individual
account.
Matching employer contributions provide a strong incentive, and
employees have found thrift plans to be an attractive way of saving.
In addition, the tax-favored treatment of employer contributions and
investment gains makes these plans effective capital-accumulation
vehicles.
Coverage, Participation and Vesting
Thrift plans, as qualified retirement plans, must comply with min-
imum coverage, participation and vesting standards. The 1986 Tax
Reform Act (TRA) made major changes in these rules generally be-
ginning in 1989.
Coverage rules are designed to ensure that a retirement plan does
not disproportionately cover and benefit employees who are officers,
'Thrift plans are also known as savings and investment savings plans. Defined con-
tribution plans are discussed in chapter VI.
2Profit sharing plans are discussed in chapter VIII.
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shareholders or highly compensated. TRA standardized the rules for
all types of qualified retirement plans .3
Participation in a plan must be allowed to employees who have
attained age 21 and have one year of service. Plans with full and
immediate vesting may require as many as three years of service
before participation begins. In plan years beginning after December
31, 1988, the maximum service requirement is lowered to two years.
In actual practice, participation usually depends on some minimum
service requirement. Employees are usually able to participate after
a short service period, such as six months or a year. Maximum age
requirements are not permitted.
Until December 31, 1988, employer contributions may vest ac-
cording to one of three standards under the Employee Retirement
Income Security Act (ERISA): (1) 10-year rule; (2) 5-to-15-year rule
(sometimes called the graded 15-year rule); or (3) rule of 45 4 Addi-
tionally, the 1982 Tax Equity and Fiscal Responsibility Act requires
certain plans to use more accelerated vesting and to provide mini-
mum contributions in years when the plan primarily benefits key
employees.5 Most plans practice more liberal policies and permit
employees to fully vest upon retirement, death or disability regardless
of age and service. (A plan must provide full vesting at normal re-
tirement age.) As in other qualified employee benefit plans, employee
contributions are always fully vested. If a participating employee
terminates without full vesting, the forfeited employer contributions
may be reallocated among employees, or they may be used to reduce
employer contributions.
Beginning with plan years after December 31, 1988, employer con-
tributions must vest according to one of two schedules: (1) 100 percent
after five years of service or (2) 20 percent after three years of service
and 20 percent after each subsequent year of service until 100 percent
vesting is achieved at the end of seven years of service .6
Employee Contributions
Most thrift plans are contributory; to participate, eligible employees
agree to make voluntary contributions. Employee contributions to
3A detailed description of coverage rules for qualified plans is in chapter IV.
'For a definition of these vesting rules, see pages 32-33.
5Key employees are company officers or other individuals meeting specified ownership
and earnings criteria.
6The vesting rules are applicable for employer contributions to most qualified plans.
Multiemployer plans may satisfy different vesting standards: the 1986 Tax Reform
Act requires ten-year vesting. See chapter V for more information on multiemployer
plans.
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thrift plans are of two types: (1) basic contributions, which are matched
by employer contributions; and (2) supplemental contributions, which
are not matched by employer contributions. Depending on the plan's
structure, the employee's contributions can be made from after-tax
income or through pretax income in the form of a salary reduction?
Employee contributions are generally made through payroll deduc-
tions.
Sometimes the employer requires participants to contribute a spec-
ified percentage of pay. More often, however, employees are permitted
to choose a contribution level of between 1 percent and 6 percent of
pay. Supplemental employee contributions above the maximum basic
contribution level may also be allowed. The law permits supplemen-
tal employee contributions of up to 10 percent of pay, plus the lowest
rate of basic employer contributions.
After providing reasonable notice to the employer, employees may
be permitted to change or suspend contributions. Most plans restrict
the frequency of such changes (e.g., they may be limited to once a
year). When employees suspend contributions, the suspension is often
limited to a six-month period.
Employer Contributions
Employers can make contributions to a thrift plan through a num-
ber of arrangements. Employer contributions usually are defined as
a fixed percentage of each dollar of basic employee contributions,
although they can be defined as a flat-dollar amount. The matching
percentage may be the same for all employees, or it may increase
with years of service or participation. The most common employer
contribution is 50 percent of the basic employee contribution; how-
ever, many employers provide either lower or higher contribution
amounts. Under a different approach, employers may provide: (1) a
contribution matched (partially or fully) to an employee's contribu-
tion; and (2) a supplemental contribution based on profits. Under a
relatively uncommon approach, employer contributions are based
entirely on profits. The level of the employer's matching contribution
7Thrift plans that utilize the salary reduction approach are commonly referred to as
401(k) arrangements. Contributions made through salary reduction are treated as
employer, not employee, contributions. There are special rules governing these ar-
rangements, which are discussed in chapter X.
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appears to be the most important factor in influencing eligible em-
ployees to elect to participate a
Most thrift plans offer more than one investment option and are
allowing the participant flexibility in choosing among options. In
some cases, employer contributions must be placed in a designated
investment vehicle, and flexibility is permitted only with regard to
employee contributions. Popular investment vehicles include com-
pany stock, fixed-dollar investment accounts, guaranteed investment
contracts through insurance companies and equity funds.
Many plans permit employees to change their investment elections.
Where permitted, such a change may be limited to investment of
future contributions or it may apply to both past and future contri-
butions. An employee generally is permitted to change his or her
election at the time investment funds are valued. The question of
whether to provide investment alternatives depends on the plan's
objectives and its role in the company benefit package.
Distributions
Retirement, Disability and Death Benefits-The law requires that
participants' account balances fully vest at the plan's normal retire-
ment age. In addition, plans generally provide for full benefits upon
death and disability.
Thrift plans typically give retiring participants and beneficiaries
of deceased participants a choice of up to three payment options:
(1) annuities; (2) installments; or (3) lump-sum distributions. Usually,
those who terminate employment for reasons other than retirement,
death or disability receive lump-sum distributions, although if the
benefit exceeds $3,500, the participant cannot be forced to take an
immediate lump-sum distribution.
Withdrawals-Some plans provide for account withdrawals during
active employment. Plans that allow such account withdrawals im-
pose certain conditions, which vary widely. Withdrawal provisions
must be designed with care, or they may defeat the plan's major
objectives (e.g., whether the plan is intended to provide for retirement
income or capital accumulation). Permissible withdrawal amounts
$Bankers Trust Company, Bankers Trust Company 1977 Study of Employee Savings and
Thrift Plans (New York, 1977), p. 15. Other important factors influencing participation
are vesting provisions and the degree of investment flexibility.
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are usually the value of employee contributions or employee and
vested employer contributions. Withdrawals prior to age 591/2 (with
some exceptions) are subject to a penalty tax. (See "Taxation" section
below for a more detailed description.)
Additionally, there are certain legal restrictions on withdrawal pro-
visions. For example, employees generally cannot make withdrawals
of employer contributions that have been held in the fund for less
than two years. Thrift plan sponsors should design withdrawal pro-
visions that consider administrative costs and satisfy Internal Rev-
enue Service qualification requirements.
Loans-Some plans permit employees to borrow a portion of their
vested benefits. Generally, the employee repays the loan according
to a specified repayment schedule. If loans are permitted, they must
be: (1) available to all participants on a comparable basis; (2) ade-
quately secured; and (3) made by the plan (i.e., not by a third party
such as a bank). Loans from thrift plans must bear a reasonable
interest rate. Recent legislation has placed further restrictions on
loans.9
(1) Loans for more than $10,000 may not exceed one-half of the present
value of the employee's nonforfeitable accrued benefit, subject to an
overall loan maximum of $50,000.
(2) Loans must be repaid under a level amortization schedule within 5
years, with payments at least quarterly.
(3) The only allowable exception to the 5-year repayment rule is to acquire
a primary residence of the employee.
Qualified thrift plans are regulated by the IRC and ERISA. If the
plan is qualified, employer contributions are tax-deductible to the
employer. Employer contributions and investment earnings or gains
on employee/employer contributions are not taxed to the employee
until actually received. In plans with after-tax employee contribu-
tions, distributions are taxable on a pro rata basis. Distributions
made before the annuity starting date will be allocated in the same
proportion that the individual's total after-tax employee contribu-
tions bear to the total value of his accrued benefit or account balance.
9For a detailed description of restrictions on loans from thrift plans and all qualified
plans, see chapter IV.
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Withdrawals before age 59th are subject to a 10 percent additional
tax unless the distribution is (1) in the form of an annuity or install-
ments payable over the life or life expectancy of the participant (or
the joint lives or life expectancy of the participant and the partici-
pant's beneficiary); (2) made after the participant has separated from
service, on or after age 55; (3) used for payment of medical expenses
to the extent deductible under federal income tax rules; (4) received
in a lump sum prior to March 15, 1987 if made on account of sepa-
ration from service in 1986 and the recipient elects to treat the dis-
tribution as paid in 1986; or (5) made to or on behalf of an alternate
payee pursuant to a qualified domestic relations order. A distribution
that is rolled over to an individual retirement account or to another
qualified plan will not be subject to this tax.
The maximum amount that an employer may contribute for all
employees and deduct for federal tax purposes is 15 percent of com-
pensation. If a company has both a thrift plan and a defined benefit
pension plan covering the same employees, the combined tax-de-
ductible contributions to both plans cannot exceed 25 percent of all
covered employees' compensation.
There are also limits on the amounts that an employer can con-
tribute annually for individual participants.'?
Plan Administration
The administrative complexity of a thrift plan depends on its de-
sign. Individual participant account records must be maintained, and
annual account statements must be provided to employees. Admin-
istrative complexity varies with the number of employee options (e.g.,
contribution rates, investment vehicles and the frequency of permit-
ted changes). Larger plans usually use computerized record sys-
tems-sometimes these are internal, at other times they are provided
by an outside consulting, financial or administrative service orga-
nization. Administrative responsibilities are often divided between
the employer and an outside organization. As a plan matures and its
trust fund grows, it is frequently necessary to hire an investment
manager and an internal liaison.
Conclusion
Thrift plans can play a major role in a firm's total benefit program.
They may function as the principal retirement income vehicle, or
10See discussion on ERISA's contribution limits for defined contribution plans, pages
28-29.
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they may provide supplemental retirement income. In the past, thrift
plans could also provide savings to be used in financing a house or
a vacation; the flexible characteristics of thrift plans offered employ-
ees and employers freedom to adapt the plan to their needs. Now,
because of tax reform changes imposing a tax penalty on lump-sum
withdrawals before 59'/z and requiring pro rata recovery of employee
after-tax contributions, use of thrift plans to generate nonretirement
savings will be less desirable.
Additional Information
The Wyatt Company. Top 50: A Survey of Retirement, Thrift and Profit-
sharing Plans Covering Salaried Employees at 50 Large U.S. Industrial Com-
panies as of January 1, 1986. Washington, DC: The Wyatt Company, 1986.
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X. 401(k) Cash or Deferred
Arrangements
A qualified cash or deferred arrangement (CODA), under section
401(k) of the Internal Revenue Code (IRC), allows an employee to
elect to have a portion of his or her compensation (otherwise payable
in cash) contributed to a qualified profit sharing, stock bonus or pre-
ERISA money-purchase pension plan. The employee contribution is
treated not as current income, but most commonly as a pretax re-
duction in salary, which is then paid into the plan by the employer
on behalf of the employee. In some cases, an employer may contribute
a portion of the company's profits to the plan on behalf of the em-
ployee. Whatever portion is not contributed to the plan may be taken
in cash. In both instances, the employee defers income tax on the
401(k) contribution until withdrawal.
Various forms of deferred compensation have existed for years. As
early as the mid-1950s, cash or deferred option profit sharing plans
using pretax employee contributions were permitted by the Internal
Revenue Service (IRS) as long as at least half of the participants
electing to defer were in the lowest paid two-thirds of all plan par-
ticipants. The primary advantage of these plans is the employee's
ability to defer tax on a portion of income until a future time, when
he or she might be able to pay tax at a lower marginal rate.
The IRS, departing from general tax principle - which treats in-
come as taxable when it is constructively received, or made available,
to an individual whether or not the individual actually received the
income-determined that cash or deferred compensation would not
be considered constructively received, and thus not currently taxed.
This basic rule continued until late 1972, when the IRS issued a
proposed regulation that would have reversed its prior position on
constructive receipt and effectively eliminated tax-deferred income.
There were a number of CODAs in existence at that time, so Congress,
through the Employee Retirement Income Security Act (ERISA) of
1974, allowed the tax treatment of CODA plans in existence before
June 28, 1974, to continue. New plan formation, however, was frozen
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until Congress could study the use of cash or deferred compensation
and its preferential tax treatment.
The Revenue Act of 1978 sanctioned cash or deferred arrangements
(effective January 1, 1980) through the addition of section 401(k) to
the Internal Revenue Code-hence the commonly used reference to
this type of arrangement as a "401(k)" plan. Proposed regulations
issued in November 1981 delineated new and more restrictive cov-
erage and nondiscrimination requirements beyond ERISA's mini-
mum standards for qualified benefit plans.
Although final IRS regulations are not published, the Internal Rev-
enue Service has announced that employers can rely on the proposed
regulations as guidelines in qualifying their 401(k) plans. The pro-
posed regulations, however, leave open the interpretation of some
distribution and coverage rules, and because of this, some employers
have been reluctant to establish a 401(k) plan without final regula-
tions. Nevertheless, there has been a significant growth in 401(k)
plans since 1981. Forty-six of the nation's "top 50" companies had
401(k) plans in 1985,' although the incidence of salary reduction is
probably greater in larger companies. A survey of medium and large
firms by the Department of Labor2 shows that 31 percent of full time
workers in 1986 were eligible to make 401(k) contributions, up from
26 percent in 1985.
Types of 401(k) Arrangements
Although other forms of cash or deferred arrangements currently
exist and may evolve in the future, there are four principal types of
benefit plans to which section 401(k) is applicable: (1) thrift plans;
(2) profit sharing plans; (3) "stand alone" salary reduction plans; and
(4) as a part of cafeteria plans.3
'The Wyatt Company, Top 50: A Survey of Retirement, Thrift and Profit-sharing Plans
Covering Salaried Employees of 50 Large Industrial Companies as of January 1, 1986.
Other surveys on the design features and plan experience of 401(k) plans include:
Massachusetts Mutual Life Insurance, 401(k) Survey Report (June 1985); Hewitt As-
sociates, Survey of Plan Design and Experience in 401(k) Salary Reduction Plans, 1985;
Towers, Perrin, Forster & Crosby, What Makes 401(k) Plans Appealing? A Survey of
Design Features and Plan Experience, January 1986. See also the discussion of the
Federal Reserve Bank of Atlanta survey, in Retirement Plans: Deferred Compensa-
tion's Popularity Soars," Economic Review, (October 1983): 34-43.
'U.S., Department of Labor, Bureau of Labor Statistics, "BLS Reports on Employee
Benefits in Medium and Large Firms in 1986," USDL 87-130, March 31, 1987.
3These plan types are descriptive only. A plan utilizing section 401(k) must be part of
a profit sharing, stock bonus or pre-ERISA money-purchase pension plan.
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401(k) Thrift Plans-A thrift plan with a 401(k) feature is virtually
identical in design to a typical conventional savings, or thrift, plan:
the employee contributes a percentage of pay and the employer may
provide a matching contribution 4 The funds are held in trust and
invested. In terms of taxation, however, the two plans are quite dis-
similar. In a conventional thrift plan, contributions made by the em-
ployee are not tax deductible, although no tax is assessed to the
employee on employer contributions or on the investment earnings
of the plan account until benefits are paid from the plan. In a 401(k)
thrift plan, an employee contributes a portion of pretax earnings
through a salary reduction, and therefore, he or she can exclude the
contribution to the plan from taxable income. The tax savings from
this type of plan can be quite significant.
Profit Sharing Plans-Under a profit sharing plans with a 401(k)
feature, the employer generally makes an annual contribution derived
from current or accumulated profits, although they are no longer
necessary under the 1986 Tax Reform Act (TRA). Each eligible em-
ployee is allocated a portion of the total contribution generally based
on the employee's compensation as a percentage of the total employer
plan contribution. The employee has the option of taking the contri-
bution, or some specified portion of it, in cash or contributing it to
an individual account where it is held and invested until distribution.
Any compensation taken in cash is currently taxable. Many plans also
allow an employee to defer a portion of his or her monthly salary and
contribute it to the account, thereby reducing taxable income. These
"deferrals" are not taxed until distribution.
"Stand Alone" Salary Reduction Plans-Plan sponsors may set up
a qualified savings plan funded solely through a salary reduction
agreement with no employer contributions. This type of plan is some-
times referred to as a "stand alone" salary reduction plan, because
it can be established with employee salary reductions exclusively. A
"stand alone" plan allows an employee to defer a percentage of pretax
earnings each year and the funds are held in trust until distribution.
A conventional plan requires only employee contributions, but the
most prevalent type of plan includes employer matching contribu-
tions.
Cafeteria Plans-Section 401(k) arrangements may be part of a qual-
ified cafeteria plan, authorized under section 125 of the IRC. A caf-
eteria plan allows an employee to choose among a variety of benefit
4For more information on thrift plans, see chapter IX.
'For more information on profit sharing plans, see chapter VIII.
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options (taxable and nontaxable). Typically, a plan includes benefits
such as life insurance, medical/dental, disability, legal services, child
care and cash. The employee is not taxed on the nontaxable benefits
selected, but is taxed on the value of any taxable benefits he or she
has chosen.
An employer who maintains both a 401(k) and a cafeteria plan may
allow any cash paid from the cafeteria plan to be transferred to a
401(k) plan on a tax-sheltered basis. In addition, through a salary
reduction arrangement, cafeteria plans may permit employees to pur-
chase additional coverage with their own pretax dollars .6
Contributions
Contributions to a 401(k) plan can be of four types:
Elective contributions-tax-excludible employee contributions (made
by the employer on behalf of the employee) in the form of a salary
reduction.
(2) Nonelective contributions-contributions made by the employer from
employer funds. Sometimes these are made to help satisfy nondiscri-
mination tests (see below).
(3) Matching contributions-employer contributions that "match" em-
ployee contributions, although the employer does not always provide
a full dollar-for-dollar match.
(4) Voluntary contributions-after-tax employee contributions not made
through a salary reduction.
In general, each year the 401(k) plan participant can direct his or
her contribution to a menu of investment choices that most often
includes three fund options: (1) a fixed (or guaranteed investment)
fund, which invests in a guaranteed interest contract with an insur-
ance company; (2) a balanced fund, which is designed to provide
stability as well as growth through an investment mix of stocks and
bonds; and (3) an equity fund, which may have the most potential
growth, but also the most risk. Investments in this fund are made
only in stocks. The different funds allow the participant the option
to direct investments toward his or her individual retirement plan-
ning goal. Other options include bond funds, money market funds,
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fixed income securities, real estate and company stock. The most
prevalent investment choice appears to be guaranteed income funds .7
Employee elective contributions made with pretax dollars to a 401(k)
plan are limited to $7,000 and are coordinated with elective contri-
butions to simplified employee pensions, state and local government
plans, tax-sheltered annuities and section 501(c)(18) trusts. Beginning
in 1988, the $7,000 cap is adjusted for inflation by reference to per-
centage increases in the dollar limit under a defined benefit plan .8
The limits on total employer and employee contributions to a qual-
ified 401(k) plan are governed by the same rules as other defined
contribution plans (IRC section 415). In general, the sum of the em-
ployer's contribution (including the amount the employee elected to
contribute through salary reduction plus any employer "matching"
contributions) and any after-tax employee contribution may not exceed
the lesser of 25 percent of an employee's compensation or $30,000.
Before TRA, only a portion (6 percent) of the employee's after-tax
contribution was counted in these limits. TRA also applies a limit of
$200,000 on compensation that may be taken into account in deter-
mining the limit.
The employee's ability to withdraw funds from a 401(k) plan is
restricted. In general, distributions may be made before age 59th only
in the case of retirement, death, disability, termination of employ-
ment, plan termination (or sale of a subsidiary or substantially all
the business' assets) or limited distributions for financial "hard-
ship."9 Distributions from a 401(k) plan can be in the form of an
annuity in installments, in a lump sum or through a plan's loan
provision.
Special Legal Requirements
Because a 401(k) arrangement is a qualified retirement plan, it must
comply with coverage, participation, vesting and distribution rules.
Coverage-Section 401(k) arrangements must satisfy coverage rules
designed to insure that highly compensated employees do not dis-
'See "Retirement Plans: Deferred Compensation's Popularity Soars" and Massachu-
setts Mutual, 401(k) Survey Report, for a percentage breakdown of 401(k) funds among
types of investment vehicles.
8For greater detail on inflation adjustments for defined benefit and defined contri-
bution limits, see chapter IV.
9A more thorough discussion of 401(k) hardship rules follows later in this chapter.
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proportionately benefit from the plan. TRA standardized coverage
rules for all qualified retirement plans, effective for plan years after
December 31, 1988.10 In general, the rules require a plan to cover a
specified percentage of employees who are not "highly compensated"
as defined under the new law. In addition, TRA added a minimum
participation rule that qualified plans must satisfy.
An employee is defined as "highly compensated" under TRA if at
any time during the year or the preceding year, the employee: (1) was
a 5 percent owner of the employer; (2) earned more than $75,000 in
annual compensation from the employer; (3) earned more than $50,000
in annual compensation from the employer and was a member of the
top-paid group of employees, the top 20 percent of employees by pay
during the same year; or (4) was an officer of the employer and re-
ceived compensation greater than 150 percent of the dollar limit on
annual additions to a defined contribution plan ($45,000 in 1987).
The $50,000 and $75,000 thresholds are indexed in the same manner
as the indexation of the dollar limit for defined benefit plans under
IRC section 415. Under a special rule designed for those who are
newly hired or who receive increases in compensation, if an employee
is not a 5-percent owner the top 100 employees by compensation
during the current year and not highly compensated during the pre-
ceding year, then that employee is not treated as highly compensated
for the year, but will be considered highly compensated for the fol-
lowing year if the employee otherwise falls within the definition of
highly compensated.
Section 401(k) arrangements must also satisfy special nondiscri-
mination rules" that restrict the amounts the most highly compen-
sated elect to defer-as a percentage of compensation-with the
amounts deferred by the remainder of eligible employees. The rules
are satisfied through a set of tests that must be run annually.
The test works this way: The eligible group of employees (defined
as those employees who are eligible for employer contributions under
the plan for that year) is divided into the highly paid and the lower
paid. Then, within each group, the percentage of compensation that
each employee is contributing to the plan is determined. The per-
10A detailed description of coverage rules for qualified plans as amended by TRA is
in chapter IV.
"TRA modified the rules generally effective for plan years after December 31, 1986.
In collectively bargained plan agreements ratified before March 1, 1986, the amend-
ments are not effective for plan years beginning before the earlier of (1) January 1,
1989 or (2) the date on which the last of the agreement terminates (determined
without regard to any extensions in the agreement).
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centages for each employee are totaled and averaged to get an "actual
deferral percentage" (ADP) for the group. The ADP for the high-paid
group is then compared with the ADP for the low-paid group.
The actual deferral percentage test may be satisfied in one of two
ways:
Test 1: The ADP for the eligible highly compensated may not be more
than the ADP of the other eligible employees multiplied by 1.25.
Test 2: The excess of the ADP for the highly paid over the lower paid may
not be more than 2 percentage points, and the ADP for the highly
paid may not be more than the ADP of the lower paid multiplied
by 2.
For example, if the actual deferral percentage for the lower paid
group is 4 percent and the actual deferral percentage for the higher
paid group is 6 percent, are the nondiscrimination rules satisfied?
Test 1: Because 6 percent (the ADP of the higher paid) is greater than 5
percent (4 percent x 1.25), test 1 is not satisfied.
Test 2: Because 6 percent (the ADP of the higher paid) is not more than
2 percentage points more than 4 percent (the ADP of the lower
paid) and 6 percent is not more than 8 percent (the ADP of the
lower paid multiplied by 2), test 2 is satisfied.
Because one of the tests has been satisfied, the special nondiscri-
mination rules are, therefore, satisfied.
The following table illustrates the maximum ADPs allowed for the
top-paid employees, assuming various ADPs for the lower paid:
If the Average ADP and any
Employer
Contribution for the Lower The Maximum Average ADP (Including Any
Paid Is: Employer Contribution) for the Top Paid Will Be
Test 1
Test 2
'/2%
5/8%
1%
1
1'A
2
2
2'/2
4
3
33/4
5
4
5
6
5
6'/4
7
6
7'/2
8
7
83/4
9
8
10
10
9
11'/4
11
10
12'/2
12
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"Fail Safe" Devices-A 401(k) plan may be designed to include a
"fail-safe"mechanism, which allows plan sponsors to meet the special
nondiscrimination tests using nonelective employer contributions. 12
This provision allows the use of employer contributions to ensure
that the ADP tests are satisfied. These contributions must not cir-
cumvent the basic antidiscrimination rules applicable to qualified
plans. In addition, such amounts, unlike regular nonelective employer
contributions, must be 100 percent vested and subject to 401(k) with-
drawal restrictions.
Such a provision must be used with care, however, because the
excess amounts included in the ADP computation may cause the con-
tributions to exceed the statutory employer deductible and individual
participant limits.
Vesting and Participation-Under a qualified 401(k) plan, an em-
ployee's right to the portion of his or her accrued benefit (based on
any elective contribution and any employer contributions used to
satisfy the ADP tests) must be immediately and 100 percent nonfor-
feitable. Nonelective employer contributions that are not used to sat-
isfy the ADP tests, however, do not need to be immediately and 100
percent vested. They must, however, vest in accordance with ERISA
requirements.13 Beginning in 1989, a plan cannot require, as a con-
dition of participation, that an employee complete a service period
greater than one year.
Distributions-One of the rules that has most concerned many em-
ployees and caused much discussion among employers is the limi-
tation on withdrawals from a 401(k) plan. In a regular profit-sharing
plan, generally, employer contributions held in trust for at least two
years may be distributed to participants (but such distributions would
be subject to income tax and possibly to an additional 10 percent tax
if made before age 591/2). Amounts deferred and held in trust in a
401(k) plan may not be distributed to participants or beneficiaries
until the participant's retirement, death, disability, attainment of age
591/2, termination of employment or financial "hardship."
The IRS proposed regulations define "hardship" as an "immediate
and heavy financial need." In determining whether a plan participant
has an "immediate and heavy need," there must be: (1) a heavy and
immediate financial expense and (2) no other resources reasonably
12 Employer contributions made for this purpose must be fully vested and satisfy the
withdrawal limitations applicable to elective deferrals.
13ERISA vesting rules are described on pages 32-33.
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available to satisfy that expense. The proposed regulations offer no
additional explanation of the hardship rules, although final regula-
tions, scheduled for release in 1987, will include a precise definition.
Beginning in 1989, TRA limits hardship withdrawals to an employee's
elective contributions made through salary reduction (not including
income thereon).
Contributions-Elective and nonelective contributions to a quali-
fied section 401(k) arrangement are excludible from the employee's
gross income until distribution. The employee thus defers federal
income tax until the time he or she withdraws his or her benefit. The
deferral of taxation applies also to most states and municipalities.14
Voluntary employee contributions (i.e., those not made through a
salary deferral), however, are presently taxable, and are limited to
10 percent of total salary. Any earnings generated by these contri-
butions (elective, nonelective and voluntary) are also not taxed until
withdrawal.
Until the end of 1983, employer contributions and employee con-
tributions made through a salary reduction to a 401(k) plan were not
considered wages for the purposes of Social Security (FICA) and un-
employment (FUTA) taxes. The employee, therefore, was not cur-
rently taxed for FICA or FUTA on the contribution amount, and the
employer incurred less payroll tax. The 1983 Social Security Amend-
ments imposed FICA and FUTA taxes on 401(k) plan contributions
made from salary deferrals.
The employer's total 401(k) plan contribution may be claimed as
a deductible business expense up to the statutory limits defined under
IRC section 404. Amounts contributed to the plan-elective and non-
elective-may not exceed 15 percent of total participant compensa-
tion.
Distributions-The new rules governing withdrawals from a 401(k)
plan may be a disincentive for some employees to contribute to the
plan. Withdrawals before age 591/2 are subject to a 10 percent addi-
tional tax unless the distribution is: (1) in the form of an annuity or
installments payable over the life or life expectancy of the participant
(or the joint lives or life expectancy of the participant and the par-
14State and local income tax law changes from year to year. For a list, albeit incomplete,
of 401(k) income tax withholding rules for states and municipalities, see Commerce
Clearing House, Tax Aspects of 401(k) Plans," Pension Plan Guide, Number 426, Part
II, May 23, 1983.
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ticipant's beneficiary); (2) made after the participant has separated
from service on or after age 55; (3) used for payment of medical
expenses to the extent deductible under federal income tax rules; (4)
received in a lump sum prior to March 15, 1987 if made on account
of separation from service in 1986 and the recipient elects to treat
the distribution as paid in 1986; or (5) made to or on behalf of an
alternate payee pursuant to a qualified domestic relations order. A
distribution that is rolled over to an individual retirement account
or another qualified plan will not be subject to this additional tax.
Beginning with plan years after December 31, 1988, hardship with-
drawals are limited to the employee's elective deferrals (but not in-
cluding income on those deferrals). As discussed earlier in the chapter,
distributions may be in the form of a lump sum, an annuity, install-
ments, or through a loan provision. The form of the distribution de-
termines the tax treatment of the funds.
If the distribution is in the form of a lump sum, it may qualify for
five-year averaging if received after age 591/2. Distributions in the
form of an annuity and partial distributions while a participant is
still employed are taxed as ordinary income.
Five-Year Income Averaging-A one-time election of five-year av-
eraging for a lump-sum distribution received after attainment of age
591/2 is permitted. If a participant attained age 50 by January 1, 1986,
he or she may make one election of five-year averaging or ten-year
averaging (at 1986 tax rates) with respect to a single lump-sum dis-
tribution. Five-year income averaging allows an employee to separate
the distribution into fifths, compute the income tax on one-fifth, and
multiply the result by five. In effect, the employee is allowed to pay
the tax on the distribution as if he or she had received it over five
years, disregarding any other income he may receive during those
years. The five-year forward income averaging rule can result in tax
savings.
The following requirements must be met for a 401(k) distribution
to qualify for five-year averaging:
(1) The employee has been a participant in the plan for five years (except
in the case of death).
(2) The distribution is from a qualified plan.
(3) The distribution comes from all the employer's profit-sharing plans in
which the employee had funds and constitutes the full amount credited
to the employee.
(4) The distribution is paid in a single tax year.
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(5) The distribution is paid for death, attainment of age 591/2, termination
of employment, or disability.
Rollovers-In general, distributions from a 401(k) plan may be rolled
over to another qualified plan or to an IRA, if the transaction takes
place within sixty days of the participant's receipt of the distribution.
The entire distribution or any portion may be rolled over. No tax is
paid on the portion rolled over until withdrawal from the IRA. Once
a distribution is rolled over to an IRA, however, it cannot qualify for
ten-year averaging.
Loans-Although withdrawals from a 401(k) plan are limited, some
plans permit an employee to borrow a portion of their vested benefits.
The rules governing loans from a 401(k) are the same as those for
other qualified plans.15 However, under TRA, no deduction for in-
terest paid on loans secured with 401(k) elective contributions is al-
lowed.
Plan Operation
The installation and operation of a qualified 401(k) plan can be a
complex procedure and can be a drawback for some employers. The
proposed regulations set forth specific requirements for the admin-
istration of each plan participant's 401(k) account. Under the regu-
lations, a 401(k) plan must maintain separate accounting between
the portion of the employees accrued benefit that is subject to the
special vesting and withdrawal rules and any other (after-tax)
benefits.
In each participant's account, depending on the structure of the
plan, there may need to be a separate record for deductible employer
contributions (elective and nonelective), nondeductible "voluntary"
employee contributions, and vested and nonvested company contri-
butions. Special rules exist for contributions made before 1980. The
proposed regulations do not provide a detailed accounting method
to be used, but they state that the accounting must allocate invest-
ment gains and losses on a reasonable pro rata basis and adjust
account balances for withdrawals and contributions.
401(k) Arrangements, Worker Mobility and Cost
Containment
In today's mobile society, 401(k) arrangements help meet the re-
tirement income needs among workers who change jobs frequently
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and workers with intermittent labor force participation. Employee
elective contributions to section 401(k) plans are, by law, fully and
immediately vested. When employees terminate employment or change
jobs, they can "roll over" the accumulated contributions and earnings
of the plan into an IRA or another qualified plan. As a result, 401(k)
arrangements may particularly benefit young workers with high la-
bor-force mobility, and women who may leave the labor force for a
protracted time.
Section 401(k) arrangements have also been used by employers as
a way to provide additional retirement security for their employees
without increasing overall pension costs. This has been accomplished
by supplementing the employer's primary pension plan with a 401(k)
arrangement that has little or no employer contribution. However,
because TRA restricts preretirement withdrawals, employer contri-
butions may become more common as a way to encourage employee
participation.
Conclusion
401(k) plans provide a unique vehicle for accumulating retirement
income. Their current preferential tax status makes them popular
with employees, who can defer income tax on contributions until
withdrawal. Employer contributions make 401(k)s even more attrac-
tive to employees. For many employees, however, the new restrictions
on access to funds and the 10 percent additional tax on distributions
before age 591/2 may be a disincentive to use these plans for short-
term savings, as opposed to saving for retirement.
As with other qualified retirement plans, employers can deduct
contributions to a 401(k) plan as a business expense on their income
tax. In addition it appears that employers view provision of a 401(k)
plan as a way to maintain a competitive employee benefit package.
Recognizing the limitations of a 401(k) plan is essential to the con-
sideration of adopting or participating in the plan. From the em-
ployee's standpoint, the major drawback is the restriction on
withdrawals. The employer must deal with several issues, some un-
resolved and awaiting final regulatory action: (1) additional record-
keeping procedures depending on the structure of the plan and the
method used in satisfying the nondiscrimination rules; (2) provisions,
if any, for a hardship distribution; and (3) loan provisions, if any.
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Additional Information
Employee Benefit Research Institute. "401(k) Cash or Deferred Arrange-
ments." EBRI Issue Brief 46 (September 1985).
Massachusetts Mutual Life Insurance Company. 401(k) Survey Report. Spring-
field, MA: Massachusetts Mutual, June 1985.
The Wyatt Company. Top 50: A Survey of Retirement, Thrift and Profit-sharing
Plans Covering Salaried Employees of 50 Large Industrial Companies as of
January 1, 1986. Washington, DC: The Wyatt Company, 1986.
Towers, Perrin, Forster and Crosby. What Makes 401(k) Plans Appealing? A
Survey of Design Features and Plan Experience. New York, NY: TPF&C,
January 1986.
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XI. Employee Stock Ownership Plans
The employee stock ownership plan (ESOP) is an innovative way
for employers to share company ownership with employees without
requiring the employees to invest any of their own money. Since
ESOPs are unique among employee benefit plans in their ability to
borrow money, they are also being used with growing frequency as
a technique of corporate finance. Because of tax benefits Congress
has granted, ESOPs can provide the employer with a tax-favored
financing vehicle that can significantly lower the cost of financing
transactions, while providing employees with a significant equity
position in the company.
Louis O. Kelso is generally credited with the creation of the ESOP
concept. Kelso believed that ESOPs, by providing employees with
access to capital credit, would broaden the distribution of wealth
through free enterprise mechanisms. By making employees owners
of the productive assets of the business where they work, Kelso rea-
soned that they would benefit from the wealth produced by those
assets and would thus acquire both a capital income as well as an
incentive for being more productive.
Kelso attracted a powerful ally in Sen. Russell Long (D-LA), who
used his influence to spearhead the legislative efforts to promote
ESOPs. Political support for the ESOP concept has grown steadily
and Congress has encouraged ESOPs through a number of legislative
initiatives, including the: (1) 1974 Employee Retirement Income Se-
curity Act (ERISA); (2) 1975 Tax Reduction Act; (3) 1976 Tax Reform
Act; (4) 1978 Revenue Act; (5) 1981 Economic Recovery Tax Act (ERTA);
(6) 1984 Deficit Reduction Act (DEFRA); and (7) the 1986 Tax Reform
Act (TRA).
Leveraged ESOPs
A typical leveraged ESOP (an ESOP that involves borrowing funds
to acquire stocks) usually works in the following way:
(1) The company adopts the plan, which must be designed to invest pri-
marily in company stock.
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(2) The company sets up an ESOP by creating a trust fund, managed by
a trustee (e.g., a bank or other financial organization).
(3) A loan is arranged between the lender and the ESOP. The company
guarantees repayment of the ESOP loan.
(4) The loan is used to purchase company stock at fair market value. The
stock is pledged as collateral for the loan.
(5) The company seeks IRS approval of the plan, which certifies that the
plan's provisions are in line with current law. For example, the plan
cannot discriminate in favor of shareholders, officers and highly paid
employees.
(6) The company makes regular contributions to the ESOP, which are used
to repay the loan.
(7) Participants are allocated shares of stock. Each year, as company con-
tributions are used to pay the loan, the stock originally purchased by
the trust is allocated to participants, and it no longer acts as security
for the loan.
(8) The shares are usually distributed to participants at retirement, death
or job termination.
Other ESOPs
Some companies offer ESOPs that are not leveraged. These ESOPs
do not use debt; the employer makes contributions to a trust that in
turn invests in the company stock. Maximum employer contributions
to an ESOP that is not leveraged are limited to 15 percent of covered
compensation. When the employer also offers a pension plan, the
maximum tax-deductible employer contribution to both plans cannot
exceed 25 percent of covered compensation.
ESOPs that are not leveraged but which can be leveraged have
been called "leverageable ESOPs."
Another class of ESOPs that are not leveraged is the tax credit
ESOP, including Tax Reduction Act stock ownership plans (TRA-
SOPs) and payroll-based employee stock ownership plans (PAYSOPs).
TRA eliminates the tax credit that employers received for contribu-
tions to these plans for compensation paid or accrued after December
31, 1986, but a special transition rule is provided. Many of these plans
will be maintained by employers as wasting trusts, or converted to
other types of defined contribution plans, including non-tax-credit
ESOPs.
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Plan Design
As with all tax-qualified employee benefit plans, ESOPs must es-
tablish a trust to receive the employer's contributions to the plan and
the plan must be created exclusively for the benefit of employees.
ESOPs are a type of defined contribution plan,' and such plans allow
a company flexibility in determining the amount of contribution that
should be made to the plan each year. ESOPs that are not used to
borrow money are generally qualified with the IRS as a stock bonus
plan or a combination stock bonuslmoney-purchase pension plan .2 Stock
bonus plans may receive as much as 15 percent of payroll as an annual
deductible contribution from the employer. With a leveraged ESOP,
however, the deduction limit can be as much as 25 percent and more
to allow an ESOP to repay its debt more quickly.
General pension rules3 governing minimum coverage require-
ments, nondiscrimination, vesting and the taxation of employee ben-
efits also apply to ESOPs, although there are several specific exceptions,
as will be explained, provided to ESOPs that distinguish them from
other types of employee benefit plans. The two key features that make
ESOPs unique are their ability to borrow money and the requirement
that the ESOP trust be invested primarily in the securities of the
sponsoring employer. Other plans may be fully invested in employer
securities, but ESOPs must be primarily invested in employer secu-
rities. The latter requirement is generally interpreted to mean that
the ESOP should be at least 50 percent invested in the stock of the
sponsoring employer on an ongoing basis.
Allocations to individual employee accounts are usually deter-
mined by calculating the proportion of each employee's compensa-
tion relative to the total compensation of all plan participants. Plan
participation generally begins when the employee reaches age 21 and
has completed at least one year of service with the company. Each
participant's account is held in the ESOP trust until the employee
leaves the company. Employees approaching retirement age (age 55)
must be given an option of directing that up to 25 percent of their
account balance be invested in diversified investments other than the
' Defined contribution plans are discussed in chapter VI.
2Employees sometimes make contributions to ESOPs with pretax dollars in the form
of salary reduction arrangements. ESOPs that utilize the salary reduction approach
are known as 401(k) arrangements and must satisfy Internal Revenue Code regulations
applicable to such plans.
3For more information on these pension rules, see chapters III and IV.
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stock of the employer. Alternatively, the ESOP can distribute the
amount that could be diversified.
The value of the ESOP stock in publicly traded companies is de-
termined by the market price. Closely held companies4 must have
their stock valued on at least an annual basis by an independent
appraiser.
ESOP participants in publicly traded companies must be given the
right to vote their stock on all issues. Closely held companies are
required to pass through voting rights to employees on major cor-
porate issues, such as a sale of the company, refinancing, merger, etc.
Distribution Requirements
Distributions to departing employees must begin no later than one
year after an employee retires or becomes disabled, or five years after
an employee terminates for other reasons, unless the employee elects
to defer the commencement of benefits. All or part of an employee's
account may be payable, depending on years of service and the plan's
vesting provisions. In the case of publicly traded companies, the em-
ployer may distribute stock which the employee may then sell on the
open market.
In closely held companies for which there is no recognized market,
employees must be given a put option on their stock which requires
the employer to redeem the stock in cash. The put option requires
the employer to purchase the stock back from the former employee
in substantially equal terms over a period not to exceed five years.
This period may be extended in the case of particularly large distri-
butions.
Usually the employee has the right to receive his or her account
value in as many whole shares of stock as possible, with the value of
any fractional shares paid in cash. However, some plans allow the
employee to take the entire amount in cash. In either case, payments
can be made in a lump sum or in installments.
An employee who receives stock has all the ownership rights as-
sociated with that class of stock. Some plans of closely held companies
require employees to give the company an opportunity to buy their
shares at fair market value before selling such shares to anyone else.
Some plans of closely held companies must provide the employee
4Closely held companies are generally those owned by a small number of people whose
securities are not registered on a recognized exchange.
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with the right to demand that the employer purchase the stock; there-
fore, the employee is assured of a market.
Dividends can be: (1) paid to participants in cash; (2) kept in the
ESOP; or (3) used to repay the loan.
ESOPs offer considerable tax benefits for both employer and em-
ployee. Companies can make tax-deductible contributions of up to
25 percent of covered employees' annual pay to repay loan principal,
plus receive an unlimited deduction to repay interest. Contributions
in excess of the deductible limits may be deductible in later years,
within the maximum limits. If an employer provides both an ESOP
that is not leveraged and a pension plan, the maximum tax-deductible
contribution to both plans generally cannot exceed 25 percent of
covered compensation.
Under a leveraged ESOP, the loan payments (both the principal
and interest portions) are tax deductible to the employer, because
they are treated as contributions to an employee benefit plan. These
tax savings must be weighed against the increased cost to the em-
ployer of repaying the loan, if the employer is not the lender. However,
since the passage of DEFRA, certain lenders may exclude from their
taxable income 50 percent of the interest they receive on loans to
ESOPs. Their savings may be passed along to the company in the
form of lower interest charges.
Employers can also claim a tax deduction for dividends on ESOP
stock paid directly in cash to participants or used to repay the ESOP
loan. Dividend payments paid in cash to a participant are fully tax-
able to the employee. However, dividends retained in the trust are
not taxed until they are paid out. Also, employer contributions to
ESOPs are not taxable to employees until benefits are distributed.
To encourage the use of ESOPs to broaden corporate ownership,
the law provides a number of tax incentives to encourage companies
to adopt these plans. The most significant ESOP incentives are as
follows:
(1) Qualified lenders to ESOPs may deduct from their taxes 50 percent of
the interest income they earn on loans to ESOPs. As a result of this
benefit, lenders are able to pass some of their savings on to the bor-
rower, resulting in lower interest rates on ESOP loans.
(2) Major shareholders of stock in a closely held company can defer all
taxes on the sale of stock to an ESOP if, upon the completion of the
sale, the ESOP owns at least 30 percent of the company and the seller
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reinvests the proceeds from the sale in qualified domestic securities
within one year. This provision allows owners of closely held businesses
who are approaching retirement age to, in essence, create a market for
their stock and to diversify their investments while providing their
employees with a significant benefit and assuring the continued in-
dependence of the business.
(3) Employers may take a tax deduction for dividends paid on ESOP stock
to the extent that the dividend is used to repay the principal on the
ESOP loan, or paid in cash to ESOP participants within 90 days. This
provision allows companies to accelerate the repayment of the ESOP
loan, thereby accelerating the transfer of stock to individual employee
accounts, or to provide employees with current benefits from their
stock ownership rather than deferring the entire benefit until they leave
the company.
(4) Estates that sell stock to an ESOP may exclude from their taxes 50
percent of the proceeds they receive on the sale. This provision is avail-
able only on sales enacted prior to January 1, 1992, and is the likely
subject of legislation designed to curb abuses. In addition, an ESOP
may assume an estate's tax liability in exchange for an equivalent
amount of stock. The ESOP may then pay the taxes on favorable terms.
(5) Finally, TRA provided temporary exemptions for ESOPs from two ex-
cise taxes imposed on other pension plans. Through December 31, 1988,
corporations may avoid the 10 percent excise tax imposed on the excess
assets recovered from terminated defined benefit pension plans to the
extent that the excess assets are contributed to an ESOP. In addition,
lump-sum distributions to ESOP participants prior to January 1, 1990,
are exempt from the 10 percent excise tax to employees who have not
yet attained age 591/2. The tax may also be avoided by rolling the
distribution over into another qualified retirement plan or an individ-
ual retirement account.
Conclusion
ESOPs can provide employees with substantial financial benefits
through stock ownership while providing companies with attractive
tax advantages and a powerful financial tool. By making employees
part-owners of the business, companies also may realize productivity
improvements, since workers benefit directly from corporate profit-
ability and are thus working in their own interest. The U.S. General
Accounting Office (GAO) estimates that as of March 1986, there were
about 4,800 active ESOPs and an additional 2,400 similar stock bonus
plans. As of 1983, GAO estimates that ESOPs covered more than 7
million workers and held nearly $19 billion in assets.
Although the advantages of ESOPs are attracting growing numbers
of companies in virtually every type of industry, there are also risks
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that should be considered. Because the ESOP is invested primarily
in employer securities, the success of the ESOP depends on the long-
term performance of the company and its stock. There is therefore a
greater degree of risk involved since the employees' capital is invested
mainly in one company. In addition, especially for closely held com-
panies, the tax benefits that ESOPs provide should not divert atten-
tion from the company's repurchase liability-the requirement that
the company redeem the shares of departing employees. This repur-
chase liability can be significant, particularly in companies that have
realized growth in the value of their stock.
An ESOP is not appropriate in every circumstance, but the many
benefits of employee ownership and ESOP financing for companies
and employees alike merit close consideration of this innovative con-
cept.
Additional Information
Employee Stock Ownership Association of America
1725 DeSales Street, NW, Suite 400
Washington, DC 20036
National Center for Employee Ownership
426 17th Street
Suite 650
Oakland, CA 94612
Employee Benefit Research Institute. "Estimated Revenue Losses Soar for
New ESOP Provision." Employee Benefit Notes (February 1987).
Case, John. "Every Worker an Owner?" Inc. (May 1987):14-16
U.S. General Accounting Office. Employee Stock Ownership Plans: Benefits
and Costs of ESOP Tax Incentives for Broadening Stock Ownership. Wash-
ington, DC: U.S. Government Printing Office, 1987.
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XII. Tax-Sheltered Annuities
Introduction
A unique type of tax-sheltered retirement arrangement is available
to certain nonprofit organizations and public schools. Since 1942, the
Internal Revenue Code (IRC) has permitted such employers to pur-
chase tax-sheltered annuities (TSAs) for their employees.' However,
it was not until 1958 that Congress established the ground rules for
today's TSAs. Through the Technical Amendments Act of 1958 and a
later series of IRC amendments, Congress has encouraged retirement
savings through TSAs 2
The tax-sheltered annuity is a tax-deferred arrangement defined
under section 403(b) of the IRC. This arrangement allows an employee
of a qualified charitable organization or a public school system, to
exclude from gross income, contributions to a tax-sheltered annuity.
Although the savings are intended for retirement purposes, such
amounts are available for emergencies and can provide a source of
income in the event of death or disability.
Retirement savings to such plans are excluded from reportable
income at the time they are set aside. During the savings accumu-
lation period, investment earnings on these funds are also sheltered
from current taxes. Later, when the employee withdraws funds, the
withdrawals are reported as ordinary income for federal tax purposes.
However, the ultimate tax impact may be reduced for employees who
make withdrawals at age 65, and whose yearly retirement incomes
are lower than working-year incomes. Additionally, an increased
standard deduction applies to most citizens who are over age 65.
Eligibility
Examples of the nonprofit, tax-exempt organizations that are eli-
gible to offer TSAs include: hospitals, educational institutions, char-
itable institutions and social welfare agencies. A number of nonprofit,
'Tax-sheltered annuities are also known as tax-deferred annuities, 403(b) annuities or
403(b) plans.
2There are a variety of other tax-sheltered arrangements available to most people,
including investments in oil, cattle and land. These arrangements, however, should
not be confused with the tax-sheltered annuities discussed in this chapter.
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tax-exempt organizations, however, do not qualify under section 403(b)
and cannot offer their employees TSAs. Ineligible organizations in-
clude some federal, state and local government offices, civic leagues,
labor organizations, recreational clubs, fraternal societies, credit
unions, business leagues and cooperatives.
Until 1989, employers may adopt a TSA for one or more employees
on a selective basis; unlike qualified retirement plans, there are no
nondiscrimination rules applicable until after this date. The Em-
ployee Retirement Income Security Act's (ERISA's) age and service
standards, however, may apply. Additionally, the IRC states that a
plan must be established exclusively for the benefit of employees.
In plan years beginning after December 31, 1988, tax-sheltered an-
nuities (except those programs maintained by churches) must satisfy
essentially the same nondiscrimination and participation rules as
qualified retirement plans (as changed by the Tax Reform Act of 1986
(TRA)). In addition, special nondiscrimination rules will apply to
elective contributions made by employees through salary reduction 3
These rules will effectively require the extension of a salary reduction
TSA to most employees if any employee has the opportunity to par-
ticipate in such a TSA.
Since many organizations (e.g., hospitals) have contracts with
professional people, TSA sponsors must determine the true employer/
employee relationship. If the employer is not paying Social Security
taxes and is not withholding federal income taxes for a particular
employee, the individual is not considered to be an employee eligible
for a TSA. Radiologists, pathologists and anesthesiologists working
at a hospital may fall into this category.
Funding
Originally, TSA contributors were required to purchase an annuity
contract or life insurance policy from a life insurance company. The
IRC has been modified and now allows mutual funds investment.
TSA plans include: (1) individual and group fixed and variable an-
nuity contracts; (2) endowment and retirement income contracts; and
(3) custodial accounts held by banks, credit unions, investment com-
panies and loan associations. Many employers specify funding ar-
rangements; others have no restrictions and permit employees to
select the type of arrangement they prefer.
3For detailed information on pension coverage and nondiscrimination rules, and the
changes made by the 1986 Tax Reform Act, see chapter N.
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Plan Operation
Types of Plans-There are two basic types of TSA plans. Under one
arrangement, employers make all contributions to a plan for covered
employees. This approach permits a qualified nonprofit organization
to provide retirement benefits through TSAs for at least some em-
ployees. This arrangement, however, is relatively uncommon. In-
stead, TSAs are usually of the second type, where plans are funded
with employee contributions through a salary agreement.
Salary Agreement-Under the second arrangement, the employee
and the employer enter into an agreement to reduce the employee's
salary by an amount determined by the employee. This is known as
a salary reduction agreement; it is a characteristic common to con-
tributory (i.e., employees make contributions) employee benefit plans.
The employer then remits these contributions to an insurance com-
pany, custodian or mutual fund.
Instead of reducing current pay, employee contributions may be
derived from what otherwise would have become a pay increase. In
this case, the employee agrees to forego the pay increase in lieu of
plan contributions. In either situation, the language in the agreement
must specifically state: (1) the level of the contribution; (2) the date
the contribution will become effective; and (3) the investment vehicle
in which the contribution will be placed.
Specific requirements of the salary reduction agreement include
the following:
(1) It must be in writing.
(2) Contributions can be derived only from money earned after the date
of the agreement.
(3) The employee can make only one agreement with the employer during
a taxable year.
(4) The reduction amount can be either a specified dollar amount or a
percentage of pay.
Contributions-Annual contributions to a TSA cannot exceed a
maximum limit referred to as an exclusion allowance. The exclusion
allowance is generally equal to 20 percent of the employee's inclu-
dible compensation from the employer multiplied by the number of
the employee's years of service with that employer, reduced by amounts
already paid by the employer to purchase the annuity. If an employee
elects to make plan contributions through a salary reduction, the
maximum allowable contribution is one-sixth of the employee's earn-
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ings. In addition to the limit imposed by the exclusion allowance,
TRA limits employee contributions made through salary reduction
to $9,500 annually, coordinated with contributions to a 401(k) plan.
The limit applies until the $7,000 annual limit for 401(k) plans, in-
dexed for cost-of-living adjustments, reaches $9,500, at which time
the TSA limit will also be indexed in the same manner as 401(k) plan
limits. If an employee is required to contribute a set percentage of
compensation to a tax-sheltered annuity as a condition of employ-
ment, the contribution does not count toward the annual limit.
A special annual catch-up election is available for employees of
educational organizations, hospitals, home health agencies, health
and welfare service agencies, or churches or conventions of churches.
Under this provision, any eligible employee who has completed 15
years of service with the employer is permitted to make an additional
salary reduction contribution equal to the lesser of the following:
(1) $3,000;
(2) $15,000 reduced by the total amount of prior contributions that, in any
year, exceed $9,500; or
(3) $5,000 multiplied by the number of years of service the individual has
with the employer, minus an individual's lifetime elective deferrals
under a 401(k) and 403(b) arrangement and a simplified employee
pension plan.
ERISA's overall limits on defined contribution plans under section
415 of the IRC also apply to amounts that can be contributed on
behalf of each employee in any one year .4
Employee Rights-A TSA participant has a wide variety of rights
and privileges. The employer who adopts a TSA will usually place
reasonable limits on its operation, but the employee enjoys a flexi-
bility not found in some other retirement programs. Some important
employee rights include:
(1) the right to determine the contribution amount and date when the
contribution will begin;
(2) the right to the account balance (i.e., the employee's contributions
cannot be forfeited);
(3) the right to select the investment vehicle (depending on the terms of
the plan);
4For a more detailed description of ERISA's limits for defined contribution plans, see
pages 28-29.
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(4) the right to select from a variety of settlement options at termination,
including lump-sum cash withdrawals, annuities or installment re-
funds;
(5) the right to transfer the account balance to an individual retirement
account (IRA) or the TSA of a new employer;
Other rights and options may be offered within the framework of
the plan and the investment vehicle.
Social Security-Employees' contributions that are attributable to
voluntary salary reduction agreements are subject to Social Security
taxes, even though they are excluded from employees' federal income
taxes. Future Social Security benefits, however, will be based on
higher income; thus, retired employees will not receive lower Social
Security benefits as a result of participating in a tax-sheltered
annuity.
Distributions-Except where an employee rolls a lump-sum distri-
bution into another tax-sheltered annuity or into an IRA, distribu-
tions will be taxed as ordinary income in the year received. Lump-
sum distributions do not qualify for capital gains treatment, but five-
year income averaging may be applicable. Also, for benefits accrued
after December 31, 1986, a TSA must comply with the standard dis-
tribution rules governing timing and payouts applicable to qualified
retirement plans.
Early Distribution Tax-As of January 1, 1987, a 10 percent addi-
tional tax will be imposed on "early" distributions (those made before
age 591/2) from all tax-sheltered annuity and custodial account (mu-
tual fund) accumulations, regardless of when the contributions to
which the accumulation is attributable were made. The additional
tax is equal to 10 percent of the portion of the amount distributed
that is includible in gross ("taxable") income. The total taxable amount
distributed will still be taxed as ordinary income for the year in which
it is received. The 10 percent tax will not apply for payments made
in the form of an annuity and payments pursuant to the death, dis-
ability, early retirement (age 55), or extraordinary medical expenses
of the covered worker (to the extent deductible under the Internal
Revenue Code).
Early Distribution Restrictions-Withdrawals from tax-sheltered
annuities will be allowed at any age, for any reason, until January
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1, 1989. (However, a 10 percent additional tax may apply to a dis-
tribution after December 31, 1986, as explained above.)
As of January 1, 1989, participants may not make early withdrawals
prior to age 591/2 from annuity accumulations attributable to salary
reduction contributions except on account of separation from service,
financial "hardship," death, or disability. These restrictions currently
apply to mutual fund custodial accounts. The restrictions will apply
to all distributions attributable to salary reduction contributions,
regardless of when the contributions to which the accumulations are
attributable were made. Withdrawals on account of hardship are
limited to salary reduction contributions only-no earnings on these
contributions may be withdrawn.
Financial "hardship" is not statutorily defined (as of January 1,
1987), but proposed IRS regulations defining hardship under 401(k)
arrangements apply to tax-sheltered annuities, according to the Con-
ference Report of the 1986 Tax Reform Act. In the proposed regula-
tions the IRS defines "hardship" as an "immediate and heavy financial
need" of the employee that cannot reasonably be met through other
resources. Final regulations are expected in 1987.
Death Benefits-Under TSAs, payments made to the beneficiary of
a deceased employee are usually fully taxed as ordinary income. How-
ever, except for employees of public schools and certain other non-
profit organizations, the $5,000 death benefit exclusion may apply.
Employer Responsibilities
Unless the plan is an employer-pay plan, the employer's respon-
sibilities are to: (1) make the plan available to certain or all employ-
ees; (2) enter into an agreement with each participating employee;
(3) make appropriate payroll deductions; and (4) remit proper amounts
to the insurance company, custodian or mutual fund organization.
The employer must comply with various regulations set forth by the
IRC and ERISA.S
Conclusion
Tax-sheltered annuities play an important role in providing retire-
ment income for eligible employees. They can supplement an em-
ployee's pension plan, personal savings and other investments intended
to provide retirement income. The unique value of a TSA lies, not
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only in the personal tax advantages, but also in forced savings through
payroll deduction.
Additional Information
Teachers Insurance and Annuity Association
College Retirement Equities Fund
730 Third Avenue
New York, NY 10017
Employee Benefit Research Institute. "Tax Reform and Employee Benefits."
EBRI Issue Brief 59 (October 1986).
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XIII. Individual Retirement Accounts
Introduction
The 1974 Employee Retirement Income Security Act established
individual retirement accounts (IRAs). In establishing IRAs, Congress
intended to offer workers who did not have employer-sponsored pen-
sion coverage an opportunity to set aside tax-deferred compensation
for use in retirement. The 1981 Economic Recovery Tax Act (ERTA)
extended the availability of IRAs to all American workers (i.e., even
those who already had employer-sponsored pension coverage). The
Tax Reform Act of 1986 (TRA) retained tax-deductible IRAs for those
who are not "active participants" in an employer-sponsored plan but
restricted the tax deduction among those who are active participants
in an employer-sponsored retirement plan to taxpayers with incomes
below specified levels. TRA adds two new categories of IRAs: non-
deductible contributions that accumulate tax free until distributed;
and partial, deductible contributions, which are fully deductible con-
tributions for a maximum amount that is less than the $2,000 max-
imum contribution otherwise allowable.
Financial institutions have promoted IRA availability. Advertising
has emphasized the future value of IRAs. Varying interest rates and
varying rates of return on stocks and bonds, however, will have a
significant impact on the value of IRAs at retirement. Those pur-
chasing IRAs that have high current-year rates of returns should un-
derstand that these rates could fluctuate over their working years.
Fluctuating returns, combined with inflationary changes, will affect
an IRA's ultimate real value.
Individuals who are considering IRA investment should understand
how IRAs work-particularly their tax implications. This chapter
discusses IRA: (1) eligibility; (2) contribution limits; (3) distributions;
(4) rollovers; (5) taxation; and (6) investment options. It also discusses
employer-sponsored IRAs.
Eligibility
There are five primary types of IRA owners:
(1) Those individuals not active participants in an employer-sponsored re-
tirement plan who establish IRAs with a direct contribution from current
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earnings-Regardless of income level, any part-time or full-time worker
who is younger than age 701/2 and not an active participant in an
employer-sponsored plan can establish and contribute to a personal
IRA. An individual is considered an "active participant" if that person
is covered by a retirement plan. The individual is covered by a retire-
ment plan if an employer or union has a retirement plan under which
money is added to the individual's account or the individual is eligible
to earn retirement credits. An individual is an active participant for a
year even if the individual is not yet vested in a retirement benefit. In
certain plans, the individual may be an active participant even if the
individual was only with the employer for part of the year.
IRA investors must have earned income, which can include: (a) wages,
salaries, tips, professional fees, bonuses and other amounts received
for personal services; (b) commissions and income generated through
self-employment; (c) payments from the sale or licensing of property
created by authors, inventors, artists and others; and (d) alimony. (Un-
earned income derived from real estate rents, investments, interest,
dividends or capital gains cannot be used as the basis for IRA contri-
butions.)
(2) Those taxpayers who are active participants in an employer-sponsored
plan whose adjusted gross income (AGI) falls below $25,000 (single tax-
payers) or $40,000 (married taxpayers filing jointly)-These taxpayers
can make a fully deductible IRA contribution. Again, contributions can
only be made from earned income.
(3) Active participants in an employer-sponsored plan with AGIs between
$25,000 and $35,000 (single taxpayers) and between $40,000 and $50,000
(married taxpayers filing jointly)-These taxpayers can make a fully
deductible IRA contribution of less than $2,000 and a nondeductible
IRA contribution for the balance, as follows. The $2,000 maximum IRA
deduction is phased out by losing one dollar of deductible contribution
for each five dollars of income between the AGI limits. For example,
a single taxpayer with an AGI of $30,000 could make a $1,000 de-
ductible IRA contribution and a $1,000 nondeductible contribution.
Under a special rule, the deductible amount is not reduced below $200
if a taxpayer is eligible to make any deductible contributions at all.
Again, contributions can only be made from earned income.
(4) Active participants in an employer-sponsored plan with earnings of $35,000
and above (single taxpayers) and $50,000 and above (married taxpayers
filing jointly)-These taxpayers can only make nondeductible IRA con-
tributions of up to $2,000; earnings on the nondeductible contribution
are tax deferred until they are distributed to the IRA holder. Again,
contributions can only be made from earned income.
(5) Those IRAs established as a roll-over vehicle for a lump-sum distribution
from an employer-sponsored pension plan or another IRA-A worker who
receives a distribution from his or her employer-sponsored retirement
plan or an IRA or Keogh plan can generally place all of the distribution
in a roll-over IRA without tax penalty or current taxation.
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IRA Eligibility Test
Adjusted gross income
Covered by
pension plan?
(You or your
Type of contribution
YPe
($2,000 maximum)
Joint Tax Return
Individual
spouse)
1987
$40,000
and under
$25,000
and under
Yes
Fully Deductible
$40,000
and under
$25,000
and under
No
Fully Deductible
Between
$40,000-$50,000
Between
$25,000-$35,000
Yes
Partially Deductible
Between
$40,000-$50,000
Between
$25,000-$35,000
No
Fully Deductible
Above $50,000
Above $35,000
Yes
Nondeductible
Above $50,000
Above $35,000
No
Fully Deductible
Source: Employee Benefit Research Institute.
Contribution Limits
(1) Single Workers-Single workers can contribute up to $2,000 or 100
percent of earned income (whichever is lower) per year if they are not
active participants in an employer-sponsored plan or if they are cov-
ered and have an AGI of less than $25,000. For those with an AGI of
between $25,000 and $35,000, the deductible IRA is prorated (see (3)
under Eligibility).
(2) Two-Earner Couples-Where a husband and wife both earn income,
each may contribute up to $2,000 or 100 percent of earned income
(whichever is lower) per year. This means that a two-earner couple
could then make a combined annual contribution of up to $4,000.
Where a husband and wife file a joint tax return and either spouse is
covered by an employer-sponsored plan, both are restricted in their
eligibility to make deductible IRA contributions under the rules that
apply to their combined AGI. In other words, they are each allowed
full $2,000 contributions if their combined AGI is below $40,000; a
deductible IRA contribution of less than $2,000 and a nondeductible
IRA contribution for the balance of the $2,000 if their combined AGI
is between $40,000 and $50,000; and no deductible IRA if their AGI is
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$50,000 and above ($2,000 nondeductible IRA contribution would be
allowed for each working spouse).
If a married individual files a separate tax return, then the spouse's
active participation does not affect the individual's eligibility to make
deductible IRA contributions. But if a married person files separately,
the phase out of the $2,000 deduction begins with $0 and ends at
$10,000. In other words, every five dollars of income above $0 will
reduce the maximum $2,000 IRA deduction by $1.00, or 20 percent.
For example, if a married person is an active participant, has $3,000
of compensation and files a separate return, the maximum allowable
IRA deduction would be $1,400 (i.e., $2,000-$600 (0.20 x $3,000)). If
the same individual had compensation of $10,000 or more, no de-
ductible IRA contribution would be allowed.
(3) One-Earner Couples-A married worker with a nonworking spouse can
contribute up to $2,250 or 100 percent of the employed spouse's earned
income (whichever is lower) per year, only if the worker is not an active
participant in an employer-sponsored plan or is an active participant
but has an AGI below $40,000. (A spousal IRA can also be established
if a spouse has some small amount of earned compensation but elects
to be treated as earning no compensation and makes no IRA contri-
bution.) Spousal IRAs can be set up as a single IRA with a subaccount
for the spouse, or they can be set up as separate IRAs for each spouse.
The dollar limit on deductible contributions to spousal IRAs is phased
out (i.e., reduced) for active pension plan participants in accordance
with the same rules that apply to nonspousal IRAs (i.e., a 20 percent
reduction in the IRA $2,000 maximum for each $1.00 between the AGI
limits). The maximum amount that can be placed in either spouse's
account is $2,000 (i.e., the entire $2,250 cannot be placed in one spouse's
account). Those contributing $2,250 must file a joint tax return in the
year the contribution is made.' If the worker is covered by a pension
plan, one-earner couples with AGIs above $40,000 but less than $50,000
could make partial, deductible spousal IRA contributions and partial,
nondeductible IRA contributions; one-earner couples with AGIs of
$50,000 and above could only make a nondeductible spousal IRA.
(4) Nonworking Divorced Persons-All taxable alimony received by a di-
vorced person is treated as compensation for purposes of the IRA de-
duction limit, and the regular IRA eligibility rules apply.
IRA regulations do not require minimum contributions; nor do they
require contributions in every year. The IRA deduction limit is not
'When the working spouse reaches age 701/2, deductible contributions to spousal IRAs
are no longer permitted-even if the nonworking spouse is younger. If the working
spouse is younger, deductible contributions are not permitted for the nonworking
spouse after he or she reaches age 701/2; the working spouse, however, may continue
to make contributions to his or her own separate IRA.
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reduced below $200 if the individual is otherwise eligible to make
any deductible contribution.
Employer-Sponsored IRAs
An employer can contribute to an IRA that has been set up by the
employee, or the employer himself can set up an IRA for an employee'2
The employee's interest must be nonforfeitable, and separate records
showing the employee's contributions and the employer's contribu-
tions must be maintained. Although regular IRA contribution limits
apply, the employer is also permitted to pay reasonable administra-
tive expenses associated with the IRA.
Employers can also offer employee IRAs through payroll-deduction
arrangements. Automatic deductions from employees' earnings would
be deposited in IRAs that are set up by the company. Some employers
permit employees to select among a wide variety of investment op-
tions; others place greater restrictions on such options.
IRA distributions must begin by April 1 of the calendar year fol-
lowing the calendar year in which the individual reaches age 701/2
and must meet certain minimum distribution rules to ensure full
payout over the individual's expected life. The penalty for failure to
comply with the minimum distribution rule is a 50 percent excise
tax on the amount by which the minimum required distribution ex-
ceeds actual distributions during the tax year. The 50 percent tax is
imposed on the individual required to take the distribution. Distri-
butions can be paid in the following ways:
Lump-Sum Payments-The entire account balance is distributed in
one sum.
Periodic Certain-The account balance is paid in a predetermined
number of fixed payments over a specified period of time.
Life Annuity-Monthly payments are made to retirees for their re-
maining lifetimes. These payments cease at death.
Joint and Survivor Annuity-Monthly payments are paid for the
IRA holder's remaining lifetime. After the IRA holder's death, the
surviving spouse continues to receive monthly payments. The sur-
vivor usually receives only a portion (e.g., 50 percent) of the amount
2Note that this arrangement is not a simplified employee pension, which allows greater
employer contributions and pretax employee contributions. See chapter XIV.
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paid to the primary IRA holder. In addition, the monthly income to
the primary holder will be lower than under an individual life an-
nuity; this reflects the additional cost of insuring income over two
lifetimes rather than just one.
To repeat, distributions that fail to meet the minimum distribution
rules are subject to a 50 percent penalty tax imposed on the individ-
ual. Also, IRA distributions are included along with distributions
from all qualified plans in determining whether total annual distri-
butions exceed a threshold amount-in which case a 15 percent excise
tax on the excess is imposed on the individual with respect to whom
the excess distributions are made. The threshold for the excise tax is
the greater of $112,500, indexed for inflation, or $150,000.
The law permits individuals to roll over account balances from:
(1) one IRA to another; and (2) a qualified employer plan to an IRA.
To avoid tax penalties, the transfer of assets from one account to
another must be completed within 60 days.
Rollovers Between IRAs-Under this arrangement, the individual
can roll over his or her account balance from one IRA to another.
This provision offers individuals greater investment flexibility. This
type of rollover can occur only once annually. A transfer of IRA funds
from one trustee to another, either at the individual's request or at
the trustee's request, is not a rollover. It is a transfer not affected by
the one-year waiting period.
Rollovers Between Employer Plans and IRAs-Where employer pen-
sion and profit sharing plans provide lump-sum distributions, the
amounts corresponding to tax-deferred employee and employer con-
tributions may be transferred to a roll-over IRA. Roll-over IRAs were
established specifically to provide a savings vehicle for lump-sum
distributions without imposing a tax penalty. Rollovers of lump-sum
distributions can be made at any age. However, if the individual is
701/2 or older, distributions must begin in the roll-over year. Lump-
sum distributions from employer plans paid to a surviving spouse
after an employee's death can also be rolled over into an IRA without
penalty.
IRA taxation rules reflect the basic purpose of an IRA (i.e., to pro-
vide retirement income security). Use of IRA savings for purposes
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other than retirement income, therefore, is discouraged through tax
penalties. For retirement purposes, IRA distributions may begin as
early as age 591/2, but must begin by April 1 of the calendar year
following the calendar year in which the individual attains age 701/2.
In the case of death or disability, distributions can begin prior to age
591/2 without penalty. Distributions are considered income in the year
received and are subject to applicable marginal income tax rates.
Income Taxes-Each year, tax-deductible contributions to new or
existing IRAs must be made by the tax return filing date. Contribu-
tions can be made in one full payment, or they can be made in in-
stallments throughout the year. Income taxes on these contributions
are deferred until IRA savings are distributed. The distributions are
taxed as ordinary income in the year received, except for the portion
of the total IRA distribution that is attributable to nondeductible con-
tributions, which are excludable from gross income. All IRAs (in-
cluding roll-over IRAs and simplified employee pensions (SEPs)) are
treated as a single contract, and all distributions in any taxable year
are treated as a single distribution.3 If an individual withdraws an
amount from an IRA and had previously made both deductible and
nondeductible IRA contributions, the amount excludable from gross
income is determined by multiplying the withdrawal by a fraction,
where the numerator is the individual's total nondeductible contri-
butions and the denominator is the total balance (at the close of the
calendar year) of all the individual's IRAs. For example, if an indi-
vidual held four IRA accounts with a total value of $10,000, and $2,000
was the amount of the nondeductible contributions, then a with-
drawal of, say, $4,000 would be considered to consist of $800 attrib-
utable to excludable, nondeductible contributions (i.e., $4,000 x [$2,000/
$10,000 or 0.2]) and $3,200 fully taxable as ordinary income and
subject to any early withdrawal penalty.
IRA lump-sum distributions are not eligible for five-year income
averaging.
Estate Taxes-The entire value of a lump-sum distribution is in-
cluded in the deceased participant's gross estate.
Penalties-Under certain circumstances, tax penalties apply:
(1) Contributions in excess of the maximum limitations described above
are not deductible from taxable income. Additionally, a 6 percent excise
tax will be imposed on any excess contribution for each year it remains
in the account. (If an individual contributes more than the permissible
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amount, he or she can avoid the 6 percent tax penalty by withdrawing
the excess plus its earnings by the tax return due date in the year the
contribution is made.)
(2) Distributions are not permitted without penalty before age 591/2, unless
they are taken in the form of a life annuity or the IRA owner dies or
becomes disabled. Early withdrawals that are not rolled over to an-
other IRA are subject to income tax in the year withdrawn plus a 10
percent penalty tax. The portion of an early withdrawal that is attrib-
utable to nondeductible contributions is not taxed and is not subject
to the penalty.
(3) Regular distributions must begin prior to April 1 of the calendar year
following the year in which a participant reaches age 701/2. Such distri-
butions may be made in a lump sum or in installments, providing the
payment schedule does not exceed the individual's life expectancy. In the
case of a joint and survivor annuity, the payment schedule must not
exceed the life expectancies of the worker and spouse. A 50 percent excise
tax is levied on any excess in accounts that do not satisfy this criterion.
IRA savings can be invested in retirement accounts and retirement
annuities. The institutions that offer IRA investment vehicles include
banks, brokerage houses, insurance companies, savings and loan as-
sociations, credit unions, mutual fund companies, other investment
management organizations and the federal government. IRA contri-
butions can be placed in more than one account, provided the total
annual contribution limits are not exceeded. (Collectibles such as art,
antiques, rugs, stamps, wines and coins-other than certain U.S.-
minted gold or silver coins-are not permissible IRA investments.)
An IRA investor should understand the risks and limitations of the
various investment options. Financial institutions are required to
explain how their IRAs work and their financial ramifications. There
has been tremendous competition among financial institutions for
IRA business. Before choosing an IRA, some important questions should
be analyzed and answered. For example:
(1) What are the investor's retirement income needs? Should he or she
invest in low-risk options, or can he or she afford to gamble on higher
risks that may produce higher returns?
(2) What are the administrative fees or commissions charged on the type
of IRA under consideration?
(3) Is there a minimum deposit requirement?
(4) What is the interest rate and how is it computed? Is it likely to fluctuate
over the worker's career years?
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(5) Can the investment be quickly converted into cash in an emergency?
What penalty charges (in addition to tax penalties) will be imposed
for an early withdrawal?
(6) Should IRAs be purchased early or late in the tax year? (If money is
invested early, it accumulates interest longer. If money is invested late,
individuals have use of their money throughout the year. Additionally,
they may have a better idea about how much of a deductible contri-
bution they are eligible to invest in an IRA.)
Conclusion
IRAs can be an important addition to retirement savings oppor-
tunities. They are particularly useful for: (1) persons who do not have
employer pension coverage; or (2) highly mobile workers with min-
imal pensions or no pensions due to limited service in any one job.
The amount of retirement income generated by an IRA will depend
on factors such as: (1) contribution amounts; (2) a participant's age
when the IRA is established; (3) rates of investment return; and (4) a
participant's age at retirement.
Additional Information
Employee Benefit Research Institute. "EBRI Survey of Financial Planners
on Tax Reform and Retirement Savings." EBRI Issue Brief 61 (December
1986).
-. "Retirement Income and Individual Retirement Accounts." EBRI Issue
Brief 52 (March 1986).
-. "Tax Reform and Employee Benefits." EBRI Issue Brief 59 (October
1986).
U.S. Internal Revenue Service. "Individual Retirement Arrangements." Publ.
590. Available by calling the IRS Tax Forms/Publications number listed
in local directories under "U.S. Government."
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XIV. Simplified Employee Pensions
Introduction
Many small businesses have been reluctant to establish a retire-
ment plan for their employees because of the legal and administrative
burdens of setting up and maintaining a plan and by the costs of
complying with federal regulations.
In the Revenue Act of 1978, Congress sought to remove these ob-
stacles for small businesses through the introduction of a new tax-
favored retirement plan that was aimed primarily at small employ-
ers-the simplified employee pension (SEP).
SEPs are arrangements under which an employer establishes and
finances (in part or wholly) an individual retirement account (IRA)
for each eligible employee. The employee generally controls the in-
vestment of the money in which he or she is immediately vested.
These arrangements are sometimes called SEP-IRAs. A principal
difference between a SEP and an employer-sponsored IRA is the larger
annual contribution that can be made by an employer and an em-
ployee to the SEP-$30,000 or 15 percent of compensation, whichever
is less. Some SEPs must also meet coverage and nondiscrimination
requirements that do not exist for employer-provided IRAs.'
However, SEPs offer employers an alternative to more complex
and costly qualified pension plans. Paperwork, recordkeeping and
reporting requirements are kept to a minimum.
But acceptance of SEPs has been slow. To increase their attrac-
tiveness, Congress added a salary reduction feature in the Tax Reform
Act of 1986 (TRA). Employees in small firms may elect to have a
portion of their pretax salary contributed to a SEP. This option may
be offered only in companies with 25 or fewer employees. Salary-
reduction SEPs are not available to tax-exempt organizations or to
state or local governments.
SEPs can be set up by corporations, unincorporated businesses and
partnerships and self-employed persons. Although companies of any
size may create SEPs, the simplicity of the arrangement was expected
to interest small businesses. In large companies economies of scale
'Individual retirement accounts are discussed in greater detail in chapter XIII.
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make establishing qualified pension plans less expensive than for
small firms.
Participation
Employer contributions must be made for each employee who has
reached age 21 (and those over age 701/2), has worked for the employer
in at least 3 of the preceding 5 years and has received at least $300
in compensation from the employer during the year. The $300 figure
is indexed to increases in the cost of living beginning in 1988.
Any period of service during a year, even if only one day, qualifies
as work for the year. The employer must also contribute for employees
who worked some period during the year even if they have left the
company by the time the employer makes the contribution.
Employees covered by collective bargaining agreements and non-
resident aliens may be excluded from eligibility.
All eligible employees must participate in the SEP, including eli-
gible part-time employees. If one eligible employee elects not to par-
ticipate, the employer may not contribute to accounts for the other
employees.
Contributions
Employers-Under the Revenue Act of 1978, the maximum an em-
ployer could contribute for each employee was $7,500 or 15 percent
of compensation, whichever was less. The limit on compensation that
could be considered for calculating the annual contribution was
$100,000.
The dollar limit on contributions to SEPs was raised to $15,000
and the compensation limit to $200,000 by the Economic Recovery
Tax Act of 1981. The Tax Equity and Fiscal Responsibility Act of 1982
raised the dollar limit on contributions to $30,000. The limit includes
the amount an employee elects to contribute through salary reduc-
tion.
Contributions must be made according to a formula that does not
discriminate in favor of officers, shareholders or highly compensated
employees. Employer contributions will be considered discrimina-
tory unless the same percentage of compensation (not in excess of
$200,000) is allocated to all eligible employees. In plans integrated
with Social Security, there is a limited disparity permitted (see "Plan
Design," below).
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An employer may contribute to a SEP in addition to contributing
to other qualified pension plans. However, the contribution to the
SEP will count in the total deductible limit imposed on employer
contributions to all qualified plans.
One of the most flexible features of a SEP for an employer is that
there is no required annual contribution. If the company has a poor
year and profits are low, the employer can simply make no contri-
bution that year or decrease the amount of contribution.
Employees are fully and immediately vested in the employer's con-
tributions and the investment earnings on the contributions. This
means that even if the employee leaves the job, the employer con-
tributions belong to the employee.
Employees-When SEPs were first created, if the employer contri-
bution was less than the maximum contribution permitted for IRAs
that year, the employee was permitted to make up the difference with
a tax-deductible contribution to the SEP. In addition, an employee
could also contribute up to the maximum tax-deductible level to his
or her own IRA. Under TRA, an employee covered under a SEP may
not be able to make deductible contributions to his or her own IRA
unless his or her adjusted gross income falls below $25,000 (single)
or $40,000 (married) (see chapter XIII for more detail).
TRA considerably broadened the possibilities for employee partic-
ipation in a SEP by providing the salary reduction option. The option
is available only to employees in firms with 25 or fewer employees
and only if 50 percent of all eligible employees in the company elect
to have amounts contributed to the SEP.
Employees may elect to defer up to $7,000 annually. The $7,000
limit is reduced by any salary deferral made to a 401(k) cash or
deferred arrangement or tax-sheltered annuity (403(b) plan). Be-
ginning in 1988, the $7,000 is indexed to reflect cost-of-living in-
creases.
TRA also includes a special nondiscrimination test for elective
deferrals to a SEP. The deferral percentage for each "highly com-
pensated" employee cannot exceed 125 percent of the average de-
ferral percentage for all other eligible employees. Thus, if all
employees of a firm on average contribute 10 percent of their pay
to a SEP, the owner of the firm cannot contribute more than 12.5
percent of compensation to his own account (not to exceed $30,000).
The definition of "highly compensated" employees is the same as
provided for all qualified plans by TRA: (1) 5-percent owners; (2)
employees who earned more than $75,000 in annual compensation;
(3) employees who earned more than $50,000 in annual compensation
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and were members of the top 20 percent of employees by pay; or (4)
officers who received compensation greater than 150 percent of the
defined contribution plan dollar limit (i.e. $45,000 in 1987).2 The
$50,000 and $75,000 are indexed beginning in 1988.
Excess contributions made by highly compensated employees are
subject to a 10 percent excise tax on the employer if they are not
distributed within 2 1/2 months following the plan year in which the
excess was deferred. Any excess contribution distributed to an em-
ployee is includible in the employee's taxable income for the year in
which the contribution is made.
From their inception, SEPs have been subject to the same penalties
on premature withdrawals that have applied to IRAs. A 10 percent
penalty is imposed on any lump-sum amounts withdrawn before age
59 1/2. Exceptions from the 10 percent penalty are made for payments
in the form of an annuity and payments pursuant to the death or
disability of the covered worker. SEP distributions must begin by
April 1 of the calendar year following the calendar year in which an
individual attains 70 1/2. All distributions are fully taxable.
Until the end of 1986, employees had to include in gross income
on their tax returns the amounts contributed by their employers to
a SEP account and then claim an offsetting deduction for the amount.
The employer included the contributions on W-2 forms sent to em-
ployees. TRA changed the tax treatment of SEP contributions. Em-
ployer contributions and employees' elective deferrals to a SEP are
now excluded from employee's taxable income. Contributions and
earnings in the SEP accumulate tax free until withdrawn.
Employer contributions to a SEP are not subject to Social Security
(FICA) taxes or to unemployment (FUTA) taxes, but employee elective
deferrals are included as wages for FICA and FUTA purposes.
An employer may elect to operate a SEP on the basis of a calendar
year or the employer's taxable year. Contributions for a taxable year
may be made no later than the due date (including extensions) for
filing the return for that taxable year.
2Contribution and benefit limits for defined benefit and defined contribution plans
are discussed fully in chapter IV.
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Plan Design
Integration-Until 1989 employers are permitted to take Social Se-
curity taxes paid by the employer for each employee into account in
calculating the SEP contribution for the employee. That is, the em-
ployer can subtract the Social Security tax paid in a given year from
the SEP contribution. This enables employers to make higher per-
centage SEP contributions for higher-paid employees because the
Social Security tax is a smaller percentage of their total compensation
than it is of the compensation for lower-paid workers.
Beginning in 1989, TRA prescribes new integration rules for defined
contribution plans that also apply to the nonelective portion of SEP
contributions. These rules permit a limited disparity between the
percentage contribution above and below the Social Security wage
base.' A SEP may not be integrated with Social Security, however,
if any other qualified plan of the employer provides for integration.
Plan Operation-The Internal Revenue Service (IRS) provides a
short model form (5305-SEP) that constitutes an agreement between
employer and employee. Instructions for completing the form and
questions and answers are included with it. (The model form may
not be used if the SEP is to be integrated with Social Security or if
the employer maintains any tax-qualified pension, profit sharing or
stock bonus plan.)
The model form is not filed with the federal government. The em-
ployer retains the form and furnishes a copy with explanatory ma-
terial to each employee.
The employer also must draw up a "written allocation formula"
that explains the percentage of salary used for making contributions.
Employees may designate the kind of investment vehicle they want
to use for the SEP contribution, such as stocks, bonds, mutual funds,
certificates of deposit and other similar types of investment vehicles.
Employees are also free to change the investment vehicles. Employers
themselves might select the investments but most leave the decision
to the employees.
The employer then forwards the contributions directly to the SEP
fiduciary, which is generally a bank, insurance company or invest-
ment firm.
The employer does not have to file detailed annual reports with
the Department of Labor that are required for other qualified pension
plans. But the employer must keep track of the names of the em-
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ployees for whom contributions are made, the amounts of the con-
tributions and the institutions to which the amounts have been paid.
An employer may also set up a nonmodel SEP. In this case, an
employer must either file form 5306-SEP with the IRS or adopt a
prototype plan sponsored by banks or insurance companies and ap-
proved by the IRS.
In businesses with 25 employees or less, only 1 in 7 workers is
covered by a company-sponsored pension plan. Only 23 percent of
workers in firms with fewer than 100 employees have pension cov-
erage. This is considerably lower than the 58 percent rate for firms
with 100 to 500 workers and the nearly 83 percent rate for workers
in larger firms.
Despite attempts by Congress since 1978 to stimulate interest in
SEPs by increasing contribution limits, many of the very firms to
whom SEPs are targeted know little about them.
Among the employers who have heard of SEPs, interest in flexibility
of contributions and simplicity of administration may be tempered
with concern about the nondiscrimination requirements. The em-
ployer must make contributions on behalf of employees who may not
remain long with the employer, thus diverting funds the employer
might wish to use to reward longer-service employees.
Because employees vest immediately in employer contributions,
employers may feel that such a retirement arrangement does little
to encourage employees to remain with the employer.
Employees have the advantage of immediate vesting, but they face
penalties and taxation if they withdraw the contributions and earn-
ings before age 59 1/2. Employees also have the opportunity to con-
tribute to their SEPs through salary reduction, but the requirement
for 50 percent participation by eligible employees may limit this
option.
Additional Information
Commerce Clearing House, Inc. Individual Retirement Plans. Chicago, IL:
Commerce Clearing House, Inc., 1987.
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XV. Retirement Plans for the
Self-Employed
Introduction
The self-employed are covered under the Social Security program
and become entitled to benefits in the same manner as other em-
ployees.
In addition, self-employed individuals-with respect to a business
in which personal services of the individual are a material income-
producing factor-and noncorporate employers can now establish
supplementary retirement plans on a basis virtually identical to cor-
porate employers.' Prior to the passage of the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA), pension plans for the self-em-
ployed, or Keogh plans, were subject to more stringent limitations
on contributions and benefits than were corporate plans. In removing
the more stringent limitations on Keogh plans and imposing some
Keogh-type rules on other qualified plans, TEFRA completed two
decades of legislative effort aimed at putting corporate and noncor-
porate employers on the same footing for pension purposes.
Keogh plans originated in the Self-Employed Individuals Tax Re-
tirement Act of 1962. Prior to that time, as tax-qualified pension plans
spread, many small business people found that their employees could
benefit by being included in a tax-qualified pension plan, but the
employers themselves, could not. Self-employed individuals without
employees also could not participate in a tax-qualified plan. Fur-
thermore, where two people operated similar businesses and realized
similar profits-but one was a sole proprietor and the other was
incorporated-the corporate operator could benefit from a pension
plan even though he or she was the only employee of the corporation,
but the sole proprietor could not.
Various bills were introduced in Congress to remedy this situation.
The number H.R. 10 was assigned to an early bill and was retained
in succeeding bills until enactment of the Self-Employed Individuals
Tax Retirement Act of 1962. Today these retirement plans are often
'In addition to Keogh plans, the self-employed are also eligible for simplified employee
pensions, discussed in chapter XIV.
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referred to as H.R. 10 plans or Keogh plans (named for Representative
Eugene J. Keogh of New York, who sponsored the legislation).
The purpose of the act was to enable self-employed individuals to
participate in a tax-qualified retirement plan, if they chose to do so,
in much the same way as employees could. Various restrictions and
limitations, however, were included in this 1962 legislation. For ex-
ample, prior to passage of the Employee Retirement Income Security
Act of 1974 (ERISA), self-employed people who established a Keogh
plan were limited to a contribution of $2,500 per year, while there
was no limit imposed on corporate plans. This provision led to oth-
erwise unnecessary incorporation by self-employed persons solely for
the purpose of obtaining the tax benefits for retirement savings. To
achieve greater equity vis a vis corporate plans, ERISA increased the
annual limit for deductible contributions to Keogh plans to 15 percent
of earned income or $7,500, whichever was lower. The act also pro-
vided a new minimum deduction for those with adjusted gross income
from all sources of $15,000 or less, based on the lesser of 100 percent
of earned income or $750.
1981 Legislative Changes in Keoghs
In 1981 Congress reviewed the Keogh provisions of ERISA at the
same time that it expanded eligibility for individual retirement ac-
counts (IRAs). The 1981 law retained the ERISA limit of 15 percent
of compensation, but effective January 1, 1982, it increased the max-
imum deduction for employer contributions to a defined contribution
Keogh plan from $7,500 to $15,000.
1982 Legislative Changes in Keoghs
As part of TEFRA, Congress established parity between corporate
and noncorporate retirement plans. To this end, most of the special
rules applicable to Keogh plans were eliminated. Maximum limits
for a defined benefit or defined contribution Keogh plan are the same
limits as for corporate plans. For a defined contribution plan, the
maximum contribution each year is the lesser of $30,000 or 25 percent
of compensation. For a defined benefit plan, the maximum is the
lesser of the amount needed to fund a $90,000 annual benefit or 100
percent of the employee's average compensation for the three highest
years. The combined effect of treating Keogh plans and corporate
plans under the same pension rules is to increase the pension tax
incentives under Keogh plans and to mitigate the tendency for profes-
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sionals to incorporate simply to take advantage of the higher amounts
that were tax-deductible under prior law.
Tax Reform Act of 1986
The Tax Reform Act of 1986 (TRA) made numerous changes in the
rules governing all qualified plans, including Keoghs (see chapter IV).
Eligibility
Technically, in contributing to these Keogh plans, the self-
employed individual is treated for tax purposes as an employer as
well as an employee. In addition, the self-employed individual must
make contributions to the plan on behalf of his or her employees.
H.R. 10 plans may be classified as either defined contribution or
defined benefit plans. As explained in chapter VI, defined contribution
plans are those in which the contributions are predetermined, and
the eventual benefit depends on the total amount of contributions
and their investment performance. As a result, under a defined con-
tribution plan, the level of retirement benefits cannot be calculated
exactly in advance. On the other hand, defined benefit plans specify,
in advance, a benefit level upon retirement based on a mathematical
formula.
Self-employed individuals are also eligible to contribute to an IRA
instead of the H.R. 10 plan. But they can only contribute to an IRA
and a Keogh plan if their taxable income is below the levels estab-
lished for IRAs under TRA (see chapter XIII).
Keogh plans are subject to the same contribution and benefit limits
as other corporate retirement plans. The maximum annual addition
to a defined contribution plan may not exceed the lesser of 25 percent
of the employee's compensation (earned income)2 or $30,000 per year.
The maximum annual benefit to a participant under a defined benefit
plan is $90,000 or 100 percent of the participant's average compen-
2The Internal Revenue Service defines compensation of the self-employed as net earn-
ings from self-employment, which take into account the deduction for employer contri-
butions to qualified employee retirement plans (including Keogh plans)" [emphasis added].
Earned income can be calculated using the following formula: Gross profits minus
(-) business expenses equals (_) net income. Net income minus (-) retirement plan
contributions equals (=) earned income.
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sation for his or her three highest consecutive earning years. The
defined benefit dollar limits will remain at this level until 1988, when
a cost-of-living adjustment is scheduled in the law.
The limit on annual additions to defined contribution plans will
be frozen at current levels until they equal one-fourth of the defined
benefit limit; from that point on, they will also be adjusted for infla-
tion.
Keogh plans are subject to the same top-heavy rules as other tax-
qualified pension plans. A top-heavy plan is defined as a plan under
which more than 60 percent of the present value of accrued benefits
(or account balances) is provided for key employees.
Special requirements for top-heavy plans include accelerated vest-
ing schedules and a minimum benefit. Full vesting is required after
three years of service, or, alternatively, graded vesting may be used,
beginning with 20 percent after two years of service, increasing by
20 percent each year so that 100 percent vesting is attained at the
end of six years of service.
The minimum benefit required of a top-heavy defined benefit plan
is 2 percent of pay multiplied by the employee's years of service (not
to exceed 20 percent). A contribution of 3 percent of pay is required
for each nonkey employee in a defined contribution top-heavy plan,
or, if less, the highest contribution rate for any key employee. These
minimum benefit/contribution requirements are applicable only to
years in which a plan is top-heavy.
Keogh plan distributions can be paid in the same manner as other
plans, namely in a lump-sum payment (where the entire account
balance is distributed in one sum) or in periodic distributions from
accumulated reserves as an annuity. The annuity can be in the form
of a life annuity-in which monthly payments are made to retirees
for their remaining lifetimes and cease upon the retiree's death-or
joint and survivor annuities can be paid, in which the surviving spouse
continues to receive monthly payments after the retiree's death. Plan
distributions can also be paid out in regular installments for a fixed
number of years.
If a participant takes a lump-sum distribution from a Keogh plan
before age 59 1/2, it is subject to a 10 percent penalty tax in addition
to ordinary income tax-unless the distribution meets one of a lim-
ited number of exceptions. The exceptions are for death, disability,
age 55 and early retirement under the plan, and large medical ex-
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penses to the extent they are deductible from income tax. The tax
can be avoided if the entire lump sum is rolled over to an IRA or
another qualified plan.
Rollovers
Prior to the Deficit Reduction Act of 1984 (DEFRA), tax-free roll-
overs of lump-sum distributions could not be made by a self-
employed individual from a Keogh plan to a corporate or another
Keogh plan. DEFRA changed prior law to permit a tax-free rollover
from one qualified plan to another of a distribution attributable to
contributions made on behalf of a participant while he or she was
self-employed.
Tax-free rollovers of Keogh plan distributions can also be made to
an IRA. If an amount otherwise eligible for the lump-sum tax treat-
ment is rolled over into an IRA, however, the special income-
averaging tax treatment is not available upon subsequent distribution
from the IRA.
Contributions made by self-employed individuals are not currently
taxable to the self-employed individual, and the contributions by the
self-employed individual on behalf of his or her employees are not
currently taxable to the employees. Earnings on contributions are
also not taxable during the preretirement period.
Voluntary after-tax contributions up to 10 percent of compensation
are also allowed, even where only owner-employees participate. These
after-tax contributions, which are still subject to the overall limit of
25 percent of compensation or $30,000, generate nontaxable invest-
ment gains during the preretirement period.
During retirement, employees are taxed on benefits recovered. If
the individual is in a lower tax bracket in retirement or if five-year
income averaging of lump sums applies, it may result in benefit re-
ceipt on a tax-preferred basis. Lump-sum distributions may qualify
for the special income-averaging tax treatment only in the case of
death, disability or the attainment of age 59 1/2. Distributions of
account balances to self-employed individuals from Keogh plans other
than for death or attainment of age 59 1/2 are not eligible for lump-
sum treatment. The first $5,000 of a lump-sum death benefit paid
under a Keogh plan can be excluded from federal income tax.
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Conclusion
Over the-past two decades, Congress has passed numerous pieces
of legislation designed to provide substantial tax incentives for self-
employed individuals to supplement retirement income in addition
to their Social Security benefit.
Despite these incentives, the unincorporated self-employed have
not participated in Keogh accounts at a very high rate. Based on a
May 1983 survey jointly sponsored by the Employee Benefit Research
Institute and the U.S. Department of Health and Human Services,
only 4.8 percent of approximately 9.1 million unincorporated self-
employed people in the United States contributed to a Keogh account.
The larger maximum deductions allowed since TEFRA may expand
participation somewhat. A greater number and variety of plans can
be expected. But, historically, the self-employed have been more in-
clined to invest in their own businesses than in separate plans ear-
marked for retirement income.
Additional Information
Information Services Division Staff. How to Make the Most of Keogh Plans.
New York: Prentice-Hall, Inc., 1985.
The J.K. Lasser Tax Institute. All You Should Know About IRA, Keogh, and
Other Retirement Plans. Revised Edition. New York: Prentice-Hall, Inc.,
1987.
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XVI. Planning for Retirement
Introduction
Retirement is a relatively new phenomenon. Until a few decades
ago, most men and many women worked throughout their lives. Those
who were unable to continue working were either sustained by their
family or a public facility for destitute people. Since Social Security
retirement benefits were first paid in 1940, age 65 has become the
normal retirement age.' The growth of employer pension plans and
increased life expectancy have also contributed to present retirement
trends.
On average, men and women who reach age 65 today can expect
to live to ages 791/2 and 84, respectively. Expanded life expectancy
brings with it a new awareness of the aging process. Retirement is
increasingly an important part of one's total life. Unfortunately, many
still view their retirement years as a time of crisis. Retirement is a
challenging period that can bring rewards and new experiences. A
happy and satisfying retirement, however, requires an adjustment
period that is greatly aided by thoughtful, effective planning in earlier
working years.
Ideally, one should begin planning for retirement at age 30 to 40.
Planning at a later age, however, is better than no planning at all. A
survey of nonretired Americans conducted in 1985 for the American
Association of Retired Persons by Yankelovich, Skelly and White re-
vealed that 71 percent believe it is important to plan for retirement;
more than half, however, reported difficulty saving for retirement on
their present incomes, and 40 percent said they are worried their
retirement income will be inadequate. In 1978, the University of
Michigan's Department of Gerontology conducted a survey of early
retirees. The findings indicate that 75 percent of those who planned
ahead were enjoying retirement. Those who did not plan were gen-
'Under Social Security, the normal retirement age will be increased from age 65 to
age 67. This age increase will be phased in, in gradual steps beginning in the year
2000. See pages 20-21.
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erally less content. Advance planning can minimize the financial and
psychological problems that sometimes accompany retirement.2
The first part of this chapter identifies some areas that need atten-
tion by those who are preparing for retirement. It is not intended to
provide all the necessary information. Instead, it poses certain ques-
tions that need early consideration. Discussion is provided on: (1)
financial planning; (2) preventive health; (3) health care costs; (4)
living arrangements; (5) use of leisure time; (6) interpersonal rela-
tionships; and (7) estate planning. The second part of the chapter will
look at the potential role of employers in helping employees to pre-
pare for retirement.
Considerations for the Employee
Financial Planning-A difficult aspect of retirement planning is
ensuring adequate household income. A common misconception is
that financial planning is only necessary for wealthy people. Retire-
ment income planning may be even more important for average- or
low-income people. Workers should be saving and investing the larg-
est amounts at the peak of their earning power. Additionally, they
should understand that certain options existing at one point in time
may not be available later.
Throughout their career years, workers should give careful consid-
eration to the following questions: At what age should I retire? What
kind of retirement do I want? Where will I live? How much money
will I need? What are my assets and liabilities now? What will they
be at retirement? How can I cope with inflation? If I should die before
my spouse, will my family be left with an adequate income?
Social Security-Social Security provides a monthly benefit to retired,
blind or disabled workers who have contributed to the system during
their working years. Various requirements must be met before ben-
efits are payable. For those who qualify, benefits are paid to workers
and their nonworking spouses, widows, widowers, divorcees, depen-
dent children and dependent parents. Social Security benefits are
automatically adjusted for inflation.
Social Security replaces a portion of preretirement income. It does
not provide income sufficient to satisfy all retirement needs. Social
Security must be supplemented by private pensions, personal savings
and other investments.
2Lee Butcher, Retirement Without Fear (Princeton, NJ: Dow Jones & Company, Inc.,
1978), p. 5.
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How Much Do You Have to Save?
one 15
years of lump-sum annual
saving payment payments
5 0.216 2.79
10 0.112 1.45
15 0.077 1.00
20 0.060 0.77
25 0.049 0.63
30 0.041 0.53
35 0.035 0.46
You can use this chart to determine how much you must save at the end of each
year to accumulate a specific amount of money (adjusted for inflation). These
calculations assume a 6 percent annual rate of return on savings and a 4 percent
annual rate of inflation.
Step 1: Decide how much money you want to receive and choose the form of
payment desired: one lump-sum payment (Column B) or 15 equal annual pay-
ments (Column Q. Write the amount you want to receive here
Step 2: Look under Column A and find the number of years you plan to save.
Then find the corresponding number under Column B or Column C (depending
on the form of payment you chose) and write the number here
Step 3: Multiply the number you get resulting from Step 2 by the amount of
money you want to receive (Step 1). This will give you the amount you must
save at the end of each year to reach your target amount (adjusted for inflation)
Example 1: To determine how much you must save at the end of each year to
accumulate one lump-sum payment of $50,000 (adjusted for inflation)* after 10
years, multiply $50,000 by 0.112. You will need to save $5,600 at the end of each
year. *The actual sums accumulated will vary because the target of $50,000 is
calculated in terms of today's values. Therefore, these numbers show what you
will have to save to accumulate, in the future, the equivalent of $50,000 in today's
dollars. At the assumed 4 percent annual rate of inflation, your actual lump-
sum payment in 10 years would be $74,012 in nominal dollars.
Example 2: To determine how much you must save at the end of each year to
finance 15 annual payments of $20,000 each (adjusted for inflation)* starting
after 25 years, multiply $20,000 by 0.63. You will need to save $12,600 at the
end of each year. *The actual sums accumulated will vary because the target
amount is calculated in terms of today's values. Therefore, these numbers show
what you will have to save to finance the target amount in today's dollars. At
the assumed 4 percent annual rate of inflation, your actual first payment in 25
years would be $55,449 in nominal dollars, and the last payment would be
$96,020 in nominal dollars. The total amount accumulated would be $691,293
in nominal dollars.
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Today, most workers qualify for reduced retirement benefits at age
62 and full benefits at age 65. Social Security has no minimum age
or service criteria, thus all covered workers are also program partic-
ipants. Vesting (i.e., rights to benefits that cannot be revoked due to
job termination) occurs when employees have at least one quarter of
coverage for every year between 1950 (or, if later, the year after reach-
ing age 21) and the time they reach age 62. Individuals retiring at
age 62 in 1987 need 36 quarters of coverage. Workers with $1,920 or
more in 1987 covered earnings will earn four quarters of Social Se-
curity coverage. For those reaching age 62 after 1990, 40 quarters (the
maximum) will be required. Social Security vesting is relatively le-
nient; an overwhelming majority of the work force ultimately qual-
ifies for benefits. Social Security payments are not automatically
provided; workers must apply for full benefits three months before
retirement (two months if they retire early, i.e., at age 62).
Workers should determine whether they will qualify for Social Se-
curity benefits. They should also obtain an estimate of the dollar
amount of these benefits. Answers to questions concerning Social
Security can be obtained from local Social Security Administration
offices. The address and phone number are in your telephone book
under "Social Security Administration."3
(2) Private Pension Programs-Approximately 70 percent of the full-time
work force can expect to receive income from employer pension plans.4
Some people, however, will not become eligible for such pensions.
This often results from short service with individual employers. Al-
though vesting in a defined contribution plan is shorter, vesting in a
defined benefit plan commonly occurs after 10 years of service with
any one organization. Beginning in 1989, however, most plans will
vest workers after five years of service, under provisions of the Tax
Reform Act of 1986.
Full pension benefits are offered at a specified age-frequently age
65. It is usually possible to retire early with reduced pension benefits.
Under tax reform, however, pension payments received in a lump-
sum prior to age 591/2 will generally be subject to a 10 percent penalty
if not transferred to an individual retirement account (IRA).
The 10 percent tax does not apply, however, to certain distributions
(a) made in the form of an annuity payable over the life or life ex-
pectancy of the participant (or the joint lives or life expectancies of
the participant and his or her beneficiary); (b) made after the partic-
ipant has attained age 55, separated from service, and satisfied the
conditions for early retirement under the plan; (c) used for payment
of medical expenses to the extent deductible under federal income
tax rules; (d) received from an employee stock ownership plan (ESOP)
before January 1, 1990; or (e) made to or on behalf of an alternate
3For more information on Social Security, see chapter II.
4For more information on pension plans, see chapter IV.
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payee pursuant to a qualified domestic relations order.
Most pension plans do not provide automatic cost-of-living adjust-
ments. This is an important consideration in retirement planning,
since inflation reduces the value of fixed pension income. Some pen-
sion plans permit employees to voluntarily contribute to the plan;
these contributions result in higher retirement income.
Under the 1974 Employee Retirement Income Security Act (ERISA),
employer plans automatically provide benefits to surviving spouses
of retired workers, unless an employee rejects this option in writing.
The Retirement Equity Act of 1984 (REA) requires that an employee
may reject surviving spouse's benefits only with the written consent
of the spouse.' Survivors' benefits are provided through a joint and
survivor annuity. Before retirement, workers and their spouses should
confirm the status of their survivor benefits.
Private pension plan participants should thoroughly understand their
plans. By doing this, they can develop reasonable estimates of future
pension benefits. ERISA sets minimum funding, participation and
vesting standards for private pension plans. ERISA also requires re-
porting and disclosure of pension plan benefit provisions and financial
and operations information to plan participants and beneficiaries.
Reports to participants must be written in a manner "calculated to
be understood by the average participant or beneficiary ."6
Federal Pensions-Civil service employees are covered by their own
retirement income program. Full civil service pension benefits are
generally provided to retirees who satisfy one of several possible age
and service criteria: (1) age 55 with 30 years of service; (2) age 60 with
20 years of service; or (3) age 62 with 5 years of service. Pension
benefits are automatically adjusted for inflation.
Changes in the federal pension program were implemented as a result
of the 1983 Social Security Amendments. Effective January 1, 1984,
Social Security participation became mandatory for all newly hired
federal employees. Before the 1983 Amendments, federal employees
generally did not participate in Social Security.
These recent federal hires are also covered by a new pension system.
Full benefits are payable at age 57 with 30 years of service; benefits
paid after age 62 are indexed to inflation, and participants who work
beyond age 62 continue to accrue benefits. Workers also have the
option of taking part in a capital accumulation plan, to which they
and the government contribute.
For more information on civil service pensions, contact the United
SERISA, as modified by REA, also provides that vested employees must be given the
option to take a survivor benefit through their plan. For more information on survivor
benefits under Social Security and employer-sponsored plans, see chapter XXVI.
6For more information on ERISA, see chapter III.
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States Office of Personnel Management, 1900 E Street, NW, Wash-
ington, DC 20415.
(4) Military Plans-The Military Retirement System has traditionally
provided higher lifetime benefits than almost any other employer
plan. For active-duty military personnel with 20 years of service, the
system offers very early retirement with an immediate and continuing
lifetime benefit. Military personnel do not contribute to their pension
plans. Their retirement benefits are automatically adjusted with in-
flation, unless Congress intervenes. Military plans, however, do not
provide vesting of nondisability retirement benefits for those with
fewer than 20 years of service. Military retirees who are age 62 or
older are also entitled to Social Security benefits. For long-service
retirees, the combined military and Social Security benefits often
have produced a retirement income exceeding 100 percent of prere-
tirement take-home pay.
The Military Retirement Reform Act of 1986, however, implemented
a new pension plan for anyone entering the armed forces after August
1, 1986. Under the old system, military personnel who retired after
20 years of service received annual benefits of one-half of their base
pay for the three highest-earning years. Benefits rose 2.5 percent for
every additional year of service up to 30, when benefits peaked at 75
percent. Persons entering the military after August 1, 1986, retiring
with 20 years of service will receive 40 percent of their base pay for
the three highest years; those retiring with 30 years of service will
receive 75 percent. Benefits for early retirees are adjusted for each
year of service less than 30 years.
(5) Veterans' Pensions-Veterans with service-connected disabilities may
be eligible for compensation from the Veterans Administration if they
have wartime service. Veterans without service-connected disabilities
may be eligible for veterans' pensions. To qualify, veterans must be:
(1) totally and permanently disabled; or (2) age 65 or older; and (3)
have income below a specified amount.
More detailed information can be obtained by contacting a local Vet-
erans Administration office.
(6) Keogh Plans and Individual Retirement Accounts (IRAs)-Keogh plans
and individual retirement accounts are voluntarily established by
employers and individuals. Keoghs and IRAs offer tax savings on
personal contributions and their investment earnings? Each year,
those eligible for IRA participation can contribute up to $2,000 ($2,250
for those with nonworking spouses) or 100 percent of earned income
(whichever is lower). Persons eligible to deduct IRA contributions may
claim the deduction for the tax year in which contributions are made.
The tax reform law, however, restricts the deductibility of IRA con-
7For more information on IRAs and Keoghs and how they are treated under the revised
federal tax code, see chapters XIII and XV, respectively.
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tributions for taxpayers who are covered by an employer-sponsored
retirement plan and have income above specified levels. Distributions
from IRAs are taxed in the year they are received, with a 10 percent
penalty imposed on lump-sum distributions received before age
591/2, unless the distribution meets one of the exceptions included in
the tax code.
The self-employed covering themselves and any of their employees in
an unincorporated business can save for retirement through Keogh
plans. The annual contribution maximum for a defined benefit plan
is the lesser of the amount needed to fund a $90,000 annual benefit
or 100 percent of the employee's average compensation for the high
three years. For a defined contribution plan, the annual contribution
maximum is $30,000 or 25 percent of compensation, whichever is less.
Distributions from Keoghs are taxed in the year they are received,
with a 10 percent penalty imposed on those who take a lump-sum
distribution before age 591/2, unless the distribution meets one of the
exceptions included in the tax code.
Homeownership-Most individuals accumulate their largest share of
personal wealth in home equity; many older families do not have
outstanding mortgages. At retirement, they can convert their home
value into income-generating assets, or they can continue living in
their homes and enjoying the financial and personal advantages of
owning residential property.
A relatively new concept available in some states, the reverse mortgage
(RM), allows individuals to convert home equity into a steady income
while retaining residence. An RM is a loan secured by property; the
homeowner typically receives payments from the loan on a monthly
basis. There may also be an option to receive a larger lump-sum
payment, which can be used to purchase an annuity or fund property
maintenance or repair.
There are two types of RMs. Term RMs may be attractive to an in-
dividual who needs cash for a certain number of years-while waiting
to be accepted into a continuing care community, for example. At the
end of the term, the person would then be in a position to sell his or
her home, pay the loan balance plus interest, and move to the com-
munity. Open-ended RMs allow the homeowner to receive monthly
payments for as long as he or she is alive and residing in the home.
Since RMs enable older people to live at home, they increase the
opportunity for self-reliance while decreasing the likelihood of insti-
tutionalization. Despite their potential benefits, however, there are
some important concerns associated with RMs. They reduce mobility,
and the income generated may disqualify older persons from public
assistance programs.
For more information on home equity conversion, contact a savings
and loan institution or the National Center for Home Equity Con-
version, 110 East Main Street, Madison, WI 53703.
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Life Insurance-One major purpose of life insurance is to produce an
immediate income for surviving dependents, when working spouses
or pensioners die. As a source of retirement income, life insurance
assures that benefits will be paid to surviving beneficiaries according
to the policy's stated conditions. The rate of return on savings invested
in some policies, however, may be relatively lower than that of other
investment alternatives.
Workers may purchase individual life insurance and pay premiums
out of personal income. Sometimes employers pay group life insur-
ance premiums for active as well as retired employees. Workers should
inquire whether employer plans will continue to provide coverage
after retirement.
(9) Other Savings Alternatives-There are many other types of investment
instruments that can produce retirement income (e.g., stocks, bonds,
mutual funds and savings accounts). Workers should understand their
alternatives and weigh the advantages and disadvantages of each
against their individual needs. They should also consider the different
tax aspects of these various investment instruments.
(10) Employment-Many older persons who are eligible for retirement con-
tinue working-at least part time. Aside from the financial advan-
tages, employment provides a productive and structured activity.
Currently, there is a Social Security earnings test limiting the amount
that can be earned before Social Security benefits are partially or
fully reduced. In 1987, a 65-year-old person with $8,160 or less in
earnings can continue to work and receive all of the Social Security
benefits. Those who retire early are permitted to earn up to $6,000.
For every two dollars in earnings above the limit, Social Security will
withhold one dollar of benefits. Beginning at age 70, however, there
is no limit on the amount that can be earned without penalty.
Beginning in 1990, one benefit dollar will be withheld for every three
dollars in earnings above the limit for those 65 and older. Some em-
ployment agencies now specialize in placing older workers, and some
employers sponsor job-search seminars for retiring workers.
(11) Public Welfare Programs-For those who reach retirement age without
adequate income, public welfare programs are available. These as-
sistance programs offer economic support based on demonstrated
need.
(a) Supplemental Security Income (SSI) is a federally administered
program implemented in 1974. It provides cash assistance to low-
income aged, blind and disabled adults who have assets below
specified limits. Benefits are indexed to cost-of-living increases.
Additionally, many states supplement the basic federal benefit.
Income from other sources reduces available SSI benefits; how-
ever, the benefit calculation disregards the first $20 of unearned
monthly income (regardless of source), plus the first $65 of earned
income, as well as one-half of earnings above $65.
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More information can be obtained by contacting your local Social
Security Administration office.
(b) The Food Stamp Program was enacted in 1964. The federal gov-
ernment finances 50 percent of administration costs and 100 per-
cent of benefit costs. The benefit amount varies with household
size and income, and is inflation-adjusted.
For more information on food stamps, contact your local or county
social services offices.
Preventive Health Care-Many diseases associated with old age re-
sult from years of poor health habits. To enhance the chances of good
health in later years, doctors recommend eating properly, exercising
and having regular physical examinations.
A number of special programs have been developed to encourage
good health habits at affordable prices. Programs that provide low-
cost nutritional meals to older people can be located by contacting
an area senior center. To encourage exercise, the YMCA and other
athletic facilities offer reduced membership rates for people over age
65.
Health Care Costs-Health care costs have risen dramatically. It
has become imperative to plan ahead for potential large costs asso-
ciated with unexpected illness. Without insurance assistance, few
people have adequate financial resources to cover catastrophic ill-
nesses, particularly for long-term care associated with a chronic ill-
ness.
Medicare-Medicare is the federal health insurance program under
Social Security. Medicare consists of two parts: Part A (hospital in-
surance) helps pay for inpatient hospital care and certain follow-up
care; Part B (medical insurance) helps pay for doctors' services, out-
patient hospital services and other medical supplies and services not
covered by Part A. Medicare offers public health insurance protection
to all persons age 65 or older who are entitled to receive Social Security
(as well as the severely disabled under age 65), whether or not they
actually receive Social Security benefits.
Medicare coverage is not automatic. Application may be made three
months before reaching age 65. Those who are enrolled in Part A are
automatically enrolled in Part B, unless they choose not to be. There
is a moderate monthly charge for Part B. Those who are not covered
by Social Security may pay to participate in Parts A and B or Part B
alone.
Since Medicare does not cover all expenses, it is important that workers
planning their retirement develop a sound understanding of what is
and is not covered by Medicare. Workers should also ascertain whether
their group health coverage will continue after retirement. If not, many
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retirees purchase additional health insurance coverage on their own.
Employer group plans sometimes can be converted to individual pol-
icies. If this option is not available, some policies (known as Medicare
supplement, or "Medigap," policies) are designed specifically to fill in
the gaps not covered by Medicare. To assure that major medical ex-
penses will be covered, retirees must understand their private insur-
ance coverage and how it coordinates with Medicare.
(2) Health Maintenance Organizations (HMOs)-Participants in an HMO
make fixed monthly payments to the HMO. In turn, the HMO provides
most or all of the needed health care services. Such fixed-price ar-
rangements permit retirees to estimate future health care costs more
accurately. Many Medicare beneficiaries receive all Medicare-covered
health services through enrollment in HMOs.8
(3) Medicaid-Medicaid, created in the mid-1960s, offers health assistance
to people with low incomes. It is jointly financed by federal and state
governments. Each state that elects to participate administers its own
program. Medicaid reimburses health care providers for specified ser-
vices rendered to older and disabled persons, as well as members of
families with dependent children, who satisfy income tests. Covered
services and the amount of deductibles (i.e., an amount an individual
is required to pay before receiving any Medicaid payments) differ from
state to state, but medical services are free to most SSI recipients.
(4) Long-Term Care-Many chronically ill and functionally impaired older
persons require ongoing health and social services, known as long-term
care. An estimated 9.3 million Americans age 65 and older will need
long-term care by the year 2000. Care for debilitating chronic condi-
tions is expensive and can rapidly deplete a lifetime's savings, yet is
not covered by Medicare or most supplemental insurance policies.
Nursing home insurance is available in some parts of the country, but
premiums increase with the age of the policyholder. Research and test-
marketing efforts undertaken by the public and private sectors may in
the future lead to better options for financing and delivering long-term
care.
Even as they approach their own retirement, many persons are con-
fronted with the prospect of providing financial, emotional and often
physical support to their parents and other older relatives. This added
responsibility, sometimes referred to as eldercare, can make it difficult
to plan for retirement effectively. Some individuals may be forced to
delay their retirement or to postpone travel or relocation plans.
Living Arrangements-Choosing an appropriate living environment
after retirement requires careful thought and planning. Many options
are available and should be considered before making a decision. For
'For more information on health insurance and HMOs, see chapters XVII and XIX,
respectively.
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example, an elderly family may choose to stay in their present home
or move into an apartment, smaller house, mobile home or continuing
care community. They may buy or rent a home. They may stay in
the same geographic area or move-possibly to an area with a more
comfortable climate. Many older people choose to share homes with
others as an alternative to living alone. These decisions should be
based upon financial considerations as well as individual needs and
desires.
Financial Considerations-Capital gains on sale of a home that has
been a principal residence are offered as a once-in-a-lifetime tax break
for older homeowners. If a homeowner is age 55 or over, and if the
home has been his or her principal residence for at least three of the
last five years, he or she may sell the home and enjoy a one-time
exemption from taxes on profits of up to $125,000.
For more information, contact your local Internal Revenue Service
office.
(2) Housing Assistance-Under the 1937 Housing Act and subsequent
amendments, several programs have been developed to provide direct
and indirect housing assistance to older people. Such assistance can
be separated into four basic categories: homeownership, rental, rental
subsidy and nursing home/intermediate care facility programs. There
are often long waiting periods for housing assistance, so inquire and
apply early. These programs are subject to change, and interested par-
ties should keep abreast of new developments.
More information can be obtained through your local housing authority
or social services offices.
(3) Physical and Social Considerations-Before moving to a new home,
consider such issues as the accessibility of public transportation. A
time may come when driving a car is not possible. Older persons should
be in close proximity to grocery stores, doctors' offices and other fre-
quently used places. Isolation and loneliness are common concerns for
older people; they should locate where it is easy to establish and main-
tain contact with others.
Use of Leisure Time-One of the greatest challenges to workers who
are facing retirement is the satisfactory use of a dramatic increase
in leisure time. Discovering positive ways to use free time requires
energy and imagination. People who develop outside interests and
commitments in their working years are more likely to adjust well
in retirement. It is solely the responsibility of a retiree to structure
his or her time and to invest it in satisfying activities. Retirement
frequently provides an opportunity for more active involvement in
the community, travel, an avocation and/or further education.
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A newly retired person can begin by exploring community re-
sources. Public libraries can be a good source of information about
community programs. Free adult education courses are offered by
many community colleges. Recreational activities are sponsored by
various organizations (e.g., area senior centers, the YMCA and local
recreation departments). Opportunities for part-time and/or volun-
teer work may be available.
Interpersonal Relationships
(1) Friends-Work provides an environment for meeting people and shar-
ing common interests; thus, retirement can result in less interaction
with people. Finding new ways to meet people and develop friendships
is important. Again, those who develop strong friendships and family
relationships in earlier years usually have a happier, more productive
retirement.
(2) Spouses-Adjustments are also necessary in spousal relationships. De-
veloping friendships and outside interests before retirement reduces
the strain of retirement on a marriage. Another area that needs atten-
tion concerns the problems associated with the death of one's spouse.
Early discussion of coping methods that can be used after a spouse
dies may reduce present and future anxieties. Psychological and fi-
nancial adjustments must be considered.
Estate Planning-A decedent's estate is made up of assets minus
liabilities at death. Many people put off estate planning because they
do not want to face the unpleasant thought of death. Lack of qualified
legal assistance in estate planning can cause unnecessary hardship
and expense to a decedent's surviving family and friends. Those who
die without a will leave the distribution of their property to the state.
No estate is so small that it eliminates the need for a formalized will.
Wills should be prepared by a lawyer. To ensure legality, they must
be properly witnessed and signed. Handwritten or spoken wills are
usually not valid. States have differing probate laws; therefore, it is
advisable to have all important documents reviewed by a lawyer
when relocating to another state. If there is a major change in family
circumstances, such as a death, divorce or marriage, the will should
again be reviewed by a lawyer.
Considerations for the Employer
This chapter has stressed the worker's responsibilities in planning
for retirement. Employers can also play an important role in helping
employees prepare for retirement. The number of companies that are
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taking steps to assist employees in this way is increasing steadily.
The remainder of this chapter will focus on employer-sponsored re-
tirement planning programs.
Retirement planning programs have varied widely. Some employ-
ers have offered programs since the 1960s. After ERISA, more em-
ployers began to provide retirement planning assistance to retiring
employees. The more assistance employees receive in preparing for
retirement, the more likely they will adapt successfully.
Results of a 1984 study of Fortune 500 firms indicate that employers
recognize a need for retirement counseling programs. Of 142 respon-
dents, nearly 51 percent indicated they have such programs-26 per-
cent more than reported having them in a 1977 study. Fifty-six percent
of the firms without programs reported they plan to implement one
within the next few years. About one-half of eligible employees take
advantage of the counseling programs each year, according to those
firms with programs.
Interest in Retirement Planning Programs-Reasons for the in-
creased interest in retirement counseling programs include:
(1) Retirees are living longer and represent the fastest-growing segment
of our population. There is a growing appreciation of their problems.
The 1978 Amendments to the Age Discrimination in Employment Act
have heightened awareness of the importance of the decision to retire.
(2) The 1974 Employee Retirement Income Security Act has resulted in
greater dissemination of information about benefit plans. As more in-
formation becomes available, interest in retirement planning programs
is increasing.
(3) Concerns about high rates of inflation have contributed to employees'
uneasiness about their financial security during retirement. They have
been forced to recognize the problems of living on a fixed income.
(4) Employees nearing retirement age often experience feelings of inse-
curity and anxiety; this can lead to a reduction in productivity. By
offering retirement counseling, employers have learned they can al-
leviate anxieties and reduce the decline in productivity. Research shows
that employees who believe their employers care about them tend to
produce a better quality of work.
(5) Studies show that employees who receive employer retirement coun-
seling adapt better to retirement. By providing retirement counseling,
employers invest in the goodwill of their workers as well as a positive
public image.
(6) Loyal employees have helped organizations succeed, and most em-
ployers want to help them prepare for a satisfying retirement.
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Program Content-Retirement planning programs generally in-
clude counseling in some or all of the following areas:
(1) Financial Planning-coping with inflation, investment options, estate
planning, insurance and the roles of Social Security and pensions;
(2) Health-the importance of nutrition, exercise, health maintenance and
health care;
(3) Interpersonal Relationships-interaction with friends and spouses;
(4) Living Arrangements-the importance of financial and geographical
considerations in choosing a new home;
(5) Leisure Time-the need for recreational activities, hobbies, community
involvement and education;
(6) New Careers-the types of available opportunities for employment and
volunteer work, and guidance in brushing up on job-hunting skills.
Program Design-Individual counseling is a popular way of pro-
viding benefit information to employees. Some organizations, how-
ever, combine individual interviews with group sessions, or they
conduct only group meetings. Much of the retirement planning in-
formation is similar for all employees, and group meetings can be
efficient. Although attendance is encouraged, participation is usually
voluntary.
Employers can purchase packaged programs from firms with re-
tirement planning expertise. Some employers use a combined ap-
proach, starting with a packaged program and conforming it to their
employees' needs. Other methods of retirement planning include the
use of expert speakers, printed materials and audio/visual aids. The
majority of counseling seminars enlist the assistance of outside
professionals to hold sessions on topics such as real estate, health
care, Social Security and psychological adjustment.
Timing and Length of Counseling Sessions-Topics can be covered
in separate weekly sessions; however, a session of two to three con-
secutive days may be preferable. Most firms hold sessions during
nonworking hours. Participants should be encouraged to devote sole
attention to the retirement counseling session; the session should not
be interrupted by work. If a weekly format is adopted, two-hour ses-
sions are generally advisable. Usually, in this period of time, one
retirement topic can be discussed with a question-and-answer period.
Group Size-Because the success of a counseling program depends
on attendee participation in group discussions, it is wise to limit
attendance at each meeting to 40 participants. Assuming that most
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employees bring a spouse or friend, 20 to 25 employees should be
invited.
Who Should Attend-Employees, their spouses and other close fam-
ily members or friends generally attend retirement planning meet-
ings. Inclusion of spouses and friends helps to alleviate an employee's
anxieties about retirement. Additionally, it provides the employee
with access to other informed persons. These persons can discuss
future problems with the employee if and when they occur.
Participants' Ages-Generally, employees who are age 55 and over
are invited to participate in retirement planning programs. The
10-year period before normal retirement age is an appropriate time
for an employee's financial and attitudinal preparation.
Conclusion
Increased life expectancies make the need for retirement planning
even more crucial than in the past. Through individual and company
retirement planning efforts, employees can prepare more effectively
for a happy, healthy and productive retirement.
Additional Information
American Association of Retired Persons
1909 K Street, N.W.
Washington, DC 20049
Alberding, Russell J. "Is That All I Get?-Helping Employees Evaluate How
Ready They Are to Retire." Employee Benefits Journal (September 1986):
15-18, 28.
Employee Benefit Research Institute. "Economic Incentives for Retirement
in the Public and Private Sectors." EBRI Issue Brief 57 (August 1986).
Seibert, Eugene H., and Joanne Seibert. "Retirement: Crisis or Opportunity."
Personnel Administrator (August 1986): 43-49.
Siegel, Sidney R. "Preretirement programs in the '80s." Personnel Adminis-
trator (February 1986): 77-83.
U.S. Congress, House of Representatives, Subcommittee on Housing and
Consumer Interests, Select Committee on Aging, and Senate, Special Com-
mittee on Aging. Home Equity Conversion: Issues and Options for the Elderly
Homeowner. Washington, DC: U.S. Government Printing Office, 1985.
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XVII. Health Insurance
Nearly 75 percent of all United States workers are covered by an
employer-sponsored health insurance plan. Depending upon the na-
ture of an illness and the medical benefits provided, an employee's
financial well-being could be jeopardized by unanticipated medical
expenses. Although employees also value other types of employee
benefits (e.g., pensions, profit sharing plans and group life insurance),
medical benefits have a unique value; these benefits are received on
a current rather than a future basis.
There are two primary types of health plans that may be offered
by an employer: (1) prepaid plans, such as those provided through
health maintenance organizations (HMOs);' and (2) postpaid plans,
which are the traditional fee-for-service plans offered by insurance
companies and many self-insured employers. This chapter will de-
scribe postpaid plans, including basic medical and major medical
insurance.
Some of the important events in the development of health insur-
ance in the United States include:
As far back as 1798, a health plan for members of the merchant marine
was established.
(2) Montgomery Ward & Co., Inc., instituted an insured health contract
in place of its employee establishment fund in 1910.
(3) The first collectively bargained health and welfare plan was established
in New York City's garment industry in 1917.
(4) The first citywide Blue Cross plan to insure against hospital costs was
established in 1932. The first Blue Shield plan to insure against phy-
sician costs was established in 1939.
(5) Group medical expense benefits were introduced by private insurers in
1943.
(6) During World War II, when limits were placed on wage increases, many
employers established medical care programs to attract and retain
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workers. Medical care benefits spread rapidly after World War II.
Labor law changes and favorable court decisions accelerated this trend.
(7) Major medical benefits to supplement basic medical benefits were in-
troduced in 1949.
Employee Participation
Many employers cover all eligible employees under a single health
plan. Others have one plan for union members and another plan for
nonunion members. Most employees are covered at the time they are
hired or after satisfying a waiting period (e.g., three months).
Most plans cover employees and their dependents. The cost of the
employee's coverage is usually paid by the employer. In some plans,
family coverage is provided only if the employee pays some or all of
the cost of such coverage. Under such plans, payment for family cov-
erage is made through payroll deduction.
Continuation of Employer-Provided Coverage-The Consolidated
Omnibus Budget Reconciliation Act of 1985 (COBRA) requires em-
ployers with health insurance plans to offer continued access to group
health insurance for former employees and their dependents:
(1) for 18 months if the worker becomes unemployed for any reason other
than gross misconduct or if there is a reduction in the number of hours
worked; or
(2) for 36 months to dependents of deceased workers, to the former spouse
of a worker who is divorced, to dependent children who cease to be
dependent, or if the active employee becomes eligible for Medicare.
The coverage offered must be identical to that available prior to the
change in a worker's employment status. The qualifying employee or
dependent may be required to pay up to 102 percent of the premium.
At the end of the 18- or 36-month period, the employer must offer
conversion to an individual policy if the group plan includes a con-
version privilege (an option required in some states). The law is effec-
tive for plan years beginning on or after July 1, 1986; collectively
bargained plans must be amended by the later of (1) the termination
of the currently bargained plan or (2) January 1, 1987.
Group health plans for public and private employers with fewer than
20 employees are excluded from these provisions, as are church plans
(as defined in section 414(e) of the Internal Revenue Code), the District
of Columbia and any territory, possession or agency of the U.S.
Technical corrections to these provisions were included in the Tax
Reform Act of 1986 (TRA). The Omnibus Budget Reconciliation Act of
1986 (OBRA) further amended COBRA to make a firm's entering into
Chapter 11 bankruptcy proceedings on or after July 1, 1986, a quali-
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fying event allowing any retired employee to purchase employer cov-
erage until he or she dies or becomes covered under another plan. The
retiree's spouse would be able to continue purchasing the coverage for
an additional 36 months.
Plan Operators
A variety of sources offer health insurance: (1) commercial insur-
ance plans; (2) Blue Cross/Blue Shield plans; (3) self-funded plans;
(4) HMOs;2 and (5) public programs such as Medicare.3
(1) Commercial Insurance Plans-Insurance companies are a major source
of health insurance. Generally, the premium for such insurance pro-
tection is calculated to cover the: (a) benefits that will be paid;
(b) administrative costs; (c) insurance sales commissions; (d) state pre-
mium taxes; (e) surplus (i.e., profit); and (f) risk charges. Generally, for
employee groups of 50 or more, the insurer maintains separate claims
records and periodically adjusts the premium to reflect the group's
claims experience (called experience-rated plans).
(2) Blue Cross/Blue Shield Plans-These plans are also a major source of
health insurance coverage. Blue Cross covers hospital services and Blue
Shield covers medical and surgical services. Participating doctors and
hospitals agree to accept a predetermined specified fee from Blue Cross/
Blue Shield as payment in full for each service. Thus, if a plan member
visits a nonparticipating doctor or hospital, and if the charge is above
the scheduled Blue Cross/Blue Shield fee, the patient will be respon-
sible for paying the difference. (Most doctors and hospitals are partic-
ipating members.) Most Blue Cross/Blue Shield plans directly pay the
health care service provider.
Although many plans operate under the Blue Cross/Blue Shield name,
each plan is independent; each generally operates in a specific geo-
graphic area, and the various plans may offer different benefit struc-
tures.
Blue Cross/Blue Shield plans must comply with certain standards of
the Blue Cross and Blue Shield Association (e.g., these plans must enroll
all applicants regardless of health; they must operate as nonprofit
organizations; and they must offer terminating employees conversion
privileges).
Self-Funded Plans-Some employers self-fund (i.e., self-insure) and self-
administer their medical plans. Other employers self-fund their plans
but purchase administrative services contracts to take care of their ad-
ministrative needs. Additionally, some insurers offer stop-loss coverage
'For more information on HMOs, see chapter XIX.
3For more information on Medicare, see chapter II.
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to employers, which covers catastrophic health expenses above a max-
imum and, therefore, limits a self-funded plan's liability.
Health Insurance Benefits
Postpaid Plan Benefits-Medical benefits may be provided through
several approaches: (1) usual, customary and reasonable (UCR);4
(2) fixed; or (3) combination.
(1) Under the UCR approach, all covered services considered to be usual,
customary and reasonable are recognized in full. The range of covered
services depends upon the plan's design.
(2) Under the fixed approach, covered services are recognized only up to
a fixed dollar amount. This limit can take many forms; for example,
a plan may limit hospital benefits to $100 per day and reimburse
surgical charges according to a specified schedule of payment by pro-
cedure.
(3) The combination approach includes elements of each of the first two
approaches. An example would be a hospital plan that recognizes the
UCR amount for room and board and a scheduled amount for surgical
procedures.
In recent years, the UCR approach has become the most popular
among postpaid plans.
Prepaid Plan Benefits-Whereas postpaid plans reimburse insured
persons for covered charges they incur, prepaid plans promise to
deliver needed health care. This requires that care be obtained from
a prepaid plan provider. Because care is paid for in advance, as op-
posed to having the cost of care reimbursed after it is provided, there
are no UCR or fixed dollar limitations. However, for certain highly
elective services, such as outpatient psychiatric care, benefits might
be limited.
Refer to chapter XIX for a discussion of health maintenance or-
ganizations.
Deductibles, Coinsurance and Maximum Coverage Limits-Major
medical plans incorporate deductible, coinsurance and maximum cov-
erage limits. These plan features are intended to: (1) reduce plan costs;
(2) encourage employee cost consciousness; and (3) reduce administra-
4Usual, customary and reasonable means that the charge is the provider's usual fee
for the service, does not exceed the customary fee in that geographic area and is
reasonable based on the circumstances. A fee may be considered reasonable when
special circumstances require extensive or complex treatment, even though it does
not meet the standard UCR criteria.
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tive expenses. In 1985, 90 percent of plan participants in medium and
large establishments had a deductible and/or copayment provision for
hospital room and board coverage and nonhospital physician care.
A deductible is a specified amount of initial medical costs that each
plan participant must pay before any expenses are reimbursed by the
plan. Deductibles typically range from $100 to $500. Under a plan
with a $200 individual deductible, for example, a participant must
pay the first $200 in recognized expenses for covered health care
services. The plan then pays for additional health care expenses ac-
cording to other plan provisions.
The deductible must be satisfied generally every calendar year by
each individual participant. However, many plans contain a three-
month carry-over provision. If so, any portion of the deductible that
is satisfied during the last three months of the year can be applied
toward satisfaction of the following year's deductible.
Under a coinsurance arrangement, the plan participant pays a por-
tion of recognized medical expenses and the plan pays the remaining
portion. The employee commonly pays 20 percent, with the plan
paying the remaining 80 percent of recognized charges. Most major
medical plans incorporate both deductible and coinsurance features.
Thus, once the plan participant pays the deductible (e.g., the first
$200 in medical expenses), the plan pays up to 80 percent of all other
covered charges.
Because 20 percent of a large medical claim poses an undue financial
burden for many individuals and families, most plans contain a limit
on out-of-pocket expenditures. In this case, once an individual has reached
the out-of-pocket maximum, covered expenses are reimbursed in full
for the remainder of the year. The out-of-pocket limit is usually renewed
at the start of the calendar year for each individual participant.
Most major medical plans impose a maximum dollar limit on the
amount of health insurance coverage provided. Plans that impose
limits may do so on an episode basis such as per hospital admission
or per disability. Or, plans may impose an annual or lifetime maxi-
mum reimbursement amount for all covered services. Individual life-
time maximums are set usually at very high levels, such as $250,000
or $1 million. Separate lifetime maximums, typically $25,000, are
often set for high-risk coverages such as psychiatric care.
Basic Health Insurance
Basic health insurance plans primarily cover health care services
that are associated with hospitalization. There are three major cat-
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egories of health coverage under basic plans: (1) hospitalization;
(2) physician care; and (3) surgical.
Room and board, physician care and surgery are paid generally on
a fixed basis, often at relatively low levels. Other hospital benefits
are recognized in full. Basic services are sometimes covered on a first-
dollar basis (i.e., there is no deductible or coinsurance).
Hospitalization-This type of coverage pays for inpatient hospital
charges, such as: (1) room and board; (2) intensive care expenses;
(3) necessary medical supplies; (4) general nursing services; and
(5) other hospital expenses. Some outpatient services may also be
covered (e.g., emergency treatment as a result of an accident, or
preadmission testing). Room and board benefits are often limited on
a daily basis, total hospital benefits may be limited on a per-admis-
sion basis, and treatment for psychiatric care or substance abuse may
have separate, stricter limits.
Physician Care-This type of coverage pays for in-hospital visits by
a physician. Medical care obtained in a physician's office or at home
is usually excluded from the basic plan. A major medical plan will
cover these types of services. Benefit limits often apply, such as a
dollar amount per visit or a limited number of visits per calendar
year.
Surgical-This type of coverage pays for surgical procedures per-
formed by a licensed physician. The surgery can be performed in a
hospital, outpatient facility or physician's office. Additionally, the
services of an assistant surgeon, anesthesiologist and anesthetist may
also be covered. Surgical procedures often are reimbursed according
to a fee schedule.
Major Medical Insurance
There are two types of major medical plans: (1) supplemental and
(2) comprehensive. Supplemental plans are intended to cover services
excluded under basic plans. Comprehensive plans provide the com-
bined coverage of both a basic plan and supplemental plan. Unlike
basic medical plans, both types of major medical plans cover a broad
range of health care services and are designed to protect against large
and unpredictable medical expenses.
Supplemental Plans-Supplemental major medical plans cover
medically necessary services excluded under basic plans, as well as
charges that exceed any basic plan fixed-dollar limitations. Typical
covered services include inpatient and outpatient hospital care, spe-
cial nursing care, outpatient prescription drugs, medical appliances,
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and outpatient psychiatric care. These plans include deductible, coin-
surance, and maximum benefit features.
Comprehensive Plans-Comprehensive major medical plans pro-
vide coverage for the same types of services covered under basic and
supplemental plans combined. In fact, basic/supplemental plans are
being rapidly replaced by comprehensive plans. Most comprehensive
plans incorporate deductible and coinsurance features, although sev-
eral variations exist. Many plans may provide first-dollar coverage
for emergency accident benefits. Or they may waive any out-of-pocket
expenses altogether for certain types of benefits.
Other Health Care Plans
Medical plans generally exclude services that are not considered
medically necessary. These services include most dental, vision and
hearing care. As a result, stand-alone plans providing these benefits
are growing in popularity. Because of their highly elective nature,
various limits are placed on the benefits provided.5
Continued health insurance coverage for retirees is a common pro-
vision among medium and large employer plans. In 1985, 72 percent
of participants in such plans had coverage continued after early re-
tirement; 66 percent had coverage continued after retirement at age
65. Most of the cost of this coverage is usually paid by the employer.
Employer plans that continue health coverage for retired workers
typically maintain benefits at preretirement levels, although cover-
age under the employer plan usually is secondary to that provided
under Medicare (i.e., benefits covered by the employer plan are re-
duced by the amount Medicare pays).
Nondiscrimination rules are intended to ensure that nonhighly
compensated employees are not discriminated against, in relation to
highly compensated employees, in the benefits they receive under an
employer-provided health plan.
TRA revised the nondiscrimination rules for self-funded group health
plans and extended them to insured plans. The nondiscrimination
'For more information on dental, prescription drug and vision care plans, see chapters
XXI, XXII and XXIII, respectively.
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rules generally are effective for the later of (1) plan years beginning
after December 31, 1987, or (2) the earlier of (a) plan years beginning
at least three months following the issuance of Treasury regulations
or (b) after December 31, 1988.
Employers must meet both an eligibility test and a benefits test,
or an alternative test.
The eligibility test stipulates that the employer satisfy three re-
quirements. The first is that nonhighly compensated employees must
constitute at least 50 percent of the group of employees eligible to
participate in the plan. This requirement can be satisfied if the per-
centage of highly compensated employees who are eligible to partic-
ipate is not greater than the percentage of nonhighly compensated
employees who are eligible. This allowance is important to smaller
firms where more than 50 percent of the workers are defined as highly
compensated. In such cases, 100 percent of the nonhighly compen-
sated would have to be eligible in order for the plan to pass the test.
The second requirement is that at least 90 percent of the employer's
nonhighly compensated employees are eligible for a benefit that is
at least 50 percent as valuable as the benefit made available to the
highly compensated employee with the most valuable benefits.
The third requirement provides that a plan may not contain any
provision relating to eligibility to participate that suggests discrim-
ination in favor of highly compensated employees.
The benefits test requires that the average employer-provided ben-
efit received by nonhighly compensated employees under all plans
of the employer of the same type is at least 75 percent of the average
benefit received by the highly compensated employees under all of
the employer's plans of the same type. The average employer-pro-
vided benefit is defined as the aggregate employer-provided benefits
received by the highly or nonhighly compensated group divided by
the number of employees in the respective group, whether or not they
were covered by any of the plans.
An alternative to the eligibility and benefits tests allows an em-
ployer to meet the nondiscrimination rules if the plan benefits at
least 80 percent of the employer's nonhighly compensated employees.
Only individuals who receive coverage under a plan will be consid-
ered as benefiting from the plan-eligibility to receive coverage is
not sufficient.
There is a penalty if a plan fails to comply with the new nondis-
crimination rules: All highly compensated employees in the plan will
be taxed on the value of the discriminatory portion of the benefit.
The discriminatory excess for health insurance arrangements is de-
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fined as the amount of employer contributions and elective deferrals
required to have been made as after-tax employee contributions by
the highly compensated employees if the nondiscrimination tests were
to have been satisfied. TRA language implies that this is determined
by reducing the value of the benefits attributable to employer con-
tributions (beginning with employees receiving the greatest benefits)
until the plan is not discriminatory. The value subtracted is the dis-
criminatory excess.
Employers who fail to report in a timely manner that a plan is
discriminatory are liable for an excise tax at the highest individual
tax rate on the total value of benefits, unless reasonable cause for
failure to report is demonstrated.
Conclusion
For many decades, health insurance plans have played a significant
role in employee benefit planning. Modern medical technology, in-
creased longevity and a growing emphasis on good physical and men-
tal health make these plans even more important today. The
development of HMOs, PPOs, and dental, prescription drug, vision
and hearing care plans attests to the dynamic nature of this employee
benefit area, as does the development of wellness and employee as-
sistance programs .6 Future innovative efforts in plan design will be
influenced strongly by the continuing need for health care cost man-
agement as well as new government regulations.'
Additional Information
Health Insurance Association of America
1025 Connecticut Ave., NW, Suite 1200
Washington, DC 20036
Chollet, Deborah J. Employer-Provided Health Benefits: Coverage, Provisions
and Policy Issues. Washington, DC: Employee Benefit Research Institute,
1984.
Employee Benefit Research Institute. "Employer-Sponsored Health Insur-
ance Coverage." EBRI Issue Brief 58 (September 1986).
."Features of Employer Health Plans: Cost Containment, Plan Fund-
ing, and Coverage Continuation." EBRI Issue Brief 60 (November 1986).
6For more about employee assistance and health promotion programs, see chapter
XXIV.
7Many aspects of employer-provided health insurance plans are affected by govern-
ment regulations such as the Employee Retirement Income Security Act (ERISA).
For more information on ERISA's impact on medical care plans, see chapter III.
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XVIII. Managing Health Care Costs
Introduction
Health care costs in the United States have grown rapidly, reaching
$425 billion in 1985. This growth has occurred because of several
factors, including advances in medical technology; population growth;
increased life expectancy; lower infant mortality; and inflation.
The health care costs of employers, who provide health insurance
coverage to 75 percent of the nation's workers, reached $105 billion
in 1985, up from $51 billion in 1979. Health care spending as a per-
centage of wages and salaries also rose, from 2.2 percent in 1970 to
4.9 percent in 1985.
In recent years, virtually all employers offering health insurance
coverage to their employees have taken steps to manage costs. A 1984
survey of 1,115 firms conducted by The Wyatt Company found that
97 percent had changed their health plans in response to rising health
care expenditures. While these measures are designed to contain in-
dividual employer spending, they also may serve the broader goal of
controlling overall health care costs.
The variety of plan design changes that have been adopted by em-
ployers can be grouped into three categories:
(1) Changes that increase employee incentives to use health care more eco-
nomically-These include imposing higher deductibles and coinsur-
ance levels for all or some services covered by the plan, as well as
expanding the scope of covered services to include less-expensive al-
ternatives to inpatient hospital care.
(2) Changes that specifically restrict the use of some services-These include
requiring a formal review of hospital utilization, as well as case man-
agement and second-opinion and same-day surgery requirements.
(3) Changes that restructure the delivery of health care services to persons
covered by the plan-These include incentives for employees to select
prepaid health plans (HMOs), and the establishment of "preferred pro-
viders" for services covered by conventional health insurance plans.
Changes most commonly initiated by employers include imposing
or increasing cost-sharing requirements; requiring that tests be per-
formed prior to hospital admission; and coverage of ambulatory sur-
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gical care, treatment in extended care facilities, and second surgical
opinions. Other changes, although less common, include coverage of
home health and hospice care, case management and utilization re-
view programs, coverage of annual physical examinations, wellness
programs and coverage through PPOs or HMOs.t
In addition to these changes within the framework of existing em-
ployer health insurance plans, some employers have initiated a much
more sweeping reorganization of their health insurance benefits. In
some cases, this reorganization involves simply offering more than
one health insurance plan option to employees with the same em-
ployer contribution to health insurance coverage under each plan
option. Other employers have more fundamentally reorganized their
health insurance plans within the framework of flexible benefit or
"cafeteria" plans 2 Most employers adopting flexible benefit plans try
to induce employees to share more of, and take greater responsibility
for controlling, their health care costs.
Improving Incentives for Economic Health Care Use
Plan design changes that encourage employees to use health care
services more economically include increasing employee cost sharing
and redesigning service coverage under the plan. Raising the level of
cost sharing required by the plan refers to the portion of the cost-
called the copayment or coinsurance3-paid by the employee for
services actually used. Cost sharing under employer group plans may
be increased by raising deductibles and coinsurance levels for all or
some services covered by the plan, and by raising employee premiums
for their own or for dependents' coverage.
Because changes in the range of services covered reduce real com-
pensation levels by raising employees' out-of-pocket health care costs,
they have been generally resisted by employees, particularly by those
with collectively bargained health insurance plans. It is important,
therefore, for employers to effectively communicate to employees the
reasons that changes are being made in their health plans, and for
'Robert B. Friedland, "Private Initiatives to Control Health Care Expenditures." In
Frank B. McArdle, ed., The Changing Health Care Market (Washington, DC: Employee
Benefit Research Institute, 1987). For more about health insurance, wellness pro-
grams, PPOs and HMOs, see chapters XVII, XXIV, XX and XIX, respectively.
2For more information on flexible compensation plans, see chapter XXXI.
3Copayment refers to a flat payment (e.g., $10 per office visit) and coinsurance refers
to a percent of payment (e.g., 20 percent of total cost).
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employees to fully understand their role in the health care partner-
ship-that of being efficient consumers of health care.
Despite some employee resistance to greater cost sharing, many
employers report having raised the deductible provisions of their
group health plans in recent years. As a result, "first-dollar" coverage
for inpatient hospital expenses has become much less common. First-
dollar coverage pays initial expenses (a specified amount, depending
on the plan) for hospital care, with no deductible or coinsurance
provision on the "first dollar" of care delivered.
Changes in the range of services covered by the plan may redirect
patient use of health services toward less expensive substitutes for
inpatient hospital care. For example, employers have expanded the
range of group health plans to include coverage of home health care
services, hospice services and outpatient hospital care. Outpatient
care covered by employer group plans usually includes preadmission
testing, outpatient surgery or surgery performed in free-standing sur-
gical centers. Coverage of these services is aimed at discouraging the
unnecessary use of inpatient hospital care or prolonged hospital stays.
Restricting Use of Benefits
Another technique for controlling employer health care costs is to
restrict the use of certain benefits under the plan. For example, cov-
erage for inpatient hospital care by plan participants may depend
on: (1) complying with a case management or hospital utilization
review program; or (2) obtaining a second confirming surgeon's opin-
ion before undergoing elective surgery.
Hospital utilization review assesses the appropriateness of hospital
admission, inpatient hospital services and hospital discharge. Indi-
vidual employers or insurers may conduct their own programs or
they may contract with peer review organizations (PROs) to evaluate
hospital use. Hospital utilization review may be conducted prospec-
tively (before hospital admission), concurrently (during the patient's
hospital stay) or retrospectively (after hospital discharge).
The use of prospective, or preadmission, review is increasing rap-
idly. Insurers, particularly Blue Cross organizations, are increasingly
conducting such reviews using their own employees. Often, however,
the review process is subcontracted to an organization in each locality
that conducts reviews for a number of third-party payers. Some of
the prospective review programs also provide concurrent monitoring
and require re-authorization for hospital stays that exceed the orig-
inally agreed-upon duration.
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Plans that require or pay for a second or third medical opinion
before elective surgery have become common. Second-opinion sur-
gery provisions are often enforced either by refusing payment or by
imposing greater cost sharing for expenses related to surgery per-
formed without a second opinion.
Same-day surgery provisions eliminate unnecessarily early hospi-
tal admissions and the higher cost of hospital room and board. Plans
that do not require same-day surgery may not cover hospital room
and board charges for nonemergency weekend admissions, unless
surgery is scheduled for the following morning.
Restructuring Service Delivery
The emergence of preferred provider organizations (PPOs, some-
times called preferred provider arrangements) is an important de-
velopment. A PPO is a contractual arrangement between providers
and buyers of health care services. Under the arrangement, providers
may agree-to grant discount rates to those paying (e.g., employers)
in return for faster payment, a patient base, or both. In addition, the
PPO may cooperate in utilization review to monitor and control the
growth of health service use and plan costs. As an incentive for plan
participants to use the services of the PPO, plan coverage is often
greater for PPO services than for services delivered by other providers.
Greater coverage for PPO services might be achieved by waiving the
deductible or by decreasing the employee's coinsurance for services
delivered by the PPO.
The number of PPOs has consistently grown over the last several
years. (For more about PPOs, see chapter XX.)
Adopting Flexible Benefit Plans
A flexible benefit or "cafeteria" plan is an employee benefit plan
that gives employees some choice among cash or nontaxable benefits
provided by the employer.
Flexible benefit plans typically include two or more health plans.
They may also include, for example, dental coverage, group life in-
surance, dependent-care benefits, and a cash account-sometimes
called a "reimbursement account"-from which employees may
reimburse themselves on a pretax basis for out-of-pocket health care
or dependent care expenditures.
Employer goals in establishing a flexible benefit program are com-
plex. They often include:
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(1) managing the cost of group health benefits by inducing employees to
share more of the health care costs covered by the plan;
(2) offering employees new, specialized benefits tailored to the needs of
individuals in a demographically changing work force, without sub-
stantially raising total benefit costs;
(3) enhancing employee perceptions of the value of employer-provided
benefits.
A cash reimbursement account in a flexible benefit plan may be
helpful in reducing health care costs paid by both employers and
employees under the plan. Employees may be more willing to "trade
down" to a less generous health insurance plan option if they can
pay out-of-pocket expenses with pretax dollars. Reimbursement ac-
counts offer employees this opportunity. Employees must decide at
the beginning of the plan year how much they wish to contribute to
the reimbursement account. Any unused reimbursement account bal-
ances are forfeited by employees at the end of the plan year.
Despite restrictions on the use of reimbursement accounts, flexible
benefit plans still offer employers an opportunity to reduce their
health insurance costs-and reduce total health care expenditures.
That is, employers are able to fix their contribution to health insur-
ance benefits-either absolutely or as a percentage of a lower-cost
health insurance option-rather than automatically raise their con-
tribution as plan costs rise. In addition, a flexible benefit plan gives
employees an incentive to use fewer health care services, with or
without a reimbursement account. The choice of a more generous,
and more costly, health insurance plan reduces the employee's ability
to elect alternative benefits (including pretax savings) or higher cash
earnings.
Adjusting the price of alternative health insurance plans offered in
a flexible benefit program is important to its success in controlling
health insurance costs. Employers providing more than one health
plan anticipate "adverse selection" by employees. That is, employees
who foresee few medical needs during the year are most likely to
choose a low-cost, less generous health insurance plan. Employees
remaining in the most generous-and most costly-health insurance
plan are likely to have greater health care costs, on average, than
employees who choose a less generous health plan. The average cost
of the most generous plan is likely to rise much faster than the average
cost of the least generous plan. Employers would, therefore, like to
adjust or "reprice" the health plans to reflect the cost history sub-
sequent to the initial offering of the alternative plans.
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Effectiveness of Plan Redesign
Evidence of the effectiveness of alternative plan design changes is
scarce. Available data (1982 National Association of Employers for
Health Care Alternatives survey of employers) indicate that adding
or increasing coinsurance requirements may be very effective in re-
ducing plan cost. Raising deductibles or the level of employee con-
tributions to the plan have apparently been less successful strategies
for controlling health plan costs. A 1986 survey by Hewitt Associates
of companies offering flexible benefit plans indicates that when em-
ployees are given a choice from among a variety of medical coverage
options, overall health care costs are reduced over time.4
A 1983 survey done by the Equitable Life Assurance Society of the
United States reflects views of corporate benefit officers in companies
experienced with specific cost-containment programs. They see the
following strategies as "very effective" in health care cost contain-
ment:
(1) requiring employees to pay a part of their health insurance premiums;
(2) preventing people in families where more than one person has em-
ployer-provided health insurance from filing duplicative insurance claims
for the same medical services;
(3) utilization reviews conducted by third-party payers to discourage the
use of expensive treatment alternatives and/or inessential procedures;
(4) insurance plans that encourage the care and treatment of the chroni-
cally ill at home instead of in hospitals and nursing homes;
(5) a system that encourages the use of nurse practitioners, midwives and
physician's assistants rather than the sole use of physicians.
Prospective Medicare Pricing
Since the passage of the Social Security Amendments of 1983, Med-
icare payments to hospitals have been based on prospective pricing,
a specific allowance for each patient based on 468 diagnosis-related
groups (DRGs).
Patients with similar diagnoses are categorized into a specific DRG.
Medicare pays a hospital a fixed amount, based on the cost history
of the DRG. Since spokesmen for the hospital industry criticized the
original proposal as too rigid, Congress allowed regional variation in
Medicare rates for the first three years of the new system. However,
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starting October 1, 1987, the Medicare rates are to be standard around
the country, with one set of rates for urban areas and another for
rural areas. New Jersey, Maryland and U.S. territories are exempt
from the DRG plan because they have their own cost-control systems
using a different form of prospective payment for all hospital patients,
including those covered by private insurance carriers. In addition,
Medicare has exempted specific hospitals extensively involved in can-
cer treatment and research, psychiatric facilities, children's hospitals
and other specialized providers of care. These facilities continue un-
der the old system of cost-based Medicare reimbursement.
Prospective pricing for hospital care is intended to encourage more
cost-effective hospital use. If the cost of care exceeds the Medicare
payment, the hospital is responsible for the remaining cost. On the
other hand, if the Medicare payment exceeds the cost of care, the
hospital still receives the full payment. Before the DRG plan, hos-
pitals had few incentives to cut the cost of serving Medicare patients,
since they were paid for all services provided. With the installment
of DRGs, a specific amount is paid, regardless of any excess care
administered. If a hospital utilizes its facilities inefficiently, it loses
money. Therefore, hospitals now have a strong incentive to provide
more efficient care. Medicare requires that hospitals cooperate with
local PROs to monitor the quality of care. Medicare's implementation
of DRG-based payment for hospital care has apparently been effective
in reducing hospital admissions and hospital costs for Medicare pa-
tients.
Recent changes in employer group health plan design have received
considerable publicity. Although no nationally representative data
document the extent of those changes or their impact, private in-
dustry's survey evidence suggests that some employer initiatives are
effective in controlling health care costs.
The changes initiated by employers are notable because they have
occurred in a relatively undramatic, gradual fashion-and without
legislation that would either encourage or require such change.
Strategies used by employers to control the cost of their health
insurance plans often rely on making employees more aware of their
own health care costs. Many who would reform the nation's health
care delivery system see the lack of consumer awareness of health
care costs as a major source of health care cost inflation. Health care
cost inflation itself has forced employers to consider major changes
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in their health insurance benefits. These changes offer promising ways
to manage the rising cost of health care for all payers.
Additional Information
Health Research Institute
49 Quail Court, Suite 200
Walnut Creek, CA 94596
Employers' Health Costs Savings Letter; Joanne M. Sammer, editorial co-
ordinator. The Employers' Health Costs Management Guide. Wall Township,
NJ: American Business Publishing, 1986.
Finkel, Madelon Lubin. Health Care Cost Management. Brookfield, WI: Inter-
national Foundation of Employee Benefit Plans, 1985.
Hicks, Laurence J. Health Care Cost Management: Solutions for Employers.
Chicago, IL: Illinois State Chamber of Commerce, 1986.
McArdle, Frank B., ed. The Changing Health Care Market. Washington, DC:
Employee Benefit Research Institute, 1987.
Wolfson, Jay, and Peter J. Levin. Managing Employee Health Benefits: A Guide
to Cost Control. Homewood, IL: Dow Jones-Irwin, 1985.
Work in America Institute. Improving Health-Care Management in the Work-
place. Elmsford, NY: Pergamon Press, 1985.
Wyatt Company, The. 1984 Group Benefits Survey. Washington, DC: The Wyatt
Company, 1984.
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XIX. Health Maintenance Organizations
Introduction
Critics of the United States health care delivery system point to
traditional fee-for-service payment for health care as a major con-
tributor to health care cost inflation. They assert that this payment-
for-services method offers little incentive for controlling costs. Health
maintenance organization (HMO) advocates believe HMOs offer a
greater potential for controlling health care costs while providing
high-quality medical care.
HMOs are organizations of physicians and other health care profes-
sionals that provide a wide range of services to subscribers and their
dependents on a prepaid basis. Subscribers purchase HMO coverage
for a contract period by paying a fixed periodic fee. HMOs generally
emphasize preventive care and early intervention. Because HMOs are
contractually obligated to provide all covered medical services for a
fixed dollar amount, they have an incentive to provide care early,
before illnesses become more serious. At the same time, HMO mem-
bers tend to have lower rates of hospitalization than persons covered
by traditional fee-for-service insurance plans.
The first HMO was established in 1929. The number of HMOs has
risen dramatically since then. By January 1, 1987, according to the
National Association of Employers on Health Care Alternatives, there
were an estimated 720 HMOs covering about 26.5 million people-
about 11 percent of the United States population. As of September 1986,
some 980,000 older Americans were enrolled in HMOs through Medi-
care.
How HMOs Work
HMOs both finance and deliver health care services. Instead of
paying a health care provider each time a service is delivered, HMO
subscribers agree to pay periodic fees. In turn, HMOs provide for
virtually all of their subscribers' health care needs. (Subscribers may
be required to make a modest copayment for some HMO services.)
Each HMO develops its own rates and benefits, although federally
qualified HMOs must provide at least the basic health services re-
quired by law. HMOs accept the risk of providing covered health care
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services at a cost that does not exceed subscriber rates. Thus, they
have an economic incentive for monitoring utilization and costs.
HMOs' basic functions are:
(1) providing comprehensive health care services to subscribers;
(2) contracting with or employing physicians and other health care profes-
sionals who will provide the covered medical services;
(3) contracting with one or more hospitals to provide covered hospital
care (a few HMOs own and operate hospitals).
The role of an HMO is different from that of a commercial insurer
or Blue Cross/Blue Shield plan. HMOs finance and provide health
care services. Conventional insurance plans reimburse health care
providers-whom the patient has to locate-usually under a fee-for-
service arrangement, although commercial insurers, self-insured em-
ployers and Blue Cross/Blue Shield plans increasingly are using pre-
ferred provider organizations (PPOs) and other managed care
arrangements to encourage employee use of certain designated health
care providers.
Types of HMOs
There are three primary types of HMOs: (1) group-model plans
(sometimes called prepaid group practice plans); (2) staff-model plans;
and (3) individual practice associations (IPAs).
(1) Group-model HMOs contract with physician groups to provide services
to HMO subscribers. They usually reimburse physicians on a capitation
basis (i.e., at a fixed rate per HMO patient). Group-model HMO phy-
sicians spend most of their professional time serving HMO subscribers;
the rest of their time may be spent in their private practices. Group-
model HMOs may contract with multiple-specialty physician groups
as well as general practitioners or other primary care physicians. Group-
model HMOs may own one or more hospitals, or they may contract
with local hospitals to provide services to subscribers.
(2) Staff-model HMOs are similar to group-model plans. Under a staff-model
plan, however, physicians and other health care professionals are directly
employed by the HMO (i.e., they are members of the HMO's staff).
(3) Individual practice associations are groups of physicians in private
practice who provide some services to HMO subscribers, but primarily
provide services to patients who are not subscribers. These physicians
do not operate from a central facility. The HMO, however, monitors
the appropriateness and quality of care provided to subscribers, as
well as utilization of services. Typically, the IPA physician shares in
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the financial loss when the cost of providing covered health services
to HMO subscribers exceeds total subscription fees. IPAs have grown
faster than other types of HMOs. As of June 1986, there were about
345 IPAs with total enrollment of nearly 8.5 million people.
The 1973 Health Maintenance Organization Act
The 1973 Health Maintenance Organization Act was intended to en-
courage the growth of HMOs. In addition, it established requirements
that have to be satisfied by an entity seeking designation as a federally
qualified HMO. Under these requirements, HMOs must offer certain
benefits and satisfy federal regulations for administrative, financial and
contractual arrangements. The Department of Health and Human Ser-
vices administers the act and oversees HMO qualification.
Some HMOs are not federally qualified because they do not meet
the act's requirements or because they have not applied for qualifi-
cation. All HMOs must, however, be state certified.
As of September 1986, 412 HMOs were federally qualified; these
HMOs provided health care services to more than three-fourths of all
HMO subscribers.
HMOs generally provide more comprehensive services than are
covered by commercial insurance plans or Blue Cross/Blue Shield
plans. For example, federally qualified HMOs must provide routine
examinations. They also have limits on allowable copayment amounts.
Services that must be provided by federally qualified HMOs in-
clude: (1) primary and specialty physician care; (2) inpatient and out-
patient hospital care; (3) emergency care; (4) short-term outpatient
mental health care; (5) medical treatment and referral for alcohol/
drug abuse and addiction; (6) diagnostic laboratory services;
(7) diagnostic and therapeutic radiology services; (8) home health care;
and (9) preventive health care.
At its discretion, a federally qualified HMO may also provide a
broad range of supplemental health care services such as:
(1) intermediate and long-term care (e.g., institutional or home health
care); (2) adult vision care; (3) dental care; (4) long-term or inpatient
mental health care; (5) long-term physical therapy and rehabilitation
services; and (6) prescription drugs.' These supplemental services can
be offered on a fee-for-service basis.
The federal HMO law and regulations also provide:
' For more about vision care, dental care and prescription drug plans, see chapters
XXIII, XXI and XXII, respectively.
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(1) Under certain circumstances, employers must offer at least two health
care plan options-the employer's regular health plan and an HMO. This
provision, known as the dual choice option, applies only if: (a) an HMO
representative approaches an employer and requests that the employer
offer the HMO as an option; (b) the employer already offers and contrib-
utes to a health plan; and (c) the employer has 25 or more employees
living in the HMO service area. The HMO would then be offered to em-
ployees as an alternative to the employer's regular health plan?
(2) The HMO solicitation must be in writing; it must be directed to a
managing official at the solicited location. The written request must
be extended at least 180 days before renewal or expiration of the em-
ployer's regular health benefit contract or collective bargaining agree-
ment. Additionally, the HMO must satisfy other requirements before
it will be considered as an optional employer plan (e.g., information
must be available on the HMO's ownership and control, facilities, op-
eration hours, service areas and rates). In actual practice, most em-
ployers who offer HMOs do so voluntarily (i.e., not as a result of the
formal solicitation process).
(3) An employer who offers an HMO plan must contribute an amount to
the HMO for each subscriber-employee that is as large as the individual
participant contribution made to the regular group health plan, but
no greater than the HMO premium. If the HMO premium is greater
than the employer contribution, an employee who chooses to subscribe
may be required to pay the difference.3
(4) Employers who offer HMOs must provide for annual group enrollment
periods, where employees can choose either the HMO or the regular
'Two or more qualified HMOs may offer services in the same geographic area. Em-
ployers that are approached by more than one qualified HMO are required to offer
one medical group or staff plan and one IPA plan (assuming more than one type of
HMO solicits the employer). If 25 or more employees live in each of a number of
service areas, and if the employer is solicited by HMOs from each area, the employer
may have to offer more than one of each HMO type. Even when an employer offers
coverage under a nonqualified HMO, the employer is still required to offer qualified
HMO coverage if approached by a qualified HMO.
Other rules apply to union employees. The HMO alternative is subject to collective
bargaining and can be accepted or rejected by the union employees. If the union
rejects the HMO option, the option must still be offered to nonunion employees.
Employees who select the HMO option may not lose eligibility for dental, vision or
prescription drug benefits if they are offered under employer plans separate from the
regular health plan. This assumes that the HMO does not include the same services.
3The U.S. Department of Health and Human Services, which regulates federally qual-
ified HMOs, has proposed no longer requiring employers to pay the same per-employee
premium for HMO coverage as for traditional health insurance. Instead, employers
and qualified HMOs would be permitted to negotiate premiums and make adjust-
ments based on the composition of a given work force with relation to age, sex, marital
status and average family size. See Federal Register 52, no. 8, January 1987, pp. 1343-
44, for the proposed regulation.
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health insurance plan without waiting periods, exclusions or restric-
tions due to health status.
Rate Requirements
The HMO Act requires that federally qualified HMOs community rate
their services. A community rating system determines rates based on
the HMO's total membership experience rather than on the experience
of each subscriber group .4 HMOs may vary rates within subscriber
groups for individual and family coverage and among subscriber groups
depending on the amount of coverage offered to each group.
The 1981 Amendments to the HMO Act further refined the federal
HMO rating requirements. Now, federally qualified HMOs may use
factors such as age, sex, marital status and family composition to
establish classes of subscribers and group rates (community rating
by class).
Since the passage of the 1973 HMO Act, there has been evidence
that HMOs have been an important influence in restructuring our
health care system and slowing rising health care costs. The growth
of HMOs until recently was relatively slow. This slow growth reflected
several factors. Physician reluctance to break from fee-for-service
medical practice and to affiliate with HMOs has been an important
obstacle to HMO development. Additionally, there was some initial
confusion over the 1973 Act. The 1976, 1978 and 1981 amendments,
however, attempted to clarify the original act and strengthen the
competitive position of HMOs.
A 1978 Comptroller General report concluded that there was a
shortage of persons trained to develop, operate and manage HMOs.
Additionally, the group health plan marketplace is very competitive.
It requires an intricate coordination of marketing, underwriting, ac-
tuarial and management skills.
Some changes are now occurring. Sustained growth in HMO mem-
bership suggests increasing employer and consumer interest in HMOs.
Some employers make HMO enrollment mandatory for new employ-
ees for a trial period. Since 1982, national HMO membership has
grown by more than 15 percent annually. Employers, unions and
insurance companies have been more involved as direct sponsors and
'HMOs can separately rate public employees and Medicare or Medicaid subscriber
groups.
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organizers of HMOs. Involvement of business and labor leaders has
brought needed management skills. Also, hospital managers and
private-practice physicians have become more interested in HMOs
as well as other types of alternative health care delivery systems.
An indication of the importance attached to HMO competition in the
health care marketplace is the program enacted as part of the Tax
Equity and Fiscal Responsibility Act of 1982 (TEFRA). The program is
intended to encourage HMO participation in Medicare by paying HMOs
in a manner consistent with their cost efficiency. Medicare is authorized
to pay HMOs in advance at a preset rate per enrollee, regardless of the
amount or type of services rendered. Previously, Medicare would ret-
rospectively pay HMOs, based on the "reasonable" cost of providing
specific services to beneficiaries. Under final regulations issued by the
Department of Health and Human Services in January 1985,5 cost con-
trol becomes a financial incentive, which may lead to increased savings
and enable more HMOs to offer expanded benefits, such as dental care,
eyeglasses and prescription drugs.
TEFRA also defined competitive medical plans (CMPs) and autho-
rized them to enter into contracts with the federal government to
provide Part A and B services to Medicare beneficiaries. CMPs may
be hospitals, large group practices, preferred provider organizations,
non-federally qualified HMOs or any other organized group that has
met certain financial solvency requirements. As of September 1986
there were 21 CMPs in the U.S.
Despite HMOs' growth, some observers regard them as a less at-
tractive means of stemming rising health care costs. Employers may
get at least a one-time saving for each employee joining an HMO, but
it is less apparent that costs will subsequently increase any more
slowly than those for conventional fee-for-service health insurance
coverage. As a greater variety of providers and insurers compete for
a share of the health care market, the future role of HMOs in the
market becomes difficult to predict.
Additional Information
Group Health Association of America
624 9th Street, NW
Suite 700
Washington, DC 20001
5For more information on the HHS regulations, see the Federal Register, January 10,
1985, p. 1344.
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National Association of Employers on Health Care Alternatives
304 Key Executive Bldg.
104 Crandon Blvd.
Key Biscayne, FL 33149
Beam, Burton T., Jr., and John J. McFadden. Employee Benefits. Homewood,
IL: Richard D. Irwin, Inc., 1985.
Hewitt Associates. HMOs: An Employer's Guide to Complying With the Federal
HMO Act. Lincolnshire, IL: Hewitt Associates, 1986.
National Association of Employers on Health Care Alternatives. Blue Book
Digest of HMOs. Key Biscayne, FL: NAEHCA, July 1987.
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XX. Preferred Provider Organizations
Introduction
Preferred provider organizations (PPOs) are contractual arrange-
ments generally between health care providers and an employer or
insurance company to provide fee-for-service health care at a pre-
negotiated rate. The term PPO covers a variety of arrangements and
agreements between employers and organizations providing the health
care services.
Providers (e.g., physicians and hospitals) agree to prenegotiated
rates to those who contract for the services (e.g., employers and in-
surance companies) in return for an increased pool of patients, faster
claims processing or both. There are various ways to determine the
discount. Some arrangements have been based on a percent of charges,
on a specific cost per day, or on the cost to treat specific diagnostic
groups.
In most cases, employees covered by a PPO (subscribers) are free
to choose any physician or hospital they wish, but are given financial
incentives to use the services of preferred providers. These incentives
include expanded benefits and lower costs for certain services.
Financial incentives for employees might include no deductibles
and only minimal copayments, while employees who choose non-
participating physicians may have to pay a deductible and larger
copayments. For example, subscribers who use a preferred provider
might have no deductible and a copayment of only $5 or $10 on office
visits, plus extra services such as well-baby care and diabetes tests.
Those who use nonparticipating physicians might be subject to a $100
or $200 deductible, 20 percent copayments and no extra coverages.
PPOs have emerged in response to employer concern over rising
health care costs and to provider concern about growing competition
from alternative health delivery systems, such as health maintenance
organizations (HMOs), that promise lower-cost services. PPOs not
only offer reduced prices for health care services, but they contend
that they can reduce costs by selecting cost-efficient providers and
through utilization review and control.
The American Association of Preferred Provider Organization's 1987
directory lists 674 operational PPOs, the majority of which have been
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formed since 1983. According to the association, in 1985, the total
number of covered persons grew from 1.3 million to 5.8 million, and
in 1987, 37 million employees were estimated to have a PPO option
available to them.
Types of PPOs
There are three primary types of PPOs: (1) provider-based, (2) en-
trepreneur-based; and (3) purchaser-based.
(1) Provider-based PPOs include hospitals, physician groups, joint hos-
pital/physician arrangements, dentists, podiatrists and other health
professionals.
(2) Entrepreneur-based PPOs include private investors, third-party ad-
ministrators and utilization review organizations.
(3) Purchaser-based PPOs include Blue Cross/Blue Shield plans, commer-
cial insurers, employers and community groups.
A similar arrangement to a PPO is an exclusive provider organi-
zation (EPO), established by self-insured employers. In an EPO, em-
ployees must use EPO providers to receive coverage; PPOs merely
offer a financial incentive to employees to use the preferred providers.
PPOs are subject to state insurance regulations, unless established
by self-insured employers. Such employers consequently can estab-
lish EPO arrangements, agreeing to reimburse only for services of the
exclusive providers.
Another type of PPO is known as a negotiated provider agreement
(NPA), which allows employers to tailor their health insurance ar-
rangement to their specific needs. An employer can negotiate pricing
and determine how health care utilization will be monitored.
Most of the original PPOs were formed by hospitals, physicians and
investors, but the more recent arrangements have been sponsored by
Blue Cross/Blue Shield plans and commercial insurers.
Relatively few employers have organized their own PPOs, although
some employers in the same geographic area have created associa-
tions that sponsor a PPO. Employers sometimes use insurance car-
riers as middlemen with a PPO.
Physicians who provide services to a PPO might have their own
practice, be in small groups that belong to an independent practice
association (IPA) or belong to a multispecialty group practice. The
PPO might contract with a combination of these physician arrange-
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ments and offer subscribers a choice among groups. PPOs usually
include both primary care and specialists.
In a large metropolitan area, a PPO could have agreements with
as many as 10 or 15 hospitals and thousands of physicians.
Differences Between HMOs and PPOs
HMOs and PPOs are both relatively new developments in alter-
native health care delivery systems, but there are major differences
between them:
(1) HMOs are prepaid systems while PPOs operate on a fee-for-service
basis.
(2) HMO members must use the services of HMO physicians and affiliated
hospitals while PPO subscribers are not restricted to preferred provid-
ers.
(3) HMOs must bear the financial risk for their operations, while the pur-
chaser, not the provider, bears the risk in most PPOs.
As new variations of PPOs emerge, however, many PPOs are as-
suming characteristics of HMOs. For example, risk-sharing between
provider and purchaser is taking place in some PPOs. Also, some PPOs
have begun to require primary care physicians to refer patients only
to specific hospitals or specialists.
Managing Costs
PPOs can be effective in managing costs only through medical prac-
tices that carefully use health care resources. This means that phy-
sicians and hospitals are expected to avoid unnecessary tests, x-ray
examinations and other procedures; to consider alternatives to hos-
pitalization; and in general to practice efficient medicine.
Utilization review with feedback to the provider is a critical com-
ponent of a PPO's cost containment strategy. PPOs might monitor
claims, require prior authorizations for certain types of treatment
and examine physician case records. Effective utilization review might
also incorporate assurance for quality.
Utilization review is often handled within the PPO itself, as is the
case with many hospital-provider PPOs, or by using an outside profes-
sional peer review organization. Hospitals or physician groups that
conduct their own internal reviews are susceptible to the criticism
that it is difficult for organizations to police themselves.
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Employers who set up their own PPOs or insurance carriers who
act as purchasers of services for employers must often set up their
own monitoring systems to ascertain that they are receiving cost-
efficient services from the providers with whom they contract.
Self-insured employers who want to reduce their risk for large losses
are in many cases able to negotiate risk-sharing agreements with
providers. Risk sharing includes splitting costs in catastrophic cases,
paying bonuses to health care specialists for keeping costs under
certain limits and setting fees for certain procedures. If the procedure
turns out to be more costly, the hospital absorbs the difference.
In provider-based PPOs that accept responsibility for a share of
financial risk, targets might be set on expenditures. If expenditures
fall below the target, the savings might go to the physicians or be
shared by the physicians and the employer. If expenditures exceed
the target, the losses might be shared by the PPO and the employee
or by the PPO, but only up to certain limits.
Legal Issues
Questions as to the legal status of PPOs have impeded their devel-
opment in some states. Some forms of these arrangements have been
found in violation of antitrust laws as horizontal price-fixing arrange-
ments (Arizona v. Maricopa County Medical Society, 1982) or as ar-
rangements potentially in restraint of trade (Group Life and Health
Insurance Company v. Royal Drug Company, 1979).
Although PPOs in general are open to legal review, their dramatic
growth is expected to continue. State laws may, however, restrict this
growth somewhat. Illinois requires PPOs to have higher financial
reserves, for example, and New Hampshire and Utah require that
nonpreferred providers be paid at least 75 percent of the levels set
for preferred providers.
There are also liability concerns. Questions have been raised about
employer liability if an employee is directed to a particular doctor
because of lower costs, and then malpractice occurs.
Conclusion
The changes in health care delivery systems present employers with
new possibilities for cost containment. The rapid surge of PPOs in
the 1980s suggests that they are finding acceptance with employers
who are searching for alternatives to traditional indemnity plans that
will help them control rising health care costs.
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PPOs are seen as having the potential to bring about price com-
petition among providers. But they also hold out the promise that
they can provide more than discounted prices. To ensure both cost-
effective and quality care, however, they must be energetic in search-
ing out efficient and competent providers, and vigilant in discour-
aging excessive or inappropriate treatment by those providers.
Few scientific studies yet exist to support PPO contentions that
they are successful in holding down health care costs. Many PPOs
have been in existence too short a time for conclusive data to be
available.
There are trends, however, that favor the continued growth of PPOs,
including the increasing surplus of physicians and excess of hospital
beds.
PPOs also may find greater acceptance by employees because they
offer a choice of physicians in comparison to HMOs and other man-
aged care plans. Some PPOs, however, are moving closer to the HMO
model by using a primary care physician as a so-called "gatekeeper"
who controls referral to specialists and hospitals.
In today's changing medical marketplace, different models of PPOs
continue to emerge in response to the competitive marketplace and
the search for successful cost containment strategies. If studies show
that PPOs are succeeding in keeping health care costs down, they will
certainly continue to expand.
Additional Information
American Association of Preferred Provider Organizations. Directory of Pre-
ferred Provider Organizations. Washington, DC: AAPPO, 1987.
Gabel, Jon, and Dan Ermann. "The Emergence and Future of PPOs." Journal
of Health Politics, Policy and Law (Summer 1986): 305-322.
Intergovernment Health Policy Project. "Update on PPO Laws." State Health
Notes (November/December 1985).
National Association of Employers on Health Care Alternatives. Blue Book
Digest of PPOs. Key Biscayne, FL: Blue Book Inc., 1986.
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XXI. Dental Care Plans
Introduction
Health authorities agree that the dental care of many Americans
could be improved substantially. Among the deterrents to better care
are: (1) the public's perception that dental costs are high; and (2) the
fact that correction of many dental problems can be postponed for
long periods. Dental insurance has grown rapidly, and now covers
over 80 million Americans. In 1986, nearly three workers in four
employed by medium and large firms had employer-sponsored cov-
erage for dental care.
A sound dental insurance plan has two primary objectives: (1) it
helps pay for dental care costs; and (2) it encourages people to receive
regular dental attention-thus, potentially serious problems can be
detected and prevented.
Dental coverage may be provided to employees and their eligible
dependents. In most situations, the plan sponsor (i.e., employer, union
or joint fund) pays the employee's entire dental insurance premium,
with some contribution to the dependents' premiums. In some cases,
the employee and the plan sponsor share the cost.
A variety of organizations offer dental care plans: (1) insurance
companies; (2) dental service corporations; (3) those administering
Blue Cross/Blue Shield plans; (4) health maintenance organizations;
and (5) closed-panel groups of dental care providers. In addition, some
employers self-fund and self-administer their plans.
The plan should specify the types of dental services that are covered
and those that are not. Services that are usually covered include:
(1) diagnostic procedures-evaluating existing conditions and determin-
ing necessary treatment (e.g., oral examinations, regular checkups and
x-rays);
(2) preventive procedures-cleaning, polishing and scaling teeth as well
as fluoride treatment;
(3) restorative procedures-repairing teeth (e.g., fillings and crown work);
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(4) oral surgery-operations performed in the mouth;
(5) endodontics-root canal therapy (i.e., treating teeth that have diseased
roots);
(6) periodontics-treating gum diseases;
(7) prosthodontics-replacing missing teeth with fixed or removable
prostheses (e.g., bridgework, partial removable dentures or full den-
tures);
(8) orthodontics-correcting malpositioned teeth.
Services that are not usually covered include:
(1) hospitalization due to necessary dental treatment;'
(2) cosmetic dental work (e.g., closing a gap between two front teeth);
(3) cleaning and examinations performed more often than twice a year;
(4) services covered by workers' compensation or other insurance pro-
grams.
Payment of Benefits
The most common types of dental plans are:
(1) Nonscheduled Plans-Typically, these plans cover dental costs based
on usual, customary and reasonable charges. Usual, customary and rea-
sonable charges are those that are: (a) the usual fee charged by the
dentist; (b) the customary or prevailing fee charged by other dentists
in the same geographic area for the same treatment; and (c) a reason-
able amount based on the circumstances involved.
(2) Scheduled Plans-These plans use a schedule of benefits; this schedule
provides a flat-dollar amount for each service. If a dentist charges more
than the scheduled amount, the participant is responsible for the dif-
ference.
(3) Combination Plans-Some dental plans combine the usual, customary
and reasonable payment method with the schedule-of-benefits pay-
ment method. For instance, a plan may pay for diagnostic and pre-
ventive services under the usual, customary and reasonable method,
but it may pay for other services under the schedule-of-benefits method.
(4) Closed-Panel Plans-In a closed-panel arrangement, a designated group
of dentists (i.e., a closed panel) provides services to an employee group.
'Hospitalization for dental treatment as well as other dental services may be covered
under another health insurance plan. For more information on other types of health
insurance, see chapter XVII.
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The full cost of services is paid when employees go to providers spec-
ified by the plan. Employers pay a premium for such services; pre-
miums are used to pay dentists' salaries, or they cover a fixed cost per
beneficiary. If employees go to providers who are not in the closed
panel, the plan will pay only a specified amount; the employee must
pay any excess.
Dental plans may also require payment of a deductible (i.e., an amount
a participant must pay before receiving any insurance payments).
Dental plans are increasingly part of flexible compensation plans-
either as one or more of the types discussed above, or as part of a
reimbursement account.2
Other Dental Plan Features
Predetermination of Benefits-Before beginning dental treatment,
a plan participant may want to know how much he or she will have
to pay for the treatment and how much the plan will pay. A plan
may require the participant's dentist to fill out a predetermination-
of-benefits form. The dentist would list the proposed treatment and
its cost. He would then send the form to the claims office. The
claims office, in turn, advises the participant and dentist of the
benefit amount the plan will pay. Some plans require this proce-
dure in cases where anticipated charges exceed a stated amount
(e.g., $100).
Alternative Benefits-Dental problems often can be treated suc-
cessfully in more than one way. When this situation arises, many
dental plans base payments on the least expensive treatment that is
customarily used for the condition. For example, a decayed tooth
may often be satisfactorily repaired with either a crown or a filling.
In this case, a dental plan bases its payment on the filling, which is
the less expensive treatment. The participant and the dentist may
proceed with the more expensive crown, providing the participant
pays the dollar difference.
Cost Sharing-Most dental plans are designed with cost-sharing
features, which require the participant to pay some portion and the
plan to pay the remaining portion of charges for dental services. Two
common features are deductibles and copayments.
As noted earlier, a deductible is an amount a participant must pay
before receiving any insurance payments. Deductibles usually must
be satisfied once each year, depending on the plan's design. Consider
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an example where a participant's first dental bill for the year is $75;
the bill covers the filling of several cavities. The yearly deductible
under this hypothetical plan is $50. Thus, the participant pays the
first $50. The remaining $25 is covered, either partially or fully, by
the plan. No other deductible is required of this individual in this
year. Another $50 deductible, however, will have to be satisfied in
the following year.
If a plan has a coinsurance feature, the plan and the participant
share the costs of each covered dental service. The plan pays a
specified percentage of covered services (e.g., 80 percent), and the
participant pays the balance (in this case, 20 percent). Additionally,
a plan may offer a number of coinsurance schedules depending on
the treatment. For example, a plan may pay 80 percent of a dentist's
bill for filling a cavity, but only 50 percent of a bill for orthodontic
work.
In some plans, coinsurance is used in conjunction with a de-
ductible. Under such a plan, after the yearly deductible (e.g., $50)
has been paid by the participant, the plan will pay some stated
percentage (e.g., 80 percent) of additional incurred dental expenses.
Some plans that require a deductible for some types of treatment
do not require a deductible for preventive care services. Similarly,
some plans that require coinsurance for some types of treatment
do not require coinsurance for preventive care services. These fea-
tures are intended to encourage regular dental visits and preventive
care.
Benefit Limits-Most dental plans set maximum limits on the amount
they will pay for each participant (e.g., $1,000 per person per calendar
year). Separate maximum limits may apply for different treatments
(e.g., an annual maximum of $1,000 per person for all dental services
other than orthodontics, with orthodontics limited to a $750 lifetime
maximum).
Claims Payment-Payment of claims under a group dental plan
generally follows the same procedure as payment of claims under a
group medical plan. The participant and the dentist fill out and sub-
mit claim forms. Payment for covered services may be sent to the
dentist or to the participant. Dental plans usually experience heavy
claims the first year due to a backlog of unmet dental needs in a
newly covered employee group.
Effective and economical use of a group dental plan requires close
interaction between the employee, employer and service provider. It
requires that all parties work together to achieve the plan's goal of
maintaining good dental health at a reasonable cost.
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Nondiscrimination Rules
Employer-sponsored dental care plans are subject to the nondis-
crimination rules for health and welfare plans mandated by the
Tax Reform Act of 1986. (For an explanation of these rules, see
chapter XVII.)
Conclusion
The first comprehensive group dental insurance plan was written
nearly 25 years ago. Today, these plans can be found in almost every
major industry (e.g., auto, steel, communications), and are increas-
ingly found among outside companies that do business with these
major industries. An abundant supply of dentists also has led to an
increase in preferred provider arrangements, in which dentists pro-
vide care to covered employees for a discounted fee. Some believe
that dental plans will be as common as health and life insurance
plans by the end of this decade.
Additional Information
Beam, Burton T., Jr., and John J. McFadden. Employee Benefits. Homewood,
IL: Richard D. Irwin, Inc., 1985.
"Dental Coverage, Fastest Growing Employee Benefit." Small Business Report
(October 1986): 44-47.
Sutton, Harry L., Jr. "Prescription Drug and Dental Programs." Employee
Benefits Journal (June 1986): 20-26.
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XXII. Prescription Drug Plans
Prescription drug plans were first introduced in 1964. Coverage for
prescription drugs is intended to encourage the beneficiary to com-
plete prescribed drug therapy so as to avoid more costly medical
complications later. The average price of prescription drugs has risen
nearly 40 percent since 1980. Although most major medical plans
cover prescription drugs, many employers and joint funds prefer to
provide separate drug plans because:
(1) Employees may not otherwise know that their medical plans cover the
cost of prescription drugs.
(2) Participants covered under medical care plans that require payment
of large or separate deductibles may not submit prescription claims.
(3) Employees may be confused by the paperwork of a typical medical
plan (e.g., saving drugstore receipts and filing claims).
(4) The influx of prescription drug claims at the end of a medical plan
year can cause administrative problems for the plan.
Prescription drug plans are simple in design. Usually, a plan will
cover the employee after a brief employment period and pay the
employee's premium. In addition, most plans cover employees' de-
pendents. Some employers pay the full cost of dependent coverage;
others require employee payroll deductions to pay for part or all of
the cost.
A variety of organizations offer prescription drug plans: (1) insur-
ance companies; (2) those administering Blue Cross/Blue Shield plans;
(3) health maintenance organizations; and (4) labor unions. In ad-
dition, some employers self-fund their plans. Drug plans also are
available through such organizations as the American Association of
Retired Persons, often on a mail-order basis. (See (3) under "Payment
of Benefits.")
Prescription drug plans provide coverage for out-of-hospital pre-
scription drugs. They usually cover legend drugs. " 'Legend' drugs
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state on the label that federal law prohibits their being dispensed
without a prescription." 1
Generally, prescription drug plans do not cover proprietary med-
icines, appliances or devices, nonprescription drugs, in-hospital drugs,
blood and blood plasma, immunization agents and any drugs or med-
icines lawfully obtained without a prescription, except insulin. Plans
may also specifically exclude contraceptive drugs.
Many plans place limits on the quantity of a drug that may be
dispensed at any one time. A typical limitation is a 34-day supply or
100 doses, whichever is greater. Frequently, a higher limitation ap-
plies to maintenance drugs. Most plans do not place a maximum on
the overall covered quantity of a drug.
[Prescription drug] plans typically apply only a small copayment
(deductible) charge, such as $1 to $5 per prescription, on the covered
person for drugs provided under the plan. So the relatively large
deductible (such as $25 to $100), the coinsurance percentage, and
the reasonable and customary charges provision, of traditional ma-
jor medical plans, do not apply in the case of these basic prescription
drug plans .2
Payment of Benefits
The most common types of plans include: (1) open-panel plans;
(2) closed-panel plans; (3) mail-order plans; and (4) nationwide panel
plans.
(1) Open-panel plans permit employees to go to pharmacies of their choice.
Participants pay for prescriptions and send the receipts with claim
forms to the plan administrator for reimbursement. If the plan has a
deductible (i.e., an amount a participant is required to pay before
receiving any insurance payments), receipts usually are accumulated
until they satisfy the deductible and then are submitted to a claims
office at one time.
(2) Closed-panel plans generally employ a number of pharmacies-the
number may range from a few to several thousand. The panel phar-
macies dispense drugs to plan members at prices agreed upon by the
plan provider and the pharmacy. Sometimes the price is the phar-
macy's cost plus a dispensing fee. The plan administrator pays the
panel pharmacies directly. Plan members pay only the applicable de-
ductible and are not required to submit claim forms. If a plan partic-
'Jerry S. Rosenbloom and G. Victor Hallman, Employee Benefit Planning (Englewood
Cliffs, NJ: Prentice-Hall, Inc., 1981), p. 197.
2lbid.
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ipant uses a nonpanel pharmacy (e.g., in an emergency situation), he
must submit a claim form as though he were in an open-panel plan.
(3) In a mail-order plan, employees send their prescriptions to specified
mail-order firms. Because of volume, mail-order pharmacies frequently
price prescriptions at lower prices than other pharmacies. This ar-
rangement usually works well, because 80 percent of prescription drugs
are for maintenance or long-term medication; the other 20 percent are
for emergencies. Costs can be reduced under the mail-order arrange-
ment because all claims are processed at one location; thus, the use of
a claim form is eliminated 80 percent of the time. Door-to-door service
also makes this plan attractive. This plan is not designed for drugs that
are needed immediately.
(4) Nationwide-panel plans, also known as prescription card service plans,
are popular. They use a network of pharmacies, usually through a
prepaid drug plan administrator (i.e., a firm administering plans for
insurance companies, employers, joint funds and others) and negotiate
price discounts. Also, nationwide-panel plans provide participating
employees with a credit card, which is used to purchase prescription
drugs. The administrators use computers to process claims and to
control costs and claims abuses. Sometimes, a nationwide-panel plan
includes a mail-order option; this approach achieves savings on main-
tenance drugs while maintaining a community-pharmacy convenience
for emergency situations.
In addition, many pharmacy chains negotiate discounts with em-
ployers in a type of preferred provider arrangement.
After more than 20 years, prescription drug plans are now mature
and have grown in number. Coverage may be decreasing, however,
as plan deductibles are increased in an attempt to contain overall
health plan costs. A few plans have encountered problems, especially
at the start. For example, under certain plans, there has been the
potential for credit card misuse. Also, since prescription drugs do not
have stated reasonable and customary charges,3 some pharmacists may
have charged inflated prices because a third party paid the bill. In
fact, prices for prescription drugs have risen faster than those for
hospital care in recent years. Despite the small incidence of the prob-
lems cited here, these plans now work reasonably well and appear
to be popular with many individuals.
3Reasonable and customary charges are those that are considered reasonable based
on the circumstances and those that are customarily charged for drugs in a particular
geographic area.
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Additional Information
Finkel, Madelon Lubin. Health Care Cost Management. Brookfield, WI: Inter-
national Foundation of Employee Benefit Plans, 1985.
Sutton, Harry L., Jr. "Prescription Drug and Dental Programs," Employee
Benefits Journal (June 1986): 20-26.
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XXIII. Vision Care Plans
Introduction
Vision problems are common. Over one-half of the United States
population requires optometric care. Approximately 12 percent of
children who are age 6 require vision care services; however, 96 per-
cent of persons who are age 70 require such services. The need for
eye care becomes pronounced at about age 40. Vision problems are
often chronic and require regular attention.
Except for medical or surgical treatment and, in some cases, con-
tact lenses after cataract surgery, traditional health insurance plans
have provided little or no vision care coverage. Employer-sponsored
vision care plans are designed to insure vision care services. In 1985,
about 34 percent of workers in medium and large firms had vision
care coverage through their employer.
Similar to most medical plans, vision benefits are usually available
to a group of covered employees after a nominal waiting period; the
employer usually pays the cost for employee coverage. In addition,
most plans provide for coverage of the employee's dependents. This
can be accomplished in a number of ways: (1) the employer may pay
the full cost of dependent protection; (2) the employee may pay for
dependent protection; or (3) the employer and the employee may
share the cost.
A variety of organizations offer vision care plans. These include:
(1) jointly managed funds; (2) health maintenance organizations;
(3) those administering Blue Cross/Blue Shield plans; (4) vision care
corporations; (5) optometric associations; (6) closed-panel groups of
vision care providers; and (7) insurance companies. In addition, some
employers self-fund and self-administer their plans.
The principal providers of vision care are:
(1) Ophthalmologist-A medical doctor specializing in eye examination,
treatment and surgery. Some ophthalmologists dispense glasses and
contact lenses.
(2) Optometrist-A health care professional who is specifically educated
and licensed in each state to examine, diagnose and treat conditions
of the vision system. Optometrists may not operate on the eye and, in
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most states, may not administer therapeutic drugs. Most optometrists
dispense glasses and contact lenses.
(3) Optician-A person who makes or sells lenses and eyeglasses.
The typical vision care plan covers eye examinations, lenses, frames
and fitting of glasses. Eye examinations provide the information needed
for lens prescriptions, and may reveal eye diseases such as glaucoma
or cataracts. (They may also reveal evidence of diabetes or high blood
pressure.) Many plans cover some portion of the cost for contact
lenses; however, some plans only cover contact lenses when vision
cannot be corrected to a stated level with conventional lenses (e.g.,
following cataract surgery).
Nearly all vision care plans impose limitations on the frequency of
covered services and glasses. Typical limitations include: (1) one eye
examination within a 12-month period; (2) one set of lenses within a
12-month period; and (3) one set of frames within a 2-year period.
Most plans do not cover the additional cost of oversized, photosen-
sitive or plastic lenses; nor do they cover prescription sunglasses.
Payment of Benefits
Similar to other types of health insurance, vision care plans cover
services in a variety of ways. For example:
(1) Some plans pay the full cost of services, provided it satisfies the usual,
customary and reasonable cost criteria. In other words, the covered
amount is: (a) the provider's usual fee for the service; (b) the customary
or prevailing fee for the service or product in that geographic area;
and (c) a reasonable amount based on the circumstances involved. A
fee may be considered reasonable when special circumstances neces-
sitate extensive or complex treatment, even though it does not meet
the usual, customary and reasonable criteria.
(2) Sometimes vision care plan participants must pay deductibles. The
deductible is a specified amount of vision care costs that the plan
participant must pay before any costs are paid by the plan. Under a
plan with a $50 individual deductible, a participant must pay his or
her first $50 in vision care expenses. The plan then pays for additional
vision care expenses according to other plan provisions.
(3) Plans may have a coinsurance arrangement. Here, the plan participant
pays some portion of the cost of vision care expenses, and the plan
pays the remaining portion. The plan participant, for instance, may
pay 20 percent and the plan may pay 80 percent of vision care costs.
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(4) Other plans specify a covered dollar amount for each service. Under
the schedule-of-benefits approach, the plan participant pays any amount
over the scheduled dollar limit. The schedule usually is adjusted at
intervals to keep it up-to-date with current charges.
(5) Plans may also use a closed-panel arrangement. A designated group
(i.e., a closed panel) of vision care professionals provides services to
an employee group. The full cost of services is paid when plan partic-
ipants go to providers specified by the plan. Employers pay a premium
for such services, which may cover a fixed cost per beneficiary. The
providers are reimbursed for their cost of materials plus a dispensing
fee. If participants go to providers who are not in the closed panel, the
plan will pay only a specified amount; the participant must pay any
excess.
(6) Plans commonly use a combination of the approaches described above.
A plan that covers services based on usual, customary and reasonable
charges may also require payment of a deductible, or it may require
coinsurance payments. Coinsurance may also be included in a sched-
ule-of-benefits approach.
When considering the cost of a vision care plan, a potential plan
sponsor should be aware that such plans have a high incidence of
claims in the first year, because there may be a backlog of unmet
needs in a newly covered employee group. Additionally, an employer-
sponsored vision care plan should include: (1) a program to increase
employee awareness and understanding of vision care and the plan;
(2) effective communication among all involved parties (i.e., em-
ployee, employer and service providers); and (3) an efficient claims
filing and payment system.
Nondiscrimination Rules
Employer-provided vision care plans are subject to the nondiscri-
mination rules for health and welfare plans as mandated in the Tax
Reform Act of 1986. (For an explanation of these rules, refer to chapter
XVII.)
Conclusion
Although some vision care plans were established more than 30
years ago, vision care coverage is presently available to only a small
portion of the population. With the increasing emphasis on compre-
hensive employee health care, however, the growth in vision care
benefits may continue.
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Additional Information
Finkel, Madelon Lubin. Health Care Cost Management. Brookfield, WI: Inter-
national Foundation of Employee Benefit Plans, 1985.
Rosenbloom, Jerry S., ed. The Handbook of Employee Benefits: Design, Fund-
ing and Administration. Homewood, IL: Dow Jones-Irwin, 1984.
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XXIV. Employee Assistance and Health
Promotion Programs
Introduction
Employee assistance and health promotion programs are increas-
ingly being utilized by employers as health care cost management
measures and as tools for improving employee productivity, morale
and job satisfaction. While the two types of programs often have
similar goals, their structures and components are quite dissimilar.
Employee assistance programs (EAPs) are generally counseling ser-
vices directed toward acute problems that affect job performance,
such as drug and alcohol abuse and emotional and financial prob-
lems. Health promotion programs, on the other hand, emphasize pre-
vention of physical and emotional illness through healthier lifestyles.
Many health promotion programs are called "wellness" or "fitness"
programs.
Today, more and more employers are offering both types of pro-
grams. In showing concern for employees' physical and mental health,
employers may: (1) offer in-house or outside counseling services;
(2) provide information on such problems as substance abuse, smok-
ing and stress through seminars, classes or written materials; and
(3) set up programs to assist employees in changing patterns of be-
havior that can lead to poor health.
In many cases, an employer provides coverage in the company
medical plan for treatment of substance abuse and mental health
problems, and also offers an EAP and a health promotion program.
Employee assistance and health promotion programs are being
developed and offered by employers to address three basic issues:
(1) rising health care costs; (2) increasing concern about how em-
ployees' personal problems affect job productivity; and (3) growing
awareness of the benefits of good health and interest in participating
in fitness programs.
Since both types of programs are relatively new employer-spon-
sored benefits, there have been few opportunities for employers or
researchers to study the results over a long period of time. There have
been few conclusive studies on the direct impact of the programs in
reducing health care costs. If properly structured and communicated
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to employees, however, the programs demonstrate employer concern
and commitment for employee well-being.
EAPs offer employees, and in most cases their families, the oppor-
tunity to receive confidential, professional counseling and assistance.
Generally there is little, if any, cost to the employee. Health pro-
motion programs, on the other hand, provide extra benefit options
to employees through activities at the work place or at easily accessed
facilities. Depending on the program's design, employees may pay a
fee for participation in certain activities.
The programs are finding wide acceptance among employers and
employees, and appear to be on the rise. The Health Research Insti-
tute surveyed the 1,500 largest employers in the United States in 1985
and found:
(1) The proportion of respondents offering EAPs increased from 37 percent
in 1983 to 50 percent in 1985.
(2) Smoking cessation programs rose from 28 percent in 1983 to 44 percent
in 1985.
(3) The proportion of employers providing on-site exercise facilities rose
from 17 percent in 1983 to 28 percent in 1985.
Employee Assistance Programs
Types-Some employers contract with specialists such as psychol-
ogists, social workers or alcoholism counselors to provide services for
employees who are referred through the EAP, while other employers
offer direct assistance through their own staff counselors. An em-
ployer also might contract with a community agency to provide ser-
vices to employees.
The problem areas that are generally covered in an EAP include:
(1) alcoholism and drug abuse; (2) emotional problems; (3) marital
and family relations; and (4) legal or financial issues. The most prev-
alent problem covered in EAPs is substance abuse. A 1986 survey by
Hewitt Associates of 293 companies-47 percent of which sponsored
EAPs-also revealed coverage for such additional areas as job per-
formance, eating disorders, employment termination and retirement.
Many employers include coverage for mental health services and
treatment for substance abuse in the company medical plan. The 1985
Employee Benefits Survey conducted by the U.S. Department of La-
bor found that insured plans were somewhat more likely than self-
insured plans to provide coverage for alcoholism and drug abuse
treatment (required of insured plans in 28 states for alcoholism treat-
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ment and in 14 states for drug abuse treatment). In 1985, 69 percent
of participants in insured plans had coverage for alcohol abuse treat-
ment and 62 percent had coverage for drug abuse treatment. By com-
parison, among participants in self-insured plans, 64 percent had
coverage for alcohol abuse treatment and 57 percent for drug abuse
treatment.
Many companies cover mental health care under their medical
plans, but with limitations on inpatient and outpatient coverage.
Many companies also include substance abuse treatment under men-
tal health coverage.
Setting Up a Program-If employees are to seek out the services of
an EAP, it must be structured to guarantee confidentiality and trust.
Communications with employees about the program need to empha-
size the EAP's role in assisting employees who need help with prob-
lems.
The program generally begins with an assessment of all employees'
needs. This can be done by reviewing claims for mental health treat-
ment, absenteeism rates, accident rates and employee interest in pro-
grams that deal with issues such as stress and caring for elderly
relatives. Initial steps in setting up a program also involve deciding
whether to develop an in-house program or contract out for services.
Supervisors and managers must be formally trained on how to
effectively refer an employee to the EAP for problems that are af-
fecting job performance. Supervisors who label employees as alco-
holics or drug abusers and who try to force or coerce employees into
treatment programs could cause legal problems for the employer.
Confidentiality of records makes the collection of information for
evaluation difficult. But employers will want to know how many
employees use the EAP, what the effects are on job performance and
how employees feel about the program.
Advantages to Employers-EAPs may help employees deal with se-
rious problems that could be interfering with their work performance,
costing employers several billion dollars in productivity each year.
Program costs are minimal for employers who mainly use referral
to outside agencies. For those employers hiring professional coun-
selors or contracting with outside providers, costs will be somewhat
higher, but the EAP will be more comprehensive.
Health Promotion Programs
Types-Programs that come under the heading of health promotion
range from modest efforts (e.g., distribution of pamphlets on health
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issues or provision of showers or changing facilities for employees
who exercise) to elaborate, well-equipped gymnasiums and a full
package of physical fitness activities.
One type of program, health risk screening, directly relates to health
care by providing testing for high blood pressure, breast cancer, di-
abetes and high cholesterol levels. Screening is sometimes followed
by education on how to reduce identified risks.
Other programs involve classes and seminars on how to stop smok-
ing, lose weight, manage stress or learn about good nutrition.
Some companies have their own exercise facilities for employees
(and sometimes for family members as well)-with swimming pools,
jogging tracks, saunas, racquetball/handball courts and work-out
rooms. If they do not have their own facilities, employers sometimes
pay a share of an employee's health club membership.
Setting Up a Program-Careful planning helps to ensure high levels
of employee participation. That planning includes:
(1) involving employees at all levels in the planning process;
(2) tailoring the program to the company and to its work force;
(3) communicating company commitment to the program and belief in
its importance;
(4) providing a variety of options and developing incentives for employee
participation;
(5) conducting periodic health assessments for employees to measure prog-
ress in achieving goals; and
(6) evaluating the program.
Employers have adopted a variety of incentives to encourage em-
ployee participation. Some employers pay a portion of the cost of
having employees attend outside clinics to stop smoking, or pay a
higher percentage of medical expenses for employees who do not
smoke or who regularly participate in an exercise program. Others
set up competitions among employees with prizes awarded to win-
ners, or offer bonuses to employees who complete a specified number
of hours of exercise.
Advantages to Employers-Companies with health promotion pro-
grams generally report lower absenteeism rates, lower health care
costs and more productive and satisfied employees. Some companies
evaluate their programs by establishing control groups and then
checking the fitness of those in the exercise program against the con-
trol group for such factors as weight control, smoking cessation,
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elevated blood pressure and number of sick days used. In many cases,
however, data have not been collected over a long period of time.
Some studies suggest that employees who are already fit and who
exercise on a regular basis before joining a company program are the
employees most likely to sign up and remain in fitness programs at
work.
To make health promotion programs cost-effective, employers must
encourage participation by employees. Drop-out rates can be high
unless employers are innovative in the choice of programs and in the
incentives offered to employees to take part in the program.
Health promotion programs can be valuable in providing early
detection of health problems and the means for employees to reduce
the risks from such problems. As employers modify and tailor pro-
grams to the needs and desires of their employees, the potential of
the programs to improve productivity and reduce health care costs
may increase.
The U.S. Chamber of Commerce estimates that employers spend
as much as $2,000 a year on health costs for each employee. According
to a 1985 study by the Office of Technology Assessment, a congres-
sional agency, the nation's combined health care costs and lost pro-
ductivity related to cigarette smoking each year total $2.17 per pack
of cigarettes sold in the United States.
Many employers believe they have achieved significant health care
cost savings through the initiation of employee assistance and health
promotion programs. Moreover, they point to employee satisfaction
with such programs.
To establish whether EAPs and health promotion programs can be
credited with health care cost savings, employers and researchers
will have to track a large number of employees over a long period of
time. Regardless of these kinds of results, many employers believe
that the existence of these programs demonstrates employers' con-
cerns for their employees and the value they place on employees'
well-being and good health.
Association for Fitness in Business
965 Hope Street
Stamford, CT 06907
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Center for Corporate Health Promotion
11490 Commerce Park Drive
Reston, VA 22091
EAP Digest
2145 Crooks Road
Suite 103
Troy, MI 48084
National Health Network
3299 K Street, NW
Washington, DC 20007
Madonia, Joseph F. Employee Assistance Programs: Their Impact on Health
Insurance and Other Company Benefits. Brookfield, WE International Foun-
dation of Employee Benefit Plans, 1985.
Meyers, Donald W. Establishing and Building Employee Assistance Programs.
Westport, CT: Greenwood Press, 1984.
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XXV. Group Life Insurance Plans
Many employers provide death benefits for survivors of deceased
employees. There are two types of plans designed specifically for this
purpose: (1) survivor income plans, which make regular (usually
monthly) payments to survivors; and (2) group life insurance plans,
which normally make lump-sum payments to a designated benefi-
ciary or beneficiaries. Additionally, benefits may be paid to survivors
from other employee benefit plans (e.g., profit sharing, thrift and
pension plans). Survivor benefits are also available under Social Se-
curity. This chapter will focus on group life insurance plans.'
The concept of individual life insurance was developed centuries
ago, but group life insurance is a relatively recent innovation. In 1911,
the first known group life insurance contract was created at the Pan-
tasote Leather Company in Passaic, New Jersey. The contract was
called the yearly renewable term employees' policy. It included many
features that are standard in today's group term life policies. By the
end of 1912, there were twelve group contracts in existence providing
total coverage of $13 million; by 1940, there were 8,800 contracts
providing total coverage of $15 billion; and by 1945, there were 11,500
contracts providing total coverage of $22 billion.
In the years after World War II, the wage freeze spurred a boom
in group life insurance. Employees, knowing they could not get wage
increases, requested additional benefits. Employer-sponsored life in-
surance coverage was one of the most demanded benefits. As a result,
in 1950, there were approximately 19,000 group contracts providing
total coverage of $48 billion.
Growth of employer-sponsored life insurance has continued. At the
end of 1985, approximately 642,000 master policy group contracts
were providing $2.56 trillion of coverage to Americans-and most of
this coverage was employer-sponsored. This $2.20 trillion group cov-
erage accounted for 42.3 percent of all life insurance coverage in the
United States in 1985.
'For a discussion of survivor benefits under Social Security, survivor income plans
and pension plans, see chapter XXVI.
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The contract between the insurance company and the employer is
usually for group term life insurance. Many associations and multiple
employer plans also provide group term life benefits.2 The word term
means that the coverage is bought for a specific time period (usually
one year) with a renewable provision. It may be referred to as yearly
or annual renewable term. Term insurance has no savings features and
no buildup of cash value. It is pure insurance protection, paying a
benefit only at death.
The cost of providing group life coverage varies depending on the
insurer and the covered group. For small groups, charges usually are
taken from a standard rates table. Monthly premiums typically range
from $0.10 per thousand dollars of coverage for employees in their
early twenties, to $2.50 per thousand dollars of coverage for employ-
ees in their sixties. For large groups, the initial premium might also
be taken from a standard rates table, but in the second and subsequent
years of coverage, the premium may vary according to the group's
claims experience. After the first year, the net premium for a large
group is essentially the sum of claims incurred, plus the insurer's
administrative costs and an amount to provide for profit and risk.
Eligibility-While some group life insurance plans cover all of a
company's employees, others cover limited groups, such as hourly-
paid employees, salaried employees, members of a specific union, or
employees at a certain plant location.
The Tax Reform Act of 1986 (TRA) revises the nondiscrimination
rules applicable to group term life insurance plans to ensure that
benefits under an employer-sponsored group life plan do not favor
the highly compensated3 and are distributed broadly among the rank-
and-file employees. The nondiscrimination rules are generally effec-
tive for the later of (1) plan years beginning after December 31, 1987;
or (2) the earlier of plan years beginning at least three months fol-
lowing the issuance of Treasury regulations or after December 31,
1988.
2Other major types of group life insurance include paid-up and ordinary life insurance.
Since term insurance is the most popular group coverage, the remainder of this
chapter will focus primarily on group term insurance.
3See chapter IV for an explanation of highly compensated.
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Under TRA, group term life insurance plans must meet three eli-
gibility tests and a benefits test, or an alternative to the eligibility
and benefits tests. The eligibility tests require that the employer sat-
isfy three requirements. The first is that nonhighly compensated em-
ployees must constitute at least 50 percent of the group of employees
eligible to participate in the plan. This requirement can be satisfied
if the percentage of highly compensated employees who are eligible
to participate is not greater than the percentage of nonhighly com-
pensated employees who are eligible. This allowance is important to
smaller firms where more than 50 percent of the workers are defined
as highly compensated. In such cases, 100 percent of the nonhighly
compensated would have to be eligible in order for the plan to pass
the test.
The second requirement is that at least 90 percent of the employer's
nonhighly compensated employees are eligible for a benefit that is
at least 50 percent as valuable as the benefit made available to the
highly compensated employee with the most valuable benefits.
The third requirement provides that a plan may not contain any
provision relating to eligibility to participate that suggests discrim-
ination in favor of highly compensated employees.
The benefits test requires that the average employer-provided ben-
efit received by nonhighly compensated employees under all plans
of the employer of the same type is at least 75 percent of the average
benefit received by the highly compensated employees under all plans
of the employer of the same type. The average employer-provided
benefit is defined as the aggregate employer-provided benefits re-
ceived by the highly or nonhighly compensated group divided by the
number of employees in the respective group, whether or not they
were covered by any of the plans.
An alternative to the eligibility and benefits tests allows an em-
ployer to meet the nondiscrimination rules if the plan benefits at
least 80 percent of the employer's nonhighly compensated employees.
Only individuals who receive coverage under a plan will be consid-
ered benefiting from the plan-eligibility to receive coverage is not
sufficient.
There is a penalty if a plan fails to comply with the new nondis-
crimination rules: All highly compensated employees in the plan will
be taxed on the value of the discriminatory portion of the benefit. In
the case of group term life insurance plans, the discriminatory excess
is defined as the amount of employer contributions and elective de-
ferrals required to have been made as after-tax employee contribu-
tions by the highly compensated employees if the nondiscrimination
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tests were to have been satisfied. TRA language implies that this is
determined by reducing the value of the benefits attributable to em-
ployer contributions (beginning with employees with the greatest
benefits) until the plan is not discriminatory. The value subtracted
is the discriminatory excess. Employers who fail to report in a timely
manner that a plan is discriminatory are liable for an excise tax at
the highest individual tax rate on the total value of benefits, unless
reasonable cause for failure to report is demonstrated.
Amounts of Insurance-Employers provide varying levels of cov-
erage. The amount of coverage can be based on one or more of a
number of factors (e.g., occupation, tenure). The most common cov-
erage is expressed as a flat-dollar amount or a percentage of salary.
Some plans provide the same amount of coverage for all employees.
Life insurance, however, is intended frequently to replace a portion
of the deceased employee's earnings for a period of time. Thus, cov-
erage may be stated as a multiple of annual earnings (e.g., one times
pay, one and one-half times pay, two times pay or four times pay).
This approach is one of the most popular and is becoming more
popular among insurers, employers and employees. Often, supple-
mental plans are also used, to offer additional coverage.
Employee Cost-According to the Bureau of Labor Statistics, in
most plans, employers pay the total premium for basic group life
insurance. In other plans, employees pay part or all of the cost. When
all or part of the cost is paid by the employee, the premium is usually
a flat amount (e.g., 25 cents or 50 cents per thousand dollars of cov-
erage per month) for each covered employee, regardless of age. The
cost of supplemental plans is usually paid entirely by the employee;
and, in supplemental plans, the monthly premium per thousand dol-
lars of coverage increases with age.
Dependent Life Insurance-As part of the group life insurance plan,
some employers offer insurance to employees' dependents. The cost
of dependent coverage is usually paid by employees who elect such
protection.
Dependent life insurance usually provides a fixed amount of cov-
erage for the worker's spouse and a smaller fixed amount of coverage
for other eligible dependents. Generally, the other eligible dependents
are unmarried children between 14 days and 19 years old. Some
contracts cover children from birth, however; and some set the upper
age limit as high as 25 years old, if the dependent is a full-time
student. Dependent coverage may continue indefinitely, if the depen-
dent is physically or mentally disabled and unable to be self-
supporting.
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The level of dependent coverage is usually less-sometimes much
less-than employee coverage. For example, a plan that provides two
times pay for the employee might specify a flat $2,000 or $5,000
coverage amount for the employee's spouse and a flat $1,000 coverage
amount for dependent children over the age of six months (and less
for newborns).
Accidental Death and Dismemberment Insurance-Frequently, group
life insurance plans include accidental death and dismemberment
insurance. Thus, if death is the result of an accident, the plan may
pay additional benefits. It may also pay benefits-usually stated frac-
tions of the policy's face amount-for the accidental loss of a hand,
foot or eyesight.
Beneficiary Provisions-Under a typical group plan, employees
may designate and change their beneficiaries. At death, the stip-
ulated benefit is paid directly to the named beneficiary. If a ben-
eficiary is not named, proceeds generally go to the deceased
employee's estate. (In the case of dependent insurance, unless some-
one is specifically named as beneficiary, the employee is considered
to be the beneficiary.)
Benefits for Retired Persons and Older Workers-Most group life
policies are designed to cover active employees. For active, older
employees (age 65 is common) coverage can be reduced to reflect
the increase in the cost of life insurance as a result of age. At re-
tirement, coverage is often reduced to a smaller amount, or it may
be canceled.
Conversion Privileges-When an employee's insurance expires be-
cause he or she terminates employment with the company, the em-
ployee may usually convert his or her group coverage to an individual
permanent life insurance plan. Application must be made and a pre-
mium paid within one month after terminating from group coverage.
(If the individual dies during the one-month period, the group pro-
tection is usually extended and benefits are paid.) The amount of
converted coverage cannot exceed the amount of insurance previously
provided under the group plan. Also, the premium will be the insur-
ance company's standard rate for individual policies, based on the
individual's age and risk classification.
Disability Benefits-Group plans generally continue to provide some
life insurance protection for a covered employee who becomes totally
and permanently disabled. Although there are several methods in use,
the most popular is a waiver-of-premium provision. Under such a pro-
vision, coverage is continued at no cost to the disabled employee pro-
viding:
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(1) the employee is under a specified age (usually 60)4 at the onset of
disability;
(2) the employee is covered under the plan at the onset of disability;
(3) disability continues until death;
(4) proof of total and continuous disability is provided annually.5
Optional Forms of Payment-The standard payment method for
group life insurance claims is a lump-sum distribution. However,
virtually all insurers permit other settlement arrangements at the
insured employee's option (or the beneficiary's option, if the employee
did not make an election before death). Alternative payment arrange-
ments include installment payments and life income annuities.
Group term life insurance is a tax-efficient benefit for the employer
and the employee. The employer's premiums are tax-deductible as a
business expense and the benefits paid to employees are exempt from
federal income taxation. The proceeds, however, generally are subject
to estate taxes.
If the employer provides the employee with coverage that exceeds
$50,000, the employee must pay taxes on the employer-provided cost
of the insurance coverage above $50,000. In cases where the plan
discriminates in favor of key employees, the $50,000 coverage cost
becomes taxable. (In the case of a discriminatory plan, some portion
of the insurance will still be tax-free once the new nondiscrimination
rules described previously take effect.) There are exceptions where
the cost for group term life insurance in excess of $50,000 is tax-
exempt. Where an employee contributes toward the cost of the in-
surance, his or her entire contribution is allocated, to the coverage in
excess of $50,000. Additionally, the $50,000 maximum does not apply
if:
(1) the employee is totally and permanently disabled;
(2) the employee has legally specified that the policy proceeds go to a
charitable organization.
'Although this is a common provision, there are legal opinions that this provision may
violate the Age Discrimination in Employment Act.
'For more information, see Jerry S. Rosenbloom and G. Victor Hallman, Employee
Benefit Planning (Englewood Cliffs: Prentice-Hall, Inc., 1981), p. 45.
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Group Universal Life Programs
Recently, employers have begun offering group universal life insur-
ance-a relatively new and fast-growing category that is paid for by
the employee, but usually offers lower premiums than similar insurance
purchased on an individual basis. In addition, coverage is usually pro-
vided up to a limit without evidence of insurability, such as medical
examinations.
Group universal life programs, also referred to by the acronym
"GULP," allow policyholders (i.e., employees) to vary the timing and
amount of premiums, in addition to the amount of the death benefit
and the extent to which it increases. Premiums, minus mortality
charges and expenses, create policy cash values. Such plans also pro-
vide competitive interest rates and allow buyers to accumulate tax-
deferred savings.
Group universal life programs, however, do not always offer spouse
and child coverage. In addition, if a master group universal life con-
tract is terminated or altered, terminated employees or retired em-
ployees may find the original costs and form of their insurance
substantially revised. Finally, introduction of a GULP could entail a
major communication effort on the part of the employer to inform
the employees about the choices offered and answer questions about
the insurance product and enrollment procedures.6
Employee contributions to group universal life premiums are made
with after-tax dollars, often via payroll deductions. If the policy is
surrendered early, there may be a penalty. Corporate benefits de-
partments should be consulted before selections are made in order
to better understand the policy's implications. Although GULP pro-
grams are group plans, the tax reform rules do not apply to most
GULP plans because they are not subject to section 79 of the Internal
Revenue Code, which governs group term life plans.
The death of a worker can be financially devastating to his or her
family. Employer-sponsored life insurance benefits can ease the fi-
nancial problems. The number of employer-sponsored life insurance
plans continues to grow, attesting to their importance. To be effective
and efficient in designing these programs, however, employers should
6For more information on group universal life insurance programs, see Ward E. Jones,
"GULPS Are Not What They're Cracked Up to Be," Benefits News Analysis 9 (January
1987): 28.
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consider all potential private and public sources of life insurance,
survivor benefits and death benefits.
Additional Information
American Council of Life Insurance
1850 K Street, NW
Washington, DC 20006
Curry, Tim, and Mark Warsrawky. "Life Insurance Companies in a Changing
Environment," Federal Reserve Bulletin 72 (July 1986): 449-460.
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XXVI. Survivor Benefits
Introduction
Most employers offer survivor or death benefits to their employees.
Traditionally, these benefits were provided through group term life
insurance, which paid a lump sum to a designated beneficiary or
beneficiaries.'
More recently, benefits to the survivors of deceased employees also
have been paid through other sources, including: (1) Social Security;
(2) employer-sponsored survivor income plans; and (3) employer-
sponsored pension plans. This chapter offers an overview of these
three survivor benefit sources.
Social Security Survivor Benefits
Social Security benefits for widows and widowers are payable at
age 60 providing: (1) the deceased spouse had attained Social Secu-
rity's fully insured status;2 and (2) the couple had been married for
nine months. Although a widow/widower generally loses the right to
benefits on the deceased worker's record when she/he remarries, she/
he does not if the marriage takes place after age 60. Survivor benefits
may also be paid to a spouse under age 60 (including a divorced
spouse) who is caring for an entitled dependent child under age 16.3
The benefit rate for widows and widowers who began receiving ben-
efits at age 65 is generally 100 percent of the deceased worker's pri-
mary insurance amount (PIA) plus any delayed retirement credits .4 The
'For more information on life insurance plans, see chapter XXV.
2Generally, to satisfy the fully insured requirement, a person must have earned at least
one quarter of Social Security coverage for each year after 1950 (or, if later, the year
when he or she reaches age 21) and before the year of death, disability or 62 birthday,
whichever occurs first.
3Requirements to determine whether a child is dependent vary according to whether
the worker is a natural parent, legally adopting parent, stepparent or grandparent.
For more information, see Social Security Administration, The Social Security Hand-
book 1984 (Washington, DC: U.S. Government Printing Office, 1984), pp. 46-48.
4Delayed retirement credit is based on when a worker attains age 62. For those reaching
age 62 in 1987, the delayed retirement credit is 3.5 percent for each year a worker
does not receive retirement benefits due to work between age 65 and 70. For those
reaching age 62 in the year 2005 or later, the credit will increase to 8 percent annually.
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benefit for a surviving spouse caring for the former worker's child is
75 percent of the worker's PIA.
If the widow or widower is disabled, benefits are payable at age
50. For a disabled widow(er) to receive benefits, certain conditions
must be satisfied: (1) the disability must be so severe that it prevents
engaging in any type of employment; and (2) the disability must have
occurred prior to the seventh anniversary of the spouse's death. A
disabled widow/widower may remarry after age 50 without affecting
benefits. The current benefit rate for disabled widows and widowers
who are age 50 to 60 is 71.5 percent of the deceased worker's primary
insurance amount.
A divorced person, who was married to a fully insured worker for
ten or more years, may also be entitled to survivor benefits.
Benefits for children and surviving spouses caring for entitled chil-
dren, as well as a small lump-sum health benefit, are payable if the
deceased worker had attained fully insured or currently insured sta-
tus.5 Unmarried children under age 18 (or under 19 if full-time high
school students) are entitled to receive benefits. The child benefit rate
is 75 percent of the deceased worker's primary insurance amount.
(The combined spouse's and children's benefits, however, cannot ex-
ceed a family maximum.) Dependent parents age 62 or older may
also be eligible to receive survivor benefits, providing specific con-
ditions are satisfied.
Survivor Income Plans
Survivor income plans typically pay benefits to specified dependents
rather than to designated beneficiaries (who may or may not be de-
pendents) of deceased employees. These benefits are generally paid
in equal monthly installments. They are related to survivors' needs
and are intended to provide continuing income support. Survivor
income plan advocates believe this need is greatest when the em-
ployee is young and has young children, instead of when the employee
has reached peak earning years and probably has substantial life
insurance protection.
When designing survivor income plans, employers should consider
the: (1) income level necessary to maintain the survivors' living stan-
'To satisfy the currently insured requirement, a person must have earned 6 quarters
of coverage in the 13-quarter period ending with the quarter when death occurs.
A lump-sum death benefit of $255, which is intended to help the worker's family pay
the costs associated with the worker's last illness and death, is paid under specified
circumstances to a surviving spouse or children of the deceased worker, p. 60.
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dard and (2) additional benefit sources that survivors may receive
(i.e., other employer-provided death benefits and Social Security ben-
efits). Some plans are designed to provide income for specified lengths
of time; these plans enable survivors to make financial adjustments
during a transition period. They may pay benefits for periods as short
as two years or as long as twenty years.
Insurance companies are commonly used as providers of survivor
income coverage. However, employers may also self-insure this cov-
erage. Survivor income plans may be entirely paid for by the em-
ployer or they may be contributory. Employee contributions are
generally made through payroll deductions.
(1) Employee Eligibility-Survivor income plans may cover employees im-
mediately upon employment or after a specified waiting period.
(2) Survivor Eligibility-The definition of a qualified survivor varies among
plans. Typically, qualified survivors include an employee's spouse and
any unmarried dependent children under age 18 (or age 19 if they are
still in high school). Less frequently, eligible survivors include parents
or other relatives. In some instances, coverage depends on whether or
not the survivors are truly dependent on the employee for support.
(3) Benefits-Survivor income plans are generally designed to supplement
Social Security survivor benefits. Usually, survivor income plans base
benefits on the employee's salary at the time of death. The spouse's
benefit is typically 20 to 30 percent, and children's benefits are 10 to
20 percent, of an employee's salary before death. However, the family's
combined benefit may be limited to an overall maximum (e.g., 40
percent).
The amount of a survivor's monthly benefit can also be: (a) a fixed-
dollar amount (specified for all employees); or (b) an amount desig-
nated according to an employee's position.
(4) Duration of Benefits-Some plans are designed to pay benefits for time
periods related to survivors' ages. Other plans pay benefits for survi-
vors' lifetimes. Generally, children's benefits stop once they reach the
plan's age limit or if they marry before reaching the age limit. Spouses'
benefits may continue until age 60 when a widow(er) becomes eligible
for Social Security survivor benefits. Other plans continue widow(er)
benefits until the date when the deceased employee would have reached
normal retirement age.
Spousal benefits may discontinue if the widow(er) remarries. However,
some plans continue benefits for a specified period regardless of whether
the widow(er) remarries. Other plans pay a dowry benefit (i.e., a lump-
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sum benefit payable upon remarriage) to encourage reporting of the
marriage .6
Taxation-The cost of survivor income benefit plans is tax deduct-
ible to the employer. Employer contributions to these plans are gen-
erally tax-free to employees. If the employer provides the employee
with coverage that exceeds $50,000 in life insurance value, the em-
ployee may be required to pay taxes on the cost of the insurance
coverage above $50,000. Life insurance proceeds are exempt from
federal income tax. But if the beneficiary receives payment in in-
stallments over time, instead of a lump sum, then a portion of the
installment payments, which represents the interest, is considered to
be taxable income. Life insurance proceeds from an unfunded, self-
insured plan are taxable if the lump-sum benefit exceeds $5,000.
Pension Plan Death Benefits
Most pension plans contain provisions for death benefits payable
when a participant dies. The Internal Revenue Service requires that
these benefits must be incidental to the plan's main purpose, which
is to provide retirement benefits.
Although the Employee Retirement Income Security Act (ERISA)
and the Retirement Equity Act of 1984 (REA) impose certain require-
ments, there is still a considerable amount of flexibility in designing
pension plan death benefits. Plans may provide preretirement death
benefits and postretirement death benefits.
The law requires that once a married participant in a pension plan
becomes vested, he or she is covered by preretirement survivor an-
nuity protection unless the participant and spouse elect otherwise.
This protection will provide an annuity to a surviving spouse in the
event the participant dies before the retirement annuity commences.
This is true whether the participant stays with the employer up to
retirement or terminates employment before that.
The minimum amount of the required preretirement survivor an-
nuity is equal to the survivor portion of a joint and survivor annuity
(discussed below). If the participant dies before reaching the earliest
age at which annuity payments could begin, the annuity is deter-
mined by assuming that the participant terminated employment in-
stead of dying and elected commencement of benefits at the earliest
6Jerry S. Rosenbloom and G. Victor Hallman. Employee Benefit Planning (Englewood
Cliffs: Prentice-Hall, Inc., 1981), p. 60.
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date allowed by the plan (usually age 55) and then died immediately
thereafter. The plan could provide that no annuity payments be pro-
vided to the surviving spouse until the date the participant would
have reached that earliest retirement age, had he or she lived. If the
participant dies after the earliest retirement age, the survivor annuity
is generally determined by assuming the participant elected com-
mencement of a joint and survivor annuity at the time of death and
died on the day after.
The law also requires that retirement benefits to married persons
must be paid as a qualified joint and survivor annuity, unless the par-
ticipant and spouse elect to receive benefits in some other form or unless
the plan meets one of the following exceptions: under the Tax Reform
Act of 1986 (TRA) a plan is exempt from the qualified joint and sur-
vivor annuity law if: (1) the plan was established before January 1,
1954, as a result of an agreement between employee representatives
and the federal government during a period of government operation,
under seizure powers, of a major part of the productive facilities of
the industry; and (2) if participation in the plan is substantially lim-
ited to participants who ceased employment covered by the plan
before January 1, 1976. Under a joint and survivor annuity, the retired
worker receives a benefit during retirement years; benefits then con-
tinue to be paid after death in the same amount or in a lesser amount
to the surviving spouse. If the spouse dies first, the lesser amount
continues until the death of the retiree. The retired worker's benefit
is usually reduced to reflect the cost of survivor protection and the
ages of the retiree and spouse at the time of retirement. Some plans,
however, pay an unreduced amount to the retired worker. If a married
participant wants to reject the joint and survivor annuity, his or her
spouse must agree to this rejection in writing before a notary public
or plan representative.
ERISA also requires that all employee contributions be paid with
interest to a beneficiary, if a participant dies before receiving benefits.
Other forms of death benefits under pension plans may include:
(1) the lump-sum value of a participant's accrued benefit; (2) a life
insurance contract with a face value equal to one hundred times the
monthly pension benefit the decedent would have received at normal
retirement; (3) monthly payments in the amount the decedent would
have received as a pension; or (4) lump-sum death benefits designed
to meet final illness and funeral expenses (usually these benefits range
from $1,000 to $3,000).
Eligibility for survivor benefits may require a couple to have been
married for a specified length of time. Or, it may require the bene-
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ficiary to be a parent of a dependent child. When there is no surviving
spouse, benefits may be paid to dependent children. Some plans pay
benefits to other dependent relatives.
Taxation-A death benefit from a qualified pension plan paid as a
lump-sum distribution may be eligible for capital gains treatment
under the six-year phase-out rule of TRA beginning on January 1,
1987, or five-year forward averaging if received after the participant
would have attained age 59 1/2. Under a transition rule, if the par-
ticipant attained or would have attained age 50 by January 1, 1986,
the lump-sum distribution may be eligible for five-year forward av-
eraging or 10-year-forward averaging (at 1986 tax rates) with respect
to a single lump-sum distribution without regard to attainment of
age 59 1/2, and to retain the capital gains character of the pre-1974
portion of such a distribution. Under the transition rule, the pre-1974
capital gains portion would be taxed at a rate of 20 percent. The
distribution must represent the full amount in the employee's ac-
count, and it must be received within the same taxable year. Lump-
sum distributions may also be eligible for a $5,000 death benefit
exclusion. This provision permits beneficiaries to exclude up to $5,000
in employer-provided death benefits from gross income for tax pur-
poses.
Under certain circumstances, a lump-sum distribution to a surviv-
ing spouse may be eligible for rollover to an individual retirement
account (IRA) or another qualified plan.
Conclusion
The death of a young worker can be devastating to the surviving
family. Statistics of elderly widows in poverty demonstrate that the
death of an elderly worker or pensioner can also be devastating to
the surviving family. Awareness of these problems has resulted in an
increasing interest in survivor benefit plans. In designing survivor
benefit plans, however, one must consider the different public and
private programs that currently provide survivor protection. Careful
benefit planning can produce effective protection while reducing costly
benefit overlaps.
Additional Information
Martorana, George. Your Pension and Your Spouse-The Joint and Survivor
Dilemma. Brookfield, WI: International Foundation of Employee Benefit
Plans, 1985.
U.S. Department of Health and Human Services. Your Social Security Rights
and Responsibilities, Retirement and Survivors Benefits. Baltimore, MD: So-
cial Security Administration, 1986.
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XXVII. Disability Income Plans
Unexpected illness or injury can result in a person's inability to
work. This may create serious financial problems for individuals and
families. The costs of necessary medical treatment can exacerbate
such financial problems. Health insurance plans may help to pay for
medical care costs while private and public disability income plans
may replace a portion of a disabled worker's lost income.
A report released by the U.S. Bureau of the Census in 1986,1 found
that 20.6 percent of people age 15 and over-including 14.1 percent
between ages 16 and 64 and 58.5 percent of those 65 and over-had
difficulty performing one or more basic physical activities. The survey
also found that the proportion of women with disabilities was 23.2
percent, compared with 17.7 percent for men. The difference occurs
largely because women outnumber men in the elderly age groups. Of
people age 16 to 64, the report said that about 18.2 million, or 12
percent, have a disability that affects their work and 8 million were
prevented from working by the disability.
When disability occurred in the past, many employers offered in-
formal pay-continuation arrangements-especially for salaried em-
ployees. Today, formal disability income programs have gained wide
acceptance. About 63 percent of business and industry employees are
covered by some form of private disability income plan. Virtually all
workers are covered by mandatory public disability plans (e.g., Social
Security and workers' compensation).
Disability can be categorized as: (1) short-term or long-term and
(2) partial or total. Most plans require disabled employees to be under
a physician's care. Benefits must be provided for pregnancy-related
disability on the same basis as for any other disability.
Public Programs
Social Security-The Social Security program provides long-term
disability benefits for workers who satisfy the following conditions:
'U.S. Bureau of the Census, Disability, Functional Limitation, and Health Insurance
Coverage: 1984/85, Washington, DC: U.S. Government Printing Office, 1986.
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(1) the worker must have achieved fully insured and disability in-
sured status;2 (2) he or she must be totally and permanently dis-
abled as defined by law; and (3) he or she must have suffered from
the disability for at least five consecutive months.
The Social Security disability benefit is equal to the primary Old-
Age benefit. However, when combined with workers' compensation,
it may not exceed 80 percent of average current earnings before dis-
ability.3 (Employees covered by the Railroad Retirement Act are en-
titled to disability income benefits under that act rather than under
Social Security.)
Workers' Compensation-Workers' compensation provides bene-
fits to workers disabled by occupational injury or illness. These
benefits are provided under state law; every state requires workers'
compensation coverage. In most states, this coverage is provided
through private insurance or through an employer self-insurance
arrangement. Twenty states offer coverage through state funds,
however, and six of these require employers to use the state funds.
Employers pay for workers' compensation through risk-related
premiums. The amount and duration of workers' compensation
benefits depend upon state laws and the extent of the
disability.
Nonoccupational Temporary Disability Insurance-Most of these plans
are voluntary. However, California, Hawaii, New Jersey, New York,
Rhode Island and Puerto Rico require employers to provide disability
income protection for nonoccupational temporary disabilities. Under
these compulsory laws, benefits are payable after a short disability
period (e.g., one week). Depending on the state, temporary disability
coverage is provided through state funds, private insurers or both.
Eligibility criteria and benefit formulas vary from state to state. How-
ever, a maximum protection period of twenty-six weeks is generally
imposed.
'To satisfy the fully insured requirement, a person usually must have earned at least
one quarter of coverage for each year after 1950 (or, if later, the year when he or she
reaches age 21) and before the year of death, disability or 62nd birthday, whichever
occurs first.
To satisfy the disability insured requirement, a person must have earned at least 20
quarters of coverage, during the 40-quarter period, ending with the quarter in which
the disability begins. If a person becomes disabled before reaching age 31, more liberal
rules apply.
3For purposes of Social Security disability, average current earnings are generally
defined as a person's highest-year earnings in the six-year period consisting of the
calendar year when disability begins and the five years preceding that year.
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Private Programs
Individual employers, jointly managed (Taft-Hartley) trust funds,
insurance companies and associations may offer private disability
income plans. Before a private plan is adopted, a number of plan
design and administration questions must be answered. For example:
What benefit level should be provided? How long should benefits be
provided? What portion of the benefits should be paid by employers
(i.e., indirectly by stockholders and customers), and what portion
should be paid by employees?
Employers are legally required to contribute to the public disability
plans discussed in the previous section. To avoid costly duplication,
private plan sponsors must recognize all sources of disability income
when determining benefit levels. This is usually accomplished by a
benefit integration provision. Integration is intended to limit com-
bined disability benefits to a reasonable income replacement level (i.e.,
the portion of a worker's income prior to disability that is replaced
after disability).
There are two primary types of private disability income plans:
(1) short-term disability plans (benefit payments usually are provided
for 26 weeks or less); and (2) long-term disability plans (benefit pay-
ments usually are provided after short-term benefits have ended).
Long-term benefits generally are paid until age 65 or the normal
retirement age. Under the 1986 Amendments to the Age Discrimi-
nation in Employment Act, which abolished mandatory retirement,
plans that provide disability benefits cannot impose an upper age
limit on eligibility for these benefits by active employees. The benefits
may be paid longer than to age 65 for older employees who become
disabled, based on age-related cost considerations. Employers must
either provide equal benefits to employees of all ages, or, as is usually
the case, provide benefits that are equal in cost to employees of all
ages. Since disability costs rise with age, this means that employees
who are disabled at older ages may be paid disability benefits for a
shorter duration or lower benefits for the same duration, both relative
to younger employees.
Short-Term Disability Plans-A short-term disability is usually de-
fined as an employee's temporary inability to perform normal occupa-
tional duties. Under most short-term disability plans, such as sickness
and accident insurance plans, the disability must exist for at least
one week before a worker becomes eligible for benefits. This waiting
period is intended to control plan costs. Often, paid sick leave is
available to the employee without any waiting period, and it may be
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used during the interim before sickness and accident insurance pay-
ments begin.
Short-term disability protection may thus include sickness and ac-
cident insurance benefit programs as well as paid sick leave. Under
these programs, sick leave usually provides 100 percent of the work-
er's normal earnings; sickness and accident insurance usually re-
places 50 to 67 percent of pay during limited disability periods. Sick
leave plans frequently specify a number of covered days each year
that are permitted for paid sick leave.
Sickness and accident insurance plans may be used instead of, or
in conjunction with, sick leave plans. When used in conjunction with
sick leave plans, sickness and accident plans provide benefits after
sick leave benefits are exhausted. The level of sickness and accident
benefits for short-term disability may be expressed as a specified
weekly dollar amount or as a percentage of straight-time pay. The
level and the duration of benefits may increase with service. Gener-
ally, benefits replace between one-half and two-thirds of a person's
predisability gross weekly income. Many believe that a higher re-
placement rate would create a disincentive for employees to return
to work.
Employers usually pay for short-term disability plans. These plans
may be financed under: (1) a group insurance contract with a private
insurance carrier; (2) an employer self-insurance arrangement; (3) an
employer-established employee benefit trust fund; (4) a Taft-Hartley
multiemployer welfare fund; or (5) general corporate assets (e.g., for
a sick leave plan). Short-term disability plans may be administered
by the: (1) employer; (2) insurance carrier; or (3) board of trustees of
a Taft-Hartley plan.
The duration of short-term disability benefits typically ranges from
13 to 52 weeks, although most workers are covered for up to 26 weeks.
Short-term disability plans usually specify when successive periods
of disability are considered to be separate disabilities and when they
are considered to be a continuous disability.
Long-Term Disability Plans-Many employers offer long-term dis-
ability benefits. In most long-term plans, disability for the first two
years is defined in the same way as disability under short-term
plans (i.e., an employee's inability to perform normal occupational
duties). If the disability continues for more than two years, the
definition of disability usually changes to: the inability to perform
any occupation that the person is reasonably suited to do by training,
education and experience. Some plans use the payment of Social
Security disability benefits as the sole test for ascertaining whether
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a participant should receive long-term disability benefits under the
plan.
Long-term disability plans generally provide benefits when short-
term disability benefits expire. Similar to short-term benefits, inte-
gration of long-term disability benefits with benefits from a variety
of sources is usually used to produce reasonable replacement rates
and to control costs.
Private sources of long-term disability benefits include disability
provisions under: (1) long-term disability plans; (2) group life insur-
ance; (3) employer-sponsored pension plans; and (4) other insurance
arrangements (e.g., individual insurance protection). Generally, these
plans pay benefits amounting to between one-half and two-thirds of
a person's predisability gross weekly income. Some plans, however,
provide as much as 70 to 80 percent of predisability pay. Additionally,
some plans contain a provision stating that private-sector long-term
disability benefits, plus Social Security disability benefits, cannot
exceed a stated amount (e.g., 75 percent of salary). The cost of long-
term disability benefits may be financed by: (1) employer contribu-
tions; (2) employee contributions; or (3) employer/employee cost
sharing.
Although long-term disability plans may limit benefits to a speci-
fied period (e.g., 5 or 10 years), most provide benefits for the length
of a disability, up to a specified age (e.g., age 65, when Social Security
and employer-provided retirement benefits begin). Similar to short-
term disability plans, long-term plans usually specify when succes-
sive periods of disability are considered to be separate disabilities
and when they are considered to be a continuous disability. Also,
some long-term plans provide for continued payment of at least some
disability benefits when long-term disabled persons take on rehabil-
itative employment.
Conclusion
The possibility of disability threatens everyone. When a family's
primary supporter becomes disabled, the financial impact can be
devastating. Employees and employers are placing greater emphasis
on disability income plans. Although nothing can eliminate the suf-
fering caused by disabling injuries or illnesses, private and public
disability plans can provide some economic security for disabled per-
sons and their families.
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Additional Information
The Disability Advisory Council
P.O. Box 17064
Baltimore, MD 21203
Berkowitz, Monroe, and Anne M. Hill. Disability and the Labor Market. Ithaca,
NY: ILR Press, New York State School of Industrial and Labor Relations,
Cornell University, 1986.
DeVol, Karen R. Income Replacement for Short-term Disability. Cambridge,
MA: Workers Compensation Research Institute, 1985.
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XXVIII. Educational Assistance
Benefits
During the last forty years, the popularity of higher education has
grown. One reason has been the demand for more skilled workers to
meet the challenges of high technology industries. Another factor was
the passage of the World War II GI bill, which entitled World War II
veterans to a higher education - previously an impossibility for low-
income veterans. In the late 1950s and in the 1960s, higher education
also became more accessible to minorities and low-income individ-
uals, due to government grant, job and loan programs, mainly es-
tablished under the Higher Education Act of 1965.
Higher education is now more expensive than ever. Many individ-
uals who cannot afford to finance their education in full look to federal
loan and grant programs for financial assistance. Some of these pro-
grams, however, apply only to students who are enrolled at least half-
time. Many part-time students, therefore, may not receive government
assistance. For these individuals, employer-provided educational
assistance is an important benefit in supplementing their educational
pursuits.
Employer-Provided Assistance
Employer-provided educational assistance benefits facilitate career
advancement for employees at all income levels, particularly for lower-
compensated employees, many of whom are women and minorities.
These programs are widely used by employers. The availability of
tuition assistance has increased from 40 percent of employers in 1977
to 69 percent in 1985, according to U.S. Chamber of Commerce esti-
mates.' Among larger firms with at least 10,000 employees, 95 percent
provide tuition assistance, while 85 percent of employers with 1,000
to 10,000 employees offer some type of tuition program?
'U.S. Chamber of Commerce, Survey Research Section, Economic Policy Division,
Employee Benefits 1985 (Washington, DC: 1986).
2Gerard Gold and Ivan Charner, Employer-paid Tuition Aid: Hidden Treasure," Ed-
ucation Record 64, no. 2 (1983): 45.
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According to recent U.S. Chamber of Commerce estimates, the cost
of employer-provided tuition assistance accounts for 0.3 percent of
total employee wages and salaries. These programs are, thus, not
excessive in cost to the employer, attract motivated employees and
may reduce employee turnover by promoting job satisfaction and
internal career-ladder programs. Educational assistance programs
can, therefore, play an important role in a worker's career develop-
ment, often being a contributing factor in an employee's salary growth.
Employee participation rates in educational assistance programs,
however, are low. According to the National Institute for Work and
Learning, a nonprofit organization that researches and implements
education and work programs, during the 1970s, only 3 to 5 percent
of employees eligible for the tuition assistance benefit took advantage
of the program annually. This percent may be increasing, but no firm
data are available. The American Society for Training and Devel-
opment estimates broadly that between 2 and 7 million working adults
annually use tuition assistance. Low worker participation can be at-
tributed to a number of factors: scheduling problems, low worker
interest and insufficient management encouragement and incentives.
Companies that actively promote educational benefits, however, ex-
perience higher participation rates of between 10 and 12 percent .3
According to a 1984 corporate survey, most tuition assistance plans
paid for degree and career-related courses as well as job-related courses.
Ninety-nine percent of the plans covered expenses directly related to
the employee's job. Seventy-nine percent of employers reimbursed
employees for career-related courses, whereas 66 percent covered
courses that were degree-related only. Only 14 percent reimbursed
expenses for courses that were neither job-related nor degree-related.
About one-fourth of the employers surveyed paid 100 percent tuition
reimbursement with no maximum.
Types of Educational Assistance
Employers can provide the following types of educational assis-
tance to employees:
Tuition Aid-Tuition aid, or assistance, is usually provided by the
employer on a reimbursement or prepayment basis to employees who
pursue educational programs on their own time. Reimbursement is
3Gerard Gold, Employment-Based Tuition Assistance: Decisions and Checklists for Em-
ployers, Educators, and Unions (Washington, DC: National Institute for Work and
Learning, 1985), p. 7.
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generally made to the employee upon course completion. Some plans
provide temporary loans for employees who cannot advance fund
their educational expenses. Most prepayment plans have recapture
provisions to protect the employer if a course is not completed or the
employee resigns. Some employers reimburse according to the grade
obtained by the employee. For instance, a grade A would be reim-
bursed at 100 percent of the tuition cost, B at 90 percent, C at 80
percent, D at 70 percent, and there would be no reimbursement for
failed courses.
In a 1983 survey of the Fortune 500 companies conducted by the
Conference of Small Private Colleges, 26.4 percent of firms responding
required that the employee pay part of the tuition. Eighty-six percent
of firms responding reimbursed the employee only after "satisfactory
completion" of a course.
Training Funds-Training funds are established for entry-level
training or apprenticeships, often through combined efforts of small
employers and trade unions. The funds are administered by a firm's
board of trustees.
Educational Leave-Many corporations offer leave to allow the em-
ployee time to complete final papers or courses needed for a degree.
The leave can be with or without pay.
Scholarships and Educational Loans-Scholarships, which are non-
taxable to the employee who is a degree candidate, and educational
loans, which are repaid to the employer, are two other types of em-
ployer-provided programs that assist employees with educational ex-
penses.
Federal Educational Assistance Programs
The U.S. Department of Education (DE) offers six major student
financial aid programs: Pell Grants, Supplemental Educational Op-
portunity Grants, College Work-Study, Perkins Loans (formerly known
as National Direct Student Loans), Guaranteed Student Loans and
PLUS Loans/Supplemental Loans for Students (SLS).
Pell Grants-Pell Grants help undergraduates finance their college
education. This is the largest federal student aid program. Awards
may be as high as $2,100 per year per student. If a student is enrolled
in two different schools, he or she may not receive Pell grants for
duplicative costs. For these grants, the U.S. Department of Education
(ED) guarantees that each participating school (i.e., one that meets
ED requirements) will receive enough money to pay the Pell grants
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for each qualifying student. A student must show financial need to
qualify.
Supplemental Educational Opportunity Grants (SEOGs)-An SEOG
is also a financial award for college undergraduates of up to $4,000
a year. Unlike the Pell grants, however, a SEOG allocates a set amount
of money each year to an institution. There is, thus, no guarantee
that each qualified applicant will receive an award. Like Pell Grants,
awards are also based on financial need.
College Work-Study (CWS)-A CWS is a program for both under-
graduate and graduate college students. It is a combined contribution
program of the employer, college, institution or off-campus agency
and the government that pays students to work on- or off-campus. A
CWS job must always be for a public or private nonprofit organi-
zation. The government may contribute up to 80 percent toward the
work-study grant of a student, and the on- or off-campus employer
contributes the remainder.
Perkins Loans-Perkins loans are low-interest loans available to
undergraduate and graduate college students through a school's fi-
nancial aid office. Repayment begins six months after the student
graduates, leaves school or drops below half-time student status. Half-
time status is based on whatever the college or institution determines
to be half-time. Depending on a student's need, the availability of
Perkins Loan funds at the school and the amount of other aid received,
a student may borrow up to:
(1) $4,500 if enrolled in a vocational program, or if completed less than
two years of a program leading to a bachelor's degree;
(2) $9,000 if an undergraduate student has already completed two years
of study toward a bachelor's degree and has achieved third-year status
(this total includes any amount borrowed under the Perkins Loan pro-
gram for first two years of study);
(3) $18,000 for graduate or professional study (this total includes any amount
borrowed under the Perkins Loan program for undergraduate study).
A Perkins loan is generally repaid monthly over a total repayment
period of ten years-with a few exceptions. An individual may defer
payment if he or she continues to study at half-time status, becomes
temporarily/totally disabled, enters the U.S. armed forces, is an of-
ficer in the U.S. Public Health Service Commissioned Corps or if he
or she serves in the Peace Corps, Action programs or a comparable
program in a tax-exempt organization. A deferment of up to two years
is allowed for service in certain internship programs, and deferment
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may be obtained under extraordinary circumstances (e.g., illness or
unemployment).
Guaranteed Student Loans (GSLs)-GSLs are also low-interest loans
financed through a bank, a credit union, savings and loan association
and other eligible lenders that are available to undergraduate and
graduate students who show financial need. A first or second year
undergraduate student may borrow up to $2,625 a year; an under-
graduate student who has completed two years of study may borrow
up to $4,000 a year; and a graduate student up to $7,500. An under-
graduate may incur a total debt of $17,250 and a graduate student,
$54,750, including undergraduate loans. A student cannot borrow
more than the cost of the education at the attending school minus
any other financial aid and the expected family contribution. Loan
repayments begin anywhere from six to twelve months after gradu-
ation; the lender must allow at least five years for repayment of the
loan and may allow up to 10 years. Deferments are allowed under
similar circumstances that apply to the Perkins Loans. GSLs allow
additional deferments, such as graduate fellowship programs or re-
turn to full-time study. A student may defer loan repayment for one
year if he or she is unemployed and actively seeking employment.
PLUS/SLS Loans-PLUS loans, are available to parents of depen-
dent students; Supplemental Loans for Students (SLS) are for student
borrowers. PLUS/SLS loans are similar to GSLs, but they are available
at higher interest rates. Unlike GSL borrowers, PLUS/SLS borrowers
do not have to show need for their loan. Parents may borrow up to
$4,000 per year to a maximum of $20,000 for each child who is enrolled
at least half-time as a dependent student. Under SLS, self-dependent
undergraduate and graduate students may borrow up to $4,000 per
year to a total of $20,000 when combined with a GSL loan.
GSLs and PLUS/SLS programs are administered by a state or
private nonprofit agency referred to as a "guarantee agency." Each
state has its own guarantee agency, which usually charges an orig-
ination fee and an insurance premium at the time the loan is dis-
bursed. The origination fee is 5 percent and the insurance fee is 3
percent of the outstanding principal balance of the loan. Interest
repayments for an SLS loan begin within 60 days unless the ap-
plicant has qualified for a deferment and the lender agrees to allow
the interest to accrue until the deferment ends. There are no de-
ferments for a parent borrower.
For more information on grant, job and loan programs and state
guarantee agency information, contact the U.S. Department of Ed-
ucation, Office of Student Financial Assistance, Washington, DC 20202.
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State Student Incentive Grant Program
The State Student Incentive Grant Program is a combination state
and federal tuition assistance program. The government allocates
funds to each state guarantee agency based on the enrollment of
students in postsecondary education in each state. The state agency
must contribute at least 50 percent of the total grant awards made
available to students.
Other Federal Assistance Programs
The Veterans Administration (VA) offers two types of educational
assistance programs today. For veterans of the Korean and Vietnam
Wars with service between February 1, 1955 and December 31, 1976,
assistance is available under the GI bill. Veterans have ten years from
the last day of active duty to use the benefit. Veterans who served
after 1976 will receive assistance under a contributory plan. Under
such a plan the serviceperson contributes $25 to $100 monthly from
his or her military pay to a fund for education or training. For every
$1 that the serviceperson pays into the fund, the government pays
$2. A veteran is eligible to receive this benefit without showing fi-
nancial need and regardless of whether his or her enrollment status
will be part-time or full-time.
For more information on these programs, contact the Veterans Ad-
ministration, Washington, DC 20420.
The Educational Assistance Act, which became effective after De-
cember 31, 1978, established section 127 of the Internal Revenue
Code. Until December 31, 1983, when the law expired, all amounts
incurred by the employer for an employee's educational assistance
were excludable from the employee's gross income. In late 1984, Con-
gress extended benefits through December 31, 1985. Under the law
(P.L. 98-611), Congress placed a $5,000 limit on the tax-free status of
employer-provided educational assistance and extended the tax ex-
clusion retroactively for the year 1984, with no penalties for employers
who did not withhold taxes from employees' salaries in that year.
Under the Tax Reform Act of 1986, the tax exclusion was retroactively
extended through December 31, 1987, and the prior $5,000 limit on
tax-free employer-provided educational assistance was increased to
$5,250 (effective January 1, 1986). One advantage of employer-pro-
vided educational assistance over individually financed education,
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where a deduction is taken, is that education reimbursed by the em-
ployer does not have to be job-related to qualify for tax-preferential
treatment.
Employer-Provided Assistance-As mentioned above, up to $5,250
of employer-provided educational assistance is excluded from an em-
ployee's income, if it is provided under a plan that does not discrim-
inate in favor of highly compensated employees. The education need
not meet the IRS definition of job-related, but may not involve sports,
games or hobbies, unless it involves the business of the employer or
is required for a degree program. The $5,250 cap does not apply to
education meeting the IRS definition of job-related.
Any excess over $5,250 is taxable income to the employee. When
an employee works multiple jobs, the annual $5,250 limit applies to
the total amount of educational assistance from all employers. Em-
ployers offering this benefit must file an information return with the
U.S. Department of Treasury that shows the: (1) number of employees
in the firm; (2) number of employees eligible to participate in such
a program; (3) number of employees participating in general; (4) total
cost of the program during the year; and (5) name, address and tax-
payer identification number of the employer, and the type of business
in which the employer is engaged.
These reporting requirements are intended to provide an accurate
picture of the rates and costs of employer-provided tuition assistance
plans.
Individual-To claim an individual income tax deduction for edu-
cational expenses, one must be currently employed or engaged in a
trade or a business. Amounts spent for education qualify as a deductible
employee business expense if the education maintains or improves skills
required for the employee's job but without qualifying the employee
for another job with the worker's current company. Deductible expenses
include tuition, books, supplies, laboratory fees, correspondence courses,
tutorial instruction and research undertaken as part of the education.
The costs of travel, meals and lodging are deductible expenses as long
as they are not personal in nature. Transportation expenses are also
deductible if directly related to educational expenses. An individual
cannot claim an individual income tax credit for educational expenses
paid by his or her employer. Under the Tax Reform Act of 1986, begin-
ning in 1987, educational expenses are included as one of the miscel-
laneous items, which may not be deducted unless in aggregate they
exceed 2 percent of adjusted gross income.
Federal Loans and Grants-The portion of a federal grant that is
used to pay for tuition fees, and required equipment is not taxable
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to the recipient. The Deficit Reduction Act of 1984 (DEFRA) required
the Internal Revenue Service (IRS) to treat defaulted loans as part
of the individual's taxable income if all measures fail on behalf of
the bank or guarantee agency to collect the debt owed. The IRS is
required to notify the individual, however, before such action is taken.
Conclusion
Like most other employee benefits, educational assistance is often
a combined effort of employers, the federal government and individ-
uals. Employers provide educational assistance that can enrich the
skills and careers of their employees. The federal government pro-
vides grants, loans and work-study for undergraduate students, and
loans and work study for graduate students seeking a degree or cer-
tificate. Employees, with or without federal or employer assistance,
also enrich their job skills and careers by pursuing education on their
own. This individual effort, in turn, is subsidized by the tax code, if
the education meets the conditions set out under the Internal Revenue
Code.
Additional Information
American Society for Training and Development
600 Maryland Avenue, SW, Suite 305
Washington, DC
Federal Student Aid Programs
Department J-8
Pueblo, CO 81009-0015
National Institute for Work and Learning
1200 18th Street, NW, Suite 316
Washington, DC
Barton, Paul. Worklife Transitions: The Adult Learning Connection. New York:
McGraw-Hill, 1984.
Gold, Gerard G. Employment-Based Tuition Assistance: Decisions and Check-
lists for Employers, Educators and Unions. Washington, DC: National In-
stitute for Work and Learning, 1985.
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XXIX. Legal Services Plans
Introduction
According to an American Bar Association (ABA) survey, 80 percent
of the public is uncertain about how to obtain legal advice. Unlike
lower-income workers, middle-income workers are not generally el-
igible for legal aid or for the services of public defenders. Unlike
higher-income workers, middle-income workers tend to postpone hir-
ing attorneys until their needs become acute. Thus, wills go unwrit-
ten, legal documents go unchecked and many people take the risk of
inadequately representing themselves in court. Legal services plans
provide affordable legal representation and consultation, especially
to middle-income workers.'
The ABA defines legal services plans as "programs in which legal
services are rendered to large numbers of the public who are asso-
ciated with groups, rather than individuals without such group as-
sociations." The legal services plan is not a new concept. Studies
indicate that the development of such plans, however, was hindered
by ABA objections. The ABA originally opposed these plans on ethical
grounds; they were concerned that legal services plans constituted a
form of client solicitation. Additionally, employees were reluctant to
accept these plans; initially, legal service plan benefits were generally
counted as gross income to the employee. Employers, however, were
allowed to take a tax deduction for their contributions to employee
legal services plans.
The legislative and judicial branches have since issued several de-
cisions, and changes in legislation removed many of the initial de-
terrents to legal services plans until the Tax Reform Act of 1986 (TRA)
eliminated the tax-favored status of legal services benefits. For ex-
ample, four Supreme Court decisions between 1963 and 1971 rec-
ognized the constitutional right to associate to obtain legal advice,
and the Court ruled that bar associations could not interfere with the
establishment of legal services plans. Furthermore, the 1976 Tax Re-
form Act provided that employees do not have to include employer-
'Legal services plans are also known as prepaid legal services plans and group legal
services plans.
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provided legal plan benefits in their gross income. Under TRA, how-
ever, these tax benefits are scheduled to expire at the end of 1987.
Legal services plans offer the potential for reduced legal rates and
broader protection against unexpected, costly lawsuits. They offer a
form of preventive service that can cut legal costs. Under these plans,
legal costs can be predicted, and they are based on group rates. A
prepayment feature permits legal services costs to be spread over a
period of time.
Plan Design
Legal services plans are financed with periodic payments, rather
than on a fee basis. Advance payments are made to a lawyer or in-
surance company by the plan sponsor. In the latter case, the plan
sponsor pays a group premium that covers all employees; or, con-
tributions may be deposited into a legal services trust fund, which
makes payments only when legal work is actually performed. The
scope of services and benefits covered under prepaid legal services
plans ranges from limited to comprehensive.
Limited Service Plans-These plans cover basic services, such as
telephone or office consultation, and advice about simple legal prob-
lems. Uncovered services are paid for by the participant at rates
agreed upon by the plan sponsor and the attorneys. Some limited
service plans have made arrangements with networks of attorneys;
in this case, the attorneys who form the network agree to charge
reduced fees for referrals.
Comprehensive Service Plans-These plans cover consultation and
other services. Services that are typically covered include: (1) providing
unlimited legal advice; (2) drafting legal documents; (3) drafting wills;
(4) filing for divorce; (5) handling lawsuits; (6) transferring real es-
tate; and (7) representing a participant in court. Most comprehensive
plans do not cover legal services associated with an employee's trade,
business or investment property. (See section below on taxation.)
The remainder of this chapter will focus on comprehensive service
plans.
Payment of Benefits
Comprehensive service plans provide benefits under three basic
arrangements: (1) open-panel plans; (2) closed-panel plans; and
(3) combination plans.
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(1) Open-Panel Plans-These plans allow participants to use any licensed
attorney. Payment for services is usually made according to an estab-
lished fee schedule; fees vary depending upon the type of services pro-
vided. The plan participant is responsible for attorney fees in excess
of the scheduled amount. Open-panel plans may also use legal services
trust funds.
Open-panel plans offer advantages and disadvantages. Participants are
able to choose their own attorneys. The attorney selected, however, is
not obligated to accept the case, especially if his or her workload is
heavy or if the case is outside his or her area of expertise. Administra-
tive costs are generally higher in open-panel plans, because the ad-
ministrator must keep records of all services provided by the various
attorneys. Since the sponsoring employers have no control over the
attorneys' fees, sponsors often restrict coverage to selected services,
require deductibles (i.e., a specified amount that the plan participant
must pay before any costs are paid by the plan) and/or impose maxi-
mum coverage limits.
(2) Closed-Panel Plans-Closed-panel plans primarily are intended to cover
job-related or occupational legal problems. There are two types of
closed-panel plans: (a) staff plans; or (b) participating attorney plans.
(a) Staff Plans-These plans provide benefits through a full-time sa-
laried staff of lawyers who are hired specifically to handle the
group's needs. This arrangement generally only works well when
most of the plan's participants live in one location that has easy
access to the lawyers who are providing the legal services.
(b) Participating Attorney Plans-Where plan participants are geo-
graphically dispersed, the plan sponsor may prefer to contract with
a number of law firms; this can assure that employees in all lo-
cations have access to legal services. Here, the law firms agree to
provide certain types of legal services for a set fee per participant.
In return for the fee, the attorneys provide services with little re-
strictions on time.
The administrative costs under closed-panel plans are generally lower
than those under open-panel plans. Since a smaller number of attor-
neys is involved, there are fewer records to manage and payment for
services may be easier. The lawyers in a closed-panel plan often ac-
quire special expertise in areas associated with the covered group's
most common problems. Unions usually favor closed-panel plans,
because under these plans, unions are able to control the quality of
the legal work by controlling the selection of attorneys. Closed-panel
plans frequently can offer more efficient legal services at lower rates
than open-panel plans. Due to the salary arrangement between the
attorney and the plan, however, it may be difficult for attorneys to
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reject cases-even when attorneys do not feel they are qualified for
the case or when they would rather not take the case.
(3) Combination Plans-Some plans offer combinations of the open- and
closed-panel plan characteristics. Under a partially closed-panel plan,
employees can choose from a small number of lawyers and law firms
selected by the plan sponsor. Alternatively, under a partially open-
panel plan, employees can choose an attorney from a specified geo-
graphic area, or from a group of lawyers who subscribe to the plan's
terms and conditions.
There are four broad service categories under typical comprehen-
sive service plans: (1) consultation; (2) general nonadversarial;
(3) domestic relations; and (4) trial and criminal.
Consultation-Most legal problems are consultative in nature. They
deal with consumer matters, landlord-tenant disputes and domestic
disputes (e.g., overdue child support payments and visitation rights).
Here, the attorney counsels the participant, either by telephone or in
the office, on appropriate legal action, or may provide self-help in-
formation so the plan participant can resolve the problem alone.
General Nonadversarial-These services are generally performed in
an attorney's office. They include reviews of documents, wills, adop-
tion papers, guardianship and conservatorship (i.e., pertaining to pro-
tector, guardianship and custodial) matters. They also include name
changes, personal bankruptcy, real estate transfers, estate closings,
as well as Social Security, unemployment and other benefit claims.
Domestic Relations-Legal separations and divorces are the most
expensive overall services covered by prepaid legal plans. Most plans
that cover these services also cover the costs of modifying divorce
and separation agreements (e.g., changes in the terms of child custody
agreements, visitation agreements, child support or separate main-
tenance arrangements). Due to the cost and emotional nature of do-
mestic relations legal problems, many plans do not cover these legal
services.
Trial and Criminal-This benefit classification includes adversarial
legal matters such as contested adoptions and guardianship, civil
suits and contested domestic relations matters. Also included in this
category are minor criminal matters such as suspension or revocation
of drivers' licenses, juvenile court proceedings and misdemeanors.
These services usually require the highest plan cost per claim. How-
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ever, utilization of these services is fairly infrequent. Many plan spon-
sors do not cover these services.
Exclusions and Limitations
Legal services plans may be subject to potential abuses such as
excessive attorney fees and unnecessary services; thus, they fre-
quently build in cost controls. The following are typical services that
may be excluded in order to control plan costs:
(1) actions against employers and unions (these actions must be excluded
in Taft-Hartley plans);
(2) services rendered for legal problems existing before the plan's effective
date;
(3) contingent fees that are charged by lawyers only if they win the case;
(4) court expenses such as fines, court costs, filing fees, subpoenas, as-
sessments, penalties and expert witness fees.
Other methods of controlling costs include:
(1) closed lists of eligible procedures-under closed-list arrangements, some
legal services are automatically excluded from the schedule of benefits;
(2) maximum ceilings on hours or costs of services rendered;
(3) limits on the frequency of a particular service over a specified time
period;
(4) yearly deductibles and/or copayments (i.e., the participant pays some
portion of the cost and the plan pays the remaining portion for each
legal service);
(5) maximum limits on the hourly fees of attorneys-usually this is set
below the prevailing rate.
In a qualified plan, the employee does not include any share of the
employer's contributions toward legal services benefits in his gross
income. Under current law, this provision is effective only through
December 31, 1987. Until then, the Internal Revenue Code contains
certain requirements that legal services plans must meet in order to
qualify for favorable tax treatment. For example:
(1) An application for qualification must be filed with the Internal Revenue
Service (IRS).
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(2) The employer must establish a separate written plan for the exclusive
benefit of employees (and their spouses or dependents), and it must
provide only legal services.
(3) The plan must provide personal legal services. It cannot provide legal
services related to an employee's trade or investment property.
(4) The plan cannot discriminate in favor of shareholders, officers and
highly paid employees. In determining whether the plan is discrimi-
natory, certain employees may be excluded from consideration. The
excluded employees are those covered by an agreement, which the
Secretary of Labor finds to be a collective bargaining agreement, pro-
viding there is evidence that group legal services benefits were the
subject of good faith bargaining. Certain limits also apply to contri-
butions that are made on behalf of shareholders and owners who have
more than a 5 percent interest.
(5) The employer must transmit his plan contributions to designated re-
cipients (e.g., insurance companies, tax-exempt trusts or authorized
service providers).
Employee Retirement Income Security Act
All legal services plans maintained by an employer or an employee
association are classified under the Employee Retirement Income
Security Act (ERISA) as employee welfare benefit plans and are sub-
ject to certain requirements. For example, summary plan descriptions
must be provided to plan participants and reports must be provided
to certain government agencies? Furthermore, 1984 legislation es-
tablished certain annual reporting requirements of plan information
that employers must submit to the IRS.
Conclusion
Legal services plans were almost unheard of a decade ago. Today
about 12 million Americans participate in these plans, which are often
used in conjunction with flexible compensation plans.3 Although cur-
rent law has extended exclusion of these benefits from gross income
only through 1987, supporters of legal services plans are hopeful that
the increased popularity of the plans will cause the tax-favored status
to become permanent.
2For more information on ERISA, see chapter III.
3For more information on flexible compensation plans, see chapter XXXI.
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Additional Information
American Prepaid Legal Services Institute
1155 East 60th Street
Chicago, IL 60637
National Resource Center for Consumers of Legal Services
3254 Jones Court, NW
Washington, DC 20037
Billings, Roger D. Prepaid Legal Services. Rochester, NY: Lawyers Cooperative
Publishing Co., 1981.
National Resources Center for Consumers of Legal Services. Group Legal
Service Plans: Organization, Operation and Management. Washington, DC:
National Resources Center for Consumers of Legal Services, 1981.
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XXX. Child Care Programs and Options
Introduction
Private-sector provisions for child care in the United States origi-
nated during the Civil War and were reestablished in World War I,
when nurseries were set up to enable women to work in hospitals
and war-related industries. During World War II, approximately 4,000
federally funded child care programs were established under the Lan-
ham Act of 1942. This legislation allowed mothers the opportunity to
help in the war effort. Most of these child care centers, however, were
terminated at the end of the war.
Interest in employer-sponsored child care centers was displayed in
the mid-1960s and early 1970s when several U.S. corporations estab-
lished on-site day care centers. Most of the corporate day care centers,
however, closed due to management problems and insufficient use
by employees. Today there is renewed interest in child care on the
part of government and private employers. As a result of the changing
needs in the work place, and as women participate in the work force
at a greater rate then ever before, child care is emerging as a valuable
employee benefit offered by a relatively small, but growing, number
of employers.
Women with children are now in the paid labor force more than
ever before. According to the Department of Labor (DOL), more than
one-half of married mothers (51 percent) with children under age
three were in the work force in March 1986.' DOL estimates that by
1990, 66 percent of new entrants in the labor force will be women.
Current estimates show that 80 percent of women in the work force
are of child-bearing age, and that 93 percent will become pregnant
at some time during their careers.'
More and more families are relying on women's earned incomes,
either as part of a two-earner couple or as a single head of household.
DOL estimated that in 1986, the husband was the sole earner in only
20.4 percent of married-couple families, down from 33.3 percent in
'U.S., Department of Labor, Bureau of Labor Statistics, "Half of Mothers With Children
Under Three Now in Labor Force," USDL 86-345 (August 20, 1986).
'U.S., Congress, House, Families and Child Care: Improving the Options, Committee
Print, 98th Cong., 2nd Sess., 1984, p.v.
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1970.1 At the same time, the number of husband and wife two-earner
couples has grown from 34 percent of all married-couple families in
1970 to 54.5 percent in 1986. Due to the growing number of families
in which both spouses work, employers providing child care benefits
may have an advantage in attracting young professionals.
The increasing rates of separation, divorce and single parenthood
have resulted in a growing number of single-headed households. Ac-
cording to data compiled by the House Select Committee on Children,
Youth, and Families, the population of children under age ten living
in single-parent households is expected to rise 48 percent-from 6
million to 8.9 million-between 1980 and 1990. The growing number
of children living in female-headed households, where earnings tend
to be substantially less than in male-headed households, could in-
crease the number of children living in poverty. For these women to
work, some form of dependent care is a necessity.
Child Care and the Employer
Child care is usually provided through one of these options: (1) in-
home care-where someone other than the parent comes into the
child's home for care; (2) family care-where a child is taken to the
home of another adult; or (3) child care centers-where the child
attends a facility for care or a play group with other children. Child
care provided in the parents' home or in another adult's home is the
most prevalent type of child care arrangement. Most of this care is
unlicensed. Care for disabled or ill children is severely inadequate.
Employer-assisted child care may be provided through a number
of options. Programs range from company-owned and operated day
care centers to indirect services, such as information and referral
services, financial assistance programs and contributions to local child
care programs.
Employer-sponsored child care is not a common employee benefit,
but it is growing. It is most often provided in the service industries
(e.g., hospitals, banks and insurance companies). The Work and Fam-
ily Information Center of the Conference Board (a nonprofit, New
York-based research organization), reports that in October 1985 ap-
proximately 2,500 of 6 million employers in the U.S. offered some
3Figures from 1970 are from U.S., Department of Labor, Bureau of Labor Statistics,
Labor Force Statistics Derived from the Current Population Survey: A Databook Volume
1, Bulletin 2096 (Washington, DC: U.S. Government Printing Office, September 1982),
p. 722.
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type of child care service-up from 600 in 1982. The following lists
employer-supported child care by type of service.
Number of
Types of Assistance Companies
On-site or near-site child care centers
Corporate ......................................................... 150
Hospitals .......................................................... 400
Public agencies .................................................. 30
Family day care support .......................................... 50
After-school child care ............................................ 75
Sick child care initiatives ........................................ 20
Information and referral .......................................... 500
Financial Assistance
Vouchers .......................................................... 25
Discounts ......................................................... 300
Comprehensive cafeteria plans ................................. 150
Flexible spending accounts/salary reduction ................. 800
Total .................................................................. 2,500
In addition, the Conference Board estimates that as many as 1,000
employers make corporate contributions to community child care
programs and another 1,000 employers offer parent education sem-
inars.
There are several possible reasons why more employers do not offer
child care services. Some employers may be unaware of the growing
need for and the available options in child care. There are potential
liabilities and administrative burdens involved in offering on-site child
care. Employers might be reluctant to offer child care services be-
cause it is estimated that in the average work force of a large com-
pany, less than 10 percent of employees will be able to use a child
care program at any given time.' Moreover, among those employees
who have the need for child care services, demand for employer-
sponsored programs is small. One reason for this under-utilization
may be that employers commonly require that licensed care be pur-
chased under the plan. Day care, other than group child care centers,
as noted before, is generally unlicensed. Parents seem to dislike, all
else being equal, institutional care. At the same time, employers un-
4Peter L. Hutchings, "Managing Salary Reduction Dependent Care Benefits," Benefits
News Analysis 6 (October 1984): 24.
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derstandably fear liability for substandard care that might occur
under unlicensed providers.
The advantages of child care benefits to the employer, however,
may include a decreased rate of employee turnover and absenteeism.
The Conference Board indicates that these benefits could also heighten
morale in the work place, create good public relations, and hence,
attract better employees. Ultimately, the quality of products and ser-
vices is affected by the quality of the work force. According to a 1984
survey of 415 businesses, in which 178 employers responded, 90 per-
cent reported that child care had a positive effect on employee morale;
79 percent of employers felt that child care programs had a positive
effect on their ability to attract employees; 65 percent reported a
positive effect on job turnover; and 53 percent reported a positive
effect on absenteeism.5
Employer-Supported Child Care Centers-Employer-sponsored cen-
ters can be administered by the company or an outside service. Cen-
ters are not always located at the work site, and admission may be
limited to include only employees' children.
Many firms support community child care programs. When the
employer chooses to finance community day care centers rather than
create an on-site child care service for employees, the employees of
the participating company may receive preferential admission, re-
duced rates or a reserved space in the day care center in exchange
for the employer's financial support to the center. In this way, the
employer avoids the administrative and legal responsibilities but still
offers support services.
Information and Referral Services-Information and referral ser-
vices can help parents obtain information on child care and, in many
cases, refer them to the most appropriate form of child care in their
community. Most companies contract with an existing referral agency
in the community; others have an in-house hotline capacity. A grow-
ing number of employers sponsor educational seminars on parenting
issues. These forms of assistance help the employer estimate the po-
tential demand for child care services before investing in other forms
of child care support.
Flexible Personnel Policies-Flexible personnel policies often reduce
the need for extensive child care. Some examples of the options avail-
able to employees are flextime (flexible work schedules), job sharing,
part-time work, work at home and flexible leave policies. From 1968
SSandra Burud, Pamela R. Aschbacker and Jacquelyn McCroskey, Employer-Supported
Child Care: Investing in Human Resources (Boston, MA: Auburn House, 1984).
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to 1985, the number of women in part-time jobs rose faster (increasing
by 87 percent) than those in full-time jobs (increasing by 64 percent).
In 1985, 10.5 million employed women, one quarter of all employed
women 20 years and over, were employed part time .6
Flexible Benefit or "Cafeteria" Plans-Flexible benefit plans, or "caf-
eteria plans," are another way for employers to offer child care as-
sistance. Flexible benefit plans allow employees to choose among a
variety of benefit options paid for by employer contributions or em-
ployee pretax contributions. Employers can include child care (and
care for elderly parents and handicapped dependents) in a cafeteria
plan if they offer a qualified Dependent Care Assistance Plan (DCAP).
When child care is offered in a cafeteria plan, employees may, for
example, elect child care benefits in lieu of dental care. By allowing
choice among different benefits, cafeteria plans allow employees flex-
ibility to meet household needs and avoid duplicate benefit coverage.
Flexible Spending Accounts-Flexible spending accounts, also known
as reimbursement accounts, are a way of funding child care and other
benefits within a cafeteria plan. These accounts, in turn, may be
funded by salary reduction, employer dollars or both. Under a salary
reduction arrangement, the employee contributes a portion of pretax
(gross) salary to his or her flexible spending acount to help fund the
benefit, in this case, child care. The employee pays no federal income
tax on the contribution, but some states impose a tax on the contri-
bution.
A flexible spending account must meet special Internal Revenue
Service (IRS) requirements if plan benefits are to be nontaxable to
the employee. If the account is funded through a salary reduction
arrangement, the employee must decide how much money to put into
the account before the beginning of the year. According to IRS reg-
ulations, the employee would be required to "use or lose" these funds.
This means that if any money remains in the account at year's end,
the remaining dollars would be forfeited by the employee.
Federal Programs
Federal support for dependent care is provided through a variety
of programs. The dependent care income tax credit is the largest
segment of federal support. An estimated $3.1 billion in dependent
care credits were claimed in 1985. Approximately $800 million are
'Thomas J. Nardone, "Part-Time Workers: Who Are They?" Monthly Labor Review 2
(February 1986): 13-19.
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spent annually on child care programs through the Human Services
Block Grant (HSBG)-formerly referred to as Title XX of the Social
Security Act-which supports low-income families. States determine
the specific allocation of funds received under the HSBG act. Among
the variety of services provided under the HSBG, child care is the
only service that does not have an alternative funding source. Limited
federal funds for extremely low-income families are provided through
programs such as Head Start, the Child Care Food Program, Job
Training Partnership Act and Aid to Families with Dependent Chil-
dren (AFDC).
In February 1984, the U.S. Senate opened a nonprofit child care
facility for its employees. Start-up funds were appropriated by the
Senate, and tuitions are based on a sliding scale depending on pa-
rental income. In late 1987, the U.S. House of Representatives is also
going to open a child care facility for its employees.
Employer-Provided Child Care-Child care programs became non-
taxable in January 1982 as a result of the 1981 Economic Recovery
Tax Act (ERTA). Child care benefits under a qualified Dependent Care
Assistance Program under section 129 of the Internal Revenue Code
may be excluded from the employee's taxable income if the program
meets certain eligibility requirements. The program provided by the
employer must be available to all employees and cannot discriminate
in favor of employees who are officers, owners or highly compensated.
The 1986 Tax Reform Act (TRA) establishes a new nondiscrimination
test generally effective for plan years after December 31, 1987.1
The maximum amount an employee (single or married) may ex-
clude from income annually is $5,000-$2,500 for a married individ-
ual filing separately. Amounts above these levels are included in the
participant's taxable income. Excludible amounts are limited to the
types of expenses eligible for the federal income tax credit (described
below). Dependent care benefits provided by the employer are not
eligible for the individual tax credit.
Individual Income Tax Credit-A federal income tax credit is avail-
able for qualified child care expenses not covered by or paid for by
7Under TRA, employer-provided child care programs must satisfy a new "benefits"
test, which is designed to prevent highly compensated employees from receiving a
disproportionate share of benefits provided under the plan. It is one of the same tests
other statutory health and welfare benefit plans must satisfy. See chapter XVII for a
complete description.
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an employer-sponsored plan. A credit is allowed for children under
age 15 when both spouses work full-time or when one spouse works
part-time or is a student.8 The amount of qualified expenses eligible
for the credit is subject to both a dollar limit and an earned income
limit.
Qualified expenses are limited to $2,400 for one child and $4,800
for two or more children, but generally cannot exceed the earned
income of the individual, if single, or, for married couples, the earned
income of the spouse with the lower earnings. A credit equal to 30
percent of eligible expenses is available to individuals with adjusted
gross incomes of $10,000 or less, with the credit reduced by one per-
centage point for each $2,000 of income between $10,000 and $28,000.
For individuals with adjusted gross incomes above $28,000, the credit
is limited to 20 percent of qualified expenses.
The federal tax credit has become the largest source of child care
support. Reports indicate, however, that the credit has not been ben-
efiting those with very low incomes. Estimates show that in 1981,
only 7 percent of the 4.6 million families claiming the dependent care
tax credit had income below $10,000.9 The credit may become more
popular in 1987 and future years. The reduced marginal tax rates
under TRA will make the value of the tax exclusion for employer-
sponsored child care benefits less valuable than the tax credit for
many more low- and lower-middle-income employees.
The shift from the traditional married-couple family, with the hus-
band as sole wage-earner, to the two-career family10 has probably
been a major influence in the increased interest of employers and
employees in parental leave.
8A credit is also allowed for other "qualifying individuals," which include a dependent
of the individual who is physically or mentally incapable of taking care of himself
or herself, or a spouse of the individual if the spouse is physically or mentally in-
capable of taking care of himself or herself. Expenses must be employment-related;
they must be incurred to enable the taxpayer to work and must be for the care of
qualifying individuals. Expenses may include household services to the extent that
such services are performed for the qualifying child or dependent.
'U.S., Congress, House, Select Committee on Children, Youth and Families, Families
and Child Care, p. 83.
10For a discussion of demographic changes affecting the work place, see Thomas Es-
penshade and Tracy Ann Goodis, "Demographic Trends Shaping the American Fam-
ily and Work Force," in America in Transition: Benefits for the Future (Washington,
DC: Employee Benefit Research Institute, 1987).
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Maternity Leave-Under the Pregnancy Discrimination Act of 1978,
employer short-term disability plans must treat disability due to
pregnancy and childbirth in the same way as any other disability.
Employers must, therefore, offer short-term disability benefits for
maternity leave if they provide a short-term disability plan to their
employees.
Federal law, however, does not require employers to provide dis-
ability plans. If the employer does not offer such a plan, then the
employer is not required to provide maternity leave. In addition,
small employers with fifteen employees or less do not have to extend
short-term disability benefits for maternity-related disabilities unless
state or local laws provide otherwise. Only five states and one U.S.
territory have mandated short-term disability policies: California,
Hawaii, New Jersey, New York, Rhode Island and the territory of
Puerto Rico. Maternity leave, therefore, is up to the discretion of the
employer if the employer does not operate in a state that requires
short-term disability and does not offer short-term disability as a
benefit.
Company policies on maternity and parental leaves have only re-
cently been documented. One of the most extensive is a 1984 survey
of the nation's 1,500 largest companies by Catalyst, a New York based
research organization.)' Catalyst reports that in 1984, 95 percent of
respondents in their survey had a short-term disability policy. Most
disability leaves were paid, with full or partial salary plus benefits,
and the average length of leave taken by women was five to eight
weeks. The Bureau of National Affairs also has surveyed parental
leave policies as part of a larger report on policies on leave from
work,'2 but the survey does not distinguish between disability leave
and other unpaid leaves.
Unpaid Leave-Unpaid leave can be granted alone or in conjunction
with disability benefits and paid leave (such as annual or sick leave).
More than one-half of the responding companies in the Catalyst sur-
vey offered unpaid leave'13 which the parent often took after the dis-
ability period (women) or after the birth of the child (men). The length
of unpaid leave offered varied, but 65 percent of respondents reported
three months or less.
"Catalyst, Report on a National Study of Parental Leaves, (New York, NY: 1986).
12 Bureau of National Affairs, Policies on Leave From Work, PPF Survey No. 136 (Wash-
ington, DC: BNA Inc., 1983), pp. 21-25.
13Catalyst included only companies that guaranteed job reinstatement after leave on
the assumption that "the conditions of reinstatement heavily influence the employ-
ee's decision on whether or not to take unpaid leave and, if so, for how long."
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Paternity Leave-Child care has become an important concern for
men as well as for women. It is estimated that 60 percent of men in
the work force have working spouses.14 Fewer firms provide child
care leave for male employees than for female employees, but the
number appears to be rising. According to the Catalyst survey, 37
percent of the firms questioned allowed men to take leave from work
for child care with a job guarantee upon return to work. The practice
is not usually called paternity or parental leave, but is classified under
the company's general personal leave or leave of absence policy.
Adoption Leave-Fewer employers offer adoption leave than ma-
ternity and paternity leave. But Catalyst reports that there has been
a significant increase since 1980-from 10 percent of responding com-
panies in that year to 27.5 percent in 1984. Adoption leaves were
generally unpaid, but about one-third of the companies Catalyst sur-
veyed reimbursed employees for adoption expenses. The amount of
reimbursement varied, but in general ranged between $1,200 and
$2,000. A report by National Adoption Exchange15 found that most
company adoption plans set a ceiling, with median reimbursement-
at about $1,500, and reimbursed for specific itemized expenses, such
as agency fees, court costs and legal fees.
The number of employers offering child care services is limited.
Benefits could be greatly expanded in the future, but the extent of
their role remains uncertain. On the one hand, because of the changes
in the composition of the U.S. work force and the need for employers
to attract and retain employees, employer-assisted child care is
emerging as a valuable employee benefit. Indeed, in the next decade
it may become a commonly offered benefit. On the other hand, the
government is carefully scrutinizing the favorable tax treatment of
child care expenditures.
As the child care industry grows and more information becomes
available, marketing of these services may become more sophisti-
cated and pervasive. Employers currently uninterested in establish-
ing child care programs may become more interested as the work
force continues to change and child care needs become more prom-
"Dana E. Friedman, "Improving Child Care Services: What Can Be Done?" testimony
presented before the House Select Committee on Children, Youth, and Families,
August 2, 1984, p. 3.
15National Adoption Exchange, Adoption Benefits Plans: Corporate Response to a Chang-
ing Society (Philadelphia, PA: National Adoption Exchange, n.d.).
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inent. The role of government will also need to be more clearly defined
to meet the changing work force. Legislation was introduced in the
99th Congress that would have required employers to provide a min-
imum period of leave without pay for the birth or adoption of a child.
It was reintroduced in the 100th Congress.
Conclusion
The demand for child care services is growing as a result of a
combination of factors, including the increase in the child population,
in two-wage earner families and in single-headed households. Al-
though some employers are providing child care benefits, individuals
still pay most day care expenses in this country. The federal govern-
ment is presently exploring new roles in child care. As the needs of
employees change and as employers try to satisfy these needs, both
the private sector and the federal government may choose to take an
expanded role in the provision of child care benefits.
Additional Information
Employee Benefit Research Institute. America in Transition: Benefits for the
Future. Washington, DC: Employee Benefit Research Institute, 1987.
Fernandez, John P. Child Care and Corporate Productivity: Resolving Family/
Work Conflicts. Lexington, MA: DC Health and Company, 1986.
Friedman, Dana. Corporate Financial Assistance for Child Care. New York:
The Conference Board, Inc., 1985.
Kamerman, Sheila B., Alfred J. Kahn, and Paul Kingston. Maternity Policies
and Working Women. New York: Columbia University Press, 1983.
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XXXI. Flexible Compensation Plans
Introduction
In recent years, family relationships, lifestyles, trends toward early
retirement and increased longevity have raised questions about the
efficacy of conventional benefit plans. We have seen an influx of young
workers and female workers whose lifestyles and values are different
from the male breadwinners of 20 years ago. Changes in social and
economic circumstances have affected the needs and preferences of
workers.
Most employee benefit programs are designed to satisfy the tradi-
tional family's needs. Workers' benefit needs are largely determined
by their ages, marital and family status, and compensation levels.
Traditional programs do not reflect the circumstances of single work-
ers with no dependents, two-earner couples and single-parent work-
ers; additionally, they seldom consider the changes in workers' needs
over time.
Some employers have implemented flexible compensation plans' to
respond to the differing needs of their workers and to help manage
employee benefit costs. Compensation is flexible when employees are
entitled to choose among benefit options paid for by employer con-
tributions. Compensation is also flexible when employees can pur-
chase nontaxable benefits through salary reduction arrangements. Such
arrangements allow employees to elect to have a portion of their
compensation (otherwise payable in cash) contributed to a qualified
profit sharing, stock bonus or pre-ERISA money-purchase pension
plan. The employee contribution is treated not as current income,
but most commonly as a pretax reduction in salary, which is then
paid into the plan by the employer on behalf of the employee.
Employee choice is not a new idea in benefit design; many tradi-
tional plans offer options to employees. For example:
(1) Employees may choose among different levels of protection under group
life insurance, survivor income and medical care programs.
'Flexible compensation plans are also known as cafeteria, supermarket and smorgas-
bord plans.
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(2) Employees may choose between cash and deferred profit sharing.
(3) Employees may choose between participating or not participating in
a thrift (i.e., savings) plan, and among a number of contribution levels
and/or investment options in such plans.
According to the U.S. Bureau of Labor Statistics (BLS) survey "Em-
ployee Benefits in Medium and Large Firms, 1986," although flexible
compensation plans and reimbursement accounts (see p. 275) have
attracted recent attention, their incidence is limited. Among the 21.3
million, private, full-time employees surveyed, 8 percent of white-
collar workers and 2 percent of blue-collar workers could participate
in one or both of these benefit plans. Five percent of all employees
covered by the survey were eligible for reimbursement accounts, and
2 percent of all employees were eligible for flexible compensation
plans. A flexible compensation plan was defined in the survey as a
plan giving employees a choice among two or more types of benefits.
Therefore, plans that permitted a selection in only one benefit (e.g.,
a choice among several health insurance options or plans) were not
classified as flexible compensation plans.
Types of Plans
In a typical flexible compensation plan, the employer provides a
minimum level (i.e., a core) of certain basic benefits. The basic ben-
efits generally include health insurance, life insurance, disability in-
surance, pensions and vacation. A second level of coverage may also
be provided in the form of benefit credits. Employees use these credits
to purchase: (1) additional coverage in the basic benefit areas; or
(2) benefits in other areas such as child care, dental care and legal
services.
Although the approach just described is common, there are many
variations. For example, employers may provide a core of benefits,
but they may permit employees to choose among several levels of core
coverage. Again, benefit credits may be offered as a second tier of
coverage and may be used for obtaining additional protection or
services. Under another arrangement, employees choose from several
predetermined benefit packages. All benefit packages try to represent
equal value, but each is designed to meet the needs of different life-
styles.
Through salary reduction arrangements, flexible plans may also
permit employees to pay for additional benefits with their own pretax
dollars. Also, some plans permit employees to purchase additional
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benefits with after-tax dollars. Within the structure of a particular
flexible compensation plan, therefore, an employee can use core ben-
efits, benefit credits and personal contributions to help design his or
her own benefit package.
Tradeable Benefits
A 1984 amendment to the Internal Revenue Code limited the ben-
efits that may be provided under a cafeteria plane to the following
menu:
(1) medical care, including dental care, eye care, hearing care, etc;
(2) group term life insurance (on employee's life or dependent's life);
(3) disability benefits;
(4) group legal services;
(5) cash or deferred plans under section 401(k);
(6) vacation days (if unused days may not be cashed out or rolled over
into a subsequent plan year).
Benefits that may not be included under a cafeteria plan include
van pooling, educational benefits, deferred compensation plans (other
than 401(k) plans), employee parking, employee discounts and other
fringe benefits, whether or not taxable.
Reimbursement Accounts
Reimbursement accounts (also known as flexible spending accounts)
became quite popular in 1983 and early 1984, and the IRS issued
proposed regulations on cafeteria plans in May 1984.
One early type of reimbursement account was set up by employers
solely as an incentive for health care cost containment. Here, the
employer agreed to reimburse uninsured medical claims incurred
over a year's period up to a fixed amount (e.g., $500). At year's end,
if the employee had not exhausted his or her "account," the balance
could be taken by the employee in cash or placed in a deferred com-
pensation plan.
2Characterization as a cafeteria plan under Internal Revenue Code section 125 protects
the participant from being taxed, under the constructive receipt doctrine, on the value
of taxable benefits (e.g., cash) the participant could have selected, even though he or
she does not select such benefits.
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A second arrangement was called a "benefit bank," which was
funded by employees through salary reduction, by employer contri-
butions or both. Here, employees typically could make claims for
reimbursement of medical, legal or dependent care expenses from
the same unallocated credit pool. At year's end, unused credits could
be taken in cash, rolled into the next year's credit pool or placed in
a qualified deferred compensation plan.
The most aggressive type of spending account was the zero-balance
reimbursement account (ZEBRA), which offered all the advantages
of the other versions, but required funding only through salary re-
duction, and only after the covered expense was incurred.
Primarily in response to the rapid growth of reimbursement ac-
counts, the IRS proposed the adoption of the following rules, which
would be applicable to all cafeteria plan elections.
(1) Advance Elections-Employees must elect to allocate flexible credits
to specific benefits before the coverage period begins. Generally these
choices cannot be revoked after the start of the plan year.'
(2) Coverage Periods-To assure that the regulations are satisfied, the cov-
erage period for each benefit should be a full year and all coverage
periods should coincide with the cafeteria plan year.
(3) No Credit Carry-Over-Here the IRS strictly construed section 125 of
the Code to prohibit the carry-over of unused benefit credits, or unused
vacation days, to a subsequent plan year.
(4) Forfeitures-Flexible credits allocated to a spending account, but not
used during the coverage period, must be forfeited.
(5) Separate Accounts-Credits allocated to one account, such as the med-
ical spending account, cannot be used to reimburse other types of
claims, such as dependent care or legal services.
Funding
Flexible compensation plans and reimbursement accounts may be
funded by employer contributions, employee contributions or both.
As mentioned, some plans utilize salary reduction, which enables
employees to use pretax dollars to pay for additional benefits. Through
this approach, employees and employers share the costs of providing
for employees' health, welfare and retirement protection.
3The proposed regulations allow a prospective change of elections in connection with
certain family status changes.
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Establishing a Flexible Compensation Plan
A common method for establishing a flexible compensation plan
is to reduce the employer's existing benefit package to a core of basic
benefits. All or part of the cost difference between the original package
and the core benefits is converted into benefit credits. Each employee
then receives a share of the credits and may use them to pay for a
second tier of coverage or convert them to cash. Alternatively, the
employer may retain present benefit coverage as the core and grant
a supplemental allowance to provide for benefit credits. This method
is more costly than the first, but it is viable when employers are
willing to allocate additional resources to employee benefits.
Benefit Taxation
IRS once took the position that employees would be taxed on the
value of all taxable benefits available under a flexible compensation
plan, whether or not the employee in fact elected the taxable benefits.
The Revenue Act of 1978, however, changed this. Section 125 of the
IRC now states:
...no amount shall be included in the gross income of a participant
in a cafeteria plan solely because, under the plan, the participant
may choose among the benefits of the plan.
Employers can now offer flexible compensation plans, which include
cash and statutory nontaxable benefits. Similar to other tax-qualified
plans, with regard to participation, contributions and benefits, flex-
ible compensation plans cannot discriminate in favor of shareholders,
officers and highly paid employees .4 When an employee selects a
taxable benefit, its cost is included in his or her taxable income in the
year the benefit is received.
The Tax Reform Act of 1986 (TRA) changes certain aspects of flex-
ible compensation plans, generally effective for the later of (1) plan
years beginning after December 31, 1987, or (2) the earlier of plan
years beginning at least three months following the issuance of Trea-
sury regulations or after December 31, 1988.
4A numerical discrimination test, added by the Deficit Reduction Act of 1984, may be
particularly troublesome to small plans. Under this test, the value of nontaxable
benefits selected by certain officers and shareholders cannot exceed 25 percent of the
value of benefits selected by all employees under the plan. Also, TRA changed the
definition of highly compensated employees (see chapter IV).
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Under TRA, each type of benefit available under a cafeteria plan
is subject to its own applicable nondiscrimination rules and to any
applicable concentration test (such a test compares the benefit amounts
of the highly compensated employees with the benefit amounts of the
remaining employees). If a cafeteria plan is discriminatory, highly
compensated employees are taxed on all benefits received. Also, salary
reduction under cafeteria plans is excluded from Social Security (FICA)
and unemployment (FUTA) taxes, unless it flows to a 401(k) plan.
Advantages of Flexible Compensation
Flexible compensation plans offer employees and employers a num-
ber of advantages:
(1) Employees may receive more benefit value, because employers provide
a benefit program that is tailored to each employee's needs. Employees
can change benefits as their lives change (e.g., when they marry or
divorce, as their salaries increase or as their children mature and leave
home).
(2) Employees become more aware and appreciative of their benefits. This
may improve employee morale and productivity.
(3) Employees may become more involved in controlling benefit costs.
Additionally, when employees want a new benefit, they are asked to
trade off another benefit, rather than look to their employer to provide
more.
(4) Flexible compensation plans can be used to convert workers' earnings
into tax-free employee benefits, thereby producing a more valuable
compensation dollar.
Flexible compensation plans also present potential disadvantages
to employees and employers. Most of these can be minimized, how-
ever, by careful planning:
(1) Some employees may not understand their choices well enough to
choose the most needed benefits; thus, families could suffer from losses
in areas where they did not select adequate coverage. This problem
can be addressed, in part, by a mandatory core program that assures
basic protection and also by an effective communications program.
(2) Effective employee benefit communication is always important, but it
is critical in a flexible compensation plan. To assure that employees
fully understand their plan and options, as well as their savings and
consumption needs, the following techniques can be used:
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(a) an advance survey to determine whether employees are receptive
to flexible compensation-the survey can also be used to identify
the benefits employees most need and want;
(b) a letter to employees' homes announcing the adoption of a flexible
compensation plan;
(c) articles in company newsletters;
(d) a booklet describing the plan's primary features;
(e) meetings where benefit professionals explain the plan using slide
or video presentations, workbooks and enrollment materials-a
question and answer period may be helpful;
(f) a telephone hotline, when benefit elections are made, to answer
employee questions;
(g) after benefit elections are made, a personalized statement deline-
ating each employee's individual elections;
(h) an election-screening process, whereby suspect choices may be re-
viewed with the employee.
(3) Flexible compensation requires substantial advance planning. Em-
ployers must make a number of basic decisions. The most basic one is
"How much do I want to spend and how can I maximize employee
satisfaction or minimize employee dissatisfaction while limiting costs
to that figure?" For example: (a) How will the present benefit package
be converted into a new flexible plan? (b) Will a core of benefits be
provided? (c) What benefits will be optional? (d) What value will be
placed on each option? (e) Will the employer provide supplemental
money to expand current benefit coverage? (f) How can adverse selec-
tion (i.e., those with the highest risks select the greatest protection) be
anticipated and minimized? (g) How often will employees be permitted
to change elections?
(4) Flexible plans may result in increased utilization and adverse selection.
Increased utilization and adverse selection can cause problems with
group insurance underwriting requirements and may result in higher
benefit costs. Plan features can be added to minimize adverse selection;
for example, limits can be placed on coverage levels and the frequency
of election periods.
(5) Greater benefit flexibility is likely to result in greater administrative
complexity and costs. To some extent, administrative costs can be
controlled by restricting employee options and the frequency of benefit
election periods. These restrictions, however, limit the amount of flex-
ibility under the plan. A number of packaged computer systems for
handling enrollment, benefit payment and record keeping, however,
are now available. Where appropriate, these systems can reduce the
time and costs of implementing flexible compensation plans.
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Conclusion
Flexible compensation programs are attracting the interests of em-
ployees and employers. Although the BLS survey data show that the
extent of flexible compensation plans is now limited, prospects for
the future seem favorable. For example, the benefits consulting firm
A.S. Hansen (now part of William M. Mercer-Meidinger-Hansen) found
in their 1986 survey of 824 employers in 7 major U.S. demographic
centers that 24 percent of the employers surveyed offered flexible
benefits in 1986, and 35 percent of the survey respondents without
such programs were seriously considering them.5 The opinion of ex-
perts in the field is that tax reform legitimizes these programs, and
therefore more companies are expected to offer them.
Additional Information
Charles D. Spencer & Associates, Inc.
222 West Adams Street
Chicago, IL 60606
Employers Council on Flexible Compensation
1660 L Street, NW
Suite 715
Washington, DC 20036
Hewitt Associates. Survey of Flexible Compensation Programs and Practices.
Lincolnshire, IL: Hewitt Associates, 1985.
Towers, Perrin, Forster & Crosby. Flexible Benefit Programs: A Comprehensive
Look at Flexible Spending Accounts and Broad-Based Plans. New York, NY:
TPF&C, 1985.
U.S. Department of Health and Human Services. Office of the Assistant Sec-
retary for Planning and Evaluation. A Study of Cafeteria Plans and Flexible
Spending Accounts. Washington, D.C. U.S. Department of Health and Hu-
man Services, 1985.
5A.S. Hansen, Inc. Instant Survey National Results. Deerfield, IL: AS. Hansen, Inc., Fall
Planning Conference, 1986.
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XXXII. Guidance on Evaluating an
Employee Benefit Package
Introduction
Employee benefits make up a sizable portion of total compensation,
and it is important not to overlook their worth. If an employee accepts
a higher paying job and pays more expenses out-of-pocket to duplicate
benefits at a prior job, the employee may not gain anything at all.
Only by understanding which benefits are provided and how each
benefit works can an employee utilize the full value of a benefit pack-
age. Just because a particular benefit fails to meet an employee's
needs, that does not mean the entire package is without value. It is
important to focus on the whole benefit package and not only on its
individual parts.
What to Expect
Employers offer a wide variety of benefits. Some are legally re-
quired, and some are offered voluntarily. Legally required benefits
include Social Security, Medicare, unemployment insurance, and
workers' compensation.
Additional benefits offered voluntarily by employers will vary. U.S.
Department of Labor statistics show that among full-time workers
'in medium and large firms in 1986, 9 in 10 participated in medical
plans, group term life insurance, short-term disability insurance, and
pension plans. Seven in 10 participated in dental plans and were
eligible for educational assistance; 4 in 10 used long-term disability
benefits; 3 in 10 used vision care coverage; and 3 in 10 participated
in 401(k) plans. Fewer than 1 in 10 were eligible to participate in
cafeteria plans, group legal services or dependent care.
The levels of benefits vary by industry and within industries. Hewitt
Associates estimates that employer-provided, voluntary retirement,
insurance and retiree benefits received by employees of the Fortune
500 Industrials ranged from 10.7 percent of pay to 34.4 percent of
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pay in 1985.' The average value of these benefits was 22.3 percent of
pay (table 1).
Part-time employees and those working for small employers often
get fewer benefits. Generally, benefits legally required for full-time
workers are also required for part-time workers. The voluntary ben-
efits that employers offer vary considerably more. In general, the
more hours worked and the longer the years of service, the greater
the likelihood of earning benefits voluntarily provided by employers.
Working 30 hours a week or more tends to increase employee benefit
coverage for major benefits like medical insurance, life insurance and
paid leave. Those working less than half time (i.e., under 17'/z hours
per week under the new tax reform nondiscrimination rules) are not
generally provided with these voluntary benefits because of benefit
costs.
Evaluating an employee benefit package requires detailed knowl-
edge of the benefits offered and a clear understanding of personal
and family situations. A good way to start is by reading the preceding
chapters for basic explanations of various benefits. Also, any private-
sector employer must automatically provide a summary description
of most types of benefit plans. More detail is usually available from
the plan administrator upon request.
General factors to consider when evaluating a benefit package in-
clude family composition, career plans, age and the tax treatment of
the benefits. An employee with a family should check which benefits
cover dependents, since employers are not required to offer dependent
coverage. Benefits specifically for dependent care can also be impor-
tant to look for when considering the value of a benefit package.
Benefit coverage sometimes overlaps in families where more than
one person is in the work force. To make the most efficient use of
benefits, employees should be aware of when and how they are cov-
ered under another family member's benefit plan. Knowing how a
plan's coverage works is especially relevant when an employee par-
ticipates in a flexible benefit plan and can choose from a variety of
benefits 2 For example, if covered under a spouse's medical plan, an
employee may want to choose a less-generous medical benefit under
'See Employee Benefit Research Institute, "Employer Outlays for Benefits Rise," Em-
ployee Benefit Notes (May 1986).
2For more information on flexible benefit plans, see chapter XXXI.
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his or her own plan and take cash or another benefit instead. Bal-
ancing employee benefits in this way maximizes the value of an em-
ployee benefit package.
The value of a benefit package varies with career plans and age.
For employees who plan to change jobs frequently-often younger
employees-shorter vesting requirements for their pension plans and
waiting periods for other benefits are important. Older workers may
prefer defined benefit retirement plans, which allow a more rapid
accrual of benefits, and health plans that will continue coverage dur-
ing retirement. In addition, older workers are more likely than youn-
ger workers to make large contributions to a pension or savings plan
to finance their approaching retirement.
The value of a benefit can be enhanced by its tax treatment. Some
benefits are taxed as ordinary income, whereas others are tax-de-
ferred or tax-exempt.3
To keep up with changes in individual circumstances, an employee
benefit package should be evaluated periodically. Most employers
allow certain changes in plan choice at specified intervals or events.
More frequent evaluations of a benefit package are necessary if an
employee has had a change in position, employer, family status or
retirement planning.
Pension Plans
An employer-sponsored pension is probably the largest single ben-
efit an employee may get in terms of the percentage of a worker's
total compensation that goes into the plan. Almost all workers will
qualify for Social Security benefits, but Social Security only provides
a minimum floor of protection-a foundation on which to build. Most
people want more than a minimum income when they retire. They
want to continue in the lifestyle they were accustomed to during their
working years. An employer-sponsored pension plan can make the
difference between a "bare-bones" retirement lifestyle and a com-
fortable one.
The first step in evaluating a pension plan is to understand how it
works. Employees should obtain a copy of the Summary Plan De-
scription available from the employer or plan administrator. It will
explain what must be done to be eligible to participate in the plan,
when a benefit becomes irrevocable (vested), what the benefit will
be, and at what ages employees may claim benefits. Employees also
3See specific chapters for tax treatment of various benefits.
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need to know what adjustments in their pension benefits or contri-
butions will occur because of their Social Security coverage .4
Most pension plans also offer other benefits in the event the worker
dies or becomes disabled. Employees should inquire which of these
may be available.
Broadly speaking, there are two general types of pension plans:
defined contribution plans and defined benefit plans.5 It is important
to understand the differences. In a defined contribution plan, the
worker bears the risk and the reward of his or her investment deci-
sions; poor investments can result in less than adequate retirement
income. Defined benefit plans, on the other hand, leave the risk and
reward of investment decisions with the employer, not with the in-
dividual.
Defined contributions are often more popular with employees, be-
cause these plans have an individual account that the worker can see
accumulate each year. But defined contribution plans, as valuable as
they are, may not necessarily be the best pension plan, depending on
a worker's age, previous work and future years of service before re-
tirement. Many employers offer both types of plans.
The tax status of the pension plan is also quite valuable. Qualified
plans-those complying with IRS regulations-allow employer con-
tributions and some types of employee contributions to accumulate
tax free until the benefit is paid to the worker. The Tax Reform Act
of 1986 adds a penalty to lump-sum withdrawals made before age 59
1/2, with some exceptions, to encourage workers to save adequate
benefits for retirement rather than spend them along the way. Early
retirement at age 55 is one such exception. Favorable tax treatment
of a pension benefit can have a major effect on the final benefit re-
ceived in retirement, so employees should keep abreast of any tax
changes and make appropriate adjustments to finance their retire-
ment.
Health Plans
With today's high health care costs, an employer-sponsored health
plan is probably the employee benefit most valued by workers and
their families. Without some form of health care coverage, a hospital
stay or prolonged illness could financially devastate a family.
'For more information on integrating pension plans with Social Security, see chapter
VII.
'The differences between defined benefit and defined contribution plans are discussed
in chapter VI.
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To evaluate a health plan, it is important to understand how it
works. A description of the employer's health plan usually provides
information on what an employee must do to qualify as a plan par-
ticipant, which expenses are covered, how the plan is financed and
how participation in other health plans could limit an employee's
participation or range of benefit choice.
Generally, there are two types of health plans offered by an em-
ployer: prepaid plans, such as health maintenance organizations; and
fee-for-service plans .6 Increasingly, employer plans are adopting
"managed care" approaches for their fee-for-service plans, in an effort
to help workers seek low-cost, high-quality health care. Managed care
approaches include design features whereby medical services per-
sonnel help the patient review health care options and select from a
variety of medical care choices and providers.
When choosing health care coverage, employees should take their
particular needs and preferences into consideration. Those with fam-
ilies making frequent medical and dental visits may prefer a prepaid
plan, where costs are limited regardless of the number of visits or
services needed. Some employees and their dependents may have or
develop medical conditions requiring specific services, and they may
want to keep or choose their own doctors. Employees have always
been able to choose their own physicians under fee-for-service plans,
and this is now becoming an option under some prepaid plans as
well.
After thoroughly analyzing individual needs and requirements, em-
ployees should take a close look at their existing coverage. When
evaluating a health plan, employees should consider these key items:
the range of benefits, the accessibility of the care, the cost of pre-
miums, the amounts of deductibles and copayments, and the limits
on out-of-pocket expenses for catastrophic illness. Different proce-
dures may be covered at the doctor's office than at the hospital, and
the amounts of deductibles and copayments may vary, depending on
the type of service or the provider. Also important are the attitude
and accountability of the medical staff, the facilities, the review pro-
cedures to monitor physicians' performances and adhere to standards
for quality of care, and the time spent waiting for appointments.
Employees should also understand what procedures need to be fol-
lowed in an emergency.
Employers with health insurance plans must offer continued access
to group health coverage, at the recipient's expense (limited to 102
6The various health care plans are explained in detail in chapters XVII, XIX and XX.
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percent of the premium), to workers and their dependents, who might
otherwise lose coverage because of changes in employment or family
status. Also, a firm's filing for chapter 11 bankruptcy qualifies retirees
and their dependents for continued access to their group health cov-
erage at their own expense-limited to 102 percent of the premium.
Companies with fewer than 20 employees are exempt from these
continued access requirements.
Understanding a health plan could mean the difference between
adequate and inadequate medical care. Employees should know their
options and regularly evaluate how their plan is meeting their in-
dividual and family needs.
Disability
Sudden injury or illness can leave an employee unable to work and
cause serious financial troubles for individuals and families. Dis-
ability income plans are intended to prevent this. Some areas to
consider are the types of disability provided, the extent and length
of coverage and the cost of various levels of benefits.
Disability plans are categorized as short-term disability and long-
term disability.? In short-term disability plans, benefit payments are
usually provided for twenty-six weeks or less. Workers may receive
paid sick leave, which usually provides 100 percent of a worker's
normal earnings, or sickness and accident insurance, which usually
provides 50 to 67 percent of normal earnings. In long-term disability
plans, benefit payments are usually provided after short-term benefits
have ended. They usually provide one-half to two-thirds of an em-
ployee's predisability gross earnings, although some plans may re-
place as much as 70 to 80 percent of predisability pay.
Employees should learn the specific definition of disability under
their plans and be aware of the conditions under which the definition
may change. One question to ask is whether the disability insurance
covers the employee in his or her own occupation, regardless of whether
the employee can get paid work in another occupation. To qualify
for disability under Social Security, which provides only long-term
disability benefits, an employee must be unable to do virtually any
paid work. Employees should also be aware of when successive pe-
riods of disability are considered separate disabilities or the same
disability, since this could substantially affect how long benefits are
provided.
7For more information on disability, see chapter XXVII.
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Employers recognize all sources of disability income when calcu-
lating a benefit, and there are usually provisions regarding the in-
tegration of an employer's voluntary disability benefits with those
required by law. Employers are legally required to contribute to
workers' compensation and to Social Security. Some states also re-
quire employer payments to nonoccupational temporary disability
insurance.
The level of benefits an employer pays is often related to each
employee's salary, so a disability benefit may increase in value as an
employee gains experience or improves position. Some plans also
make cost-of-living adjustments.
The length of time that benefits continue also varies. It may increase
with service. There is no upper age limit on eligibility for disability
benefits for active employees. The level and/or duration of disability
benefits may be reduced for older employees, based on age-related
cost considerations provided that older workers do not receive less
in benefits than that which is provided to younger employees.
Another important consideration is whether payments for partial
disability are available. This covers employees who continue to work
at their own occupation, but at a reduced capacity. Some plans re-
quire the employee to be totally disabled for a certain period of time
to become eligible for partial disability benefits. Other plans require
a certain percentage of income loss to have occurred before a worker
can qualify. Employees generally experience about a 25 percent de-
cline in income before qualifying for partial disability.
Employees should also understand what portion of the disability
premium is paid by the employer and what portion by the employee.
One way to reduce employee costs is to choose a longer waiting period
before disability payments commence. Social Security has a waiting
period of five full months from the date of onset before the individual
can begin to receive disability benefits. Private plans generally have
a waiting period before long-term benefits are paid.
Understanding the disability benefits can be one of the most im-
portant things to do in evaluating a whole benefit package.
Group Term Life Insurance
Employers often provide group term life insurance benefits for their
employees. Life insurance benefits can make a big difference in the
financial stability of an employee's survivors.
When evaluating a group life insurance plan, employees should
consider the eligibility requirements, the levels and extent of cover-
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age, the cost of premiums and what portion, if any, employees must
pay.
Group term life insurance is generally intended to replace a portion
of the deceased employee's earnings for a period of time. It is pure
insurance protection, paying a benefit to the beneficiaries only at the
employee's death.
Eligibility to participate in a life insurance plan is generally granted
after an employee has worked a designated length of time-usually
no more than a few months. Coverage may also be available for de-
pendents. They are often entitled to a lower level of coverage, usually
at an additional cost, and their coverage may last only for a specified
amount of time, usually based on their age.
When employees participate in their employer's life insurance plan,
they must designate primary beneficiaries. Contingent beneficiaries
are often overlooked and should also be designated. Employees should
find out how often the beneficiaries can be changed and keep the
beneficiary designations up to date.
The amount of life insurance coverage received is often a multiple
of an employee's annual earnings, so it varies for each employee.
Additional benefits for accidental death and dismemberment insur-
ance may be also included in a life insurance plan. Also, some plans
continue life insurance protection in the event an employee becomes
totally and permanently disabled and in the event of retirement (usu-
ally at a substantially reduced level). Employees need to find out
under what circumstances such coverage continues-and at what
cost to them.
Employees should also determine how much life insurance they
need. The cost of monthly premiums varies, and the cost may be
split between the employer and employee. In plans where employ-
ees pay all or part of the cost, the premium is often a flat amount
for each covered employee, regardless of age. Also, supplemental
insurance plans are sometimes available. Employees usually pay
for this additional coverage. Workers should be aware of how often
and under what conditions supplemental insurance can be pur-
chased.
Also important to check is whether the group insurance can be
converted to an individual insurance policy if an employee leaves the
company or retires. Workers should also be aware of the conditions
under which their employer can cancel the group policy, and what
their options are if the insurance carrier cancels their employer's
policy.
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Dental and Vision Care Plans
Proper dental care and vision care are important to the prevention
and treatment of potentially serious health problems, and growing
numbers of employers are providing benefits for this care.
When evaluating dental and vision care plans, employees should
consider eligibility requirements, services covered, the availability
of dependent coverage and the existence of copayments and deduct-
ibles.
According to Small Business Report,8 dental care is the fastest grow-
ing employee benefit,-with approximately one-third of the population
covered by dental plans in 1986. Industry experts project that over
60 percent will have some form of coverage by 1990. Dental coverage
is increasing among companies of all sizes. Small Business Report says
that two-thirds of large businesses, 40 percent of midsize companies
and 35 percent of smaller firms offer dental plans. In comparison,
vision care plans have experienced slower growth.
Eligibility to participate in these plans is usually granted imme-
diately or after a short waiting period.
Employees should consider whether specific procedures they an-
ticipate needing will be covered by their dental and vision care plans.
Coverage for certain services may be limited to the employee only or
may be less for dependents. Coverage may also be limited to a certain
number of services. For example, in a vision care plan, a participant
may only be covered for the cost of a designated number of glasses
or contact lenses. In a dental care plan, the amount of coverage may
vary by the type of treatment. Treatment and preventive services
may also get different amounts of coverage. Employees should be
aware of the amounts of deductibles and copayments and of how
often deductibles must be satisfied (e.g., once annually).
Conclusion
Today's workers often take their benefit packages for granted, but
unmet needs, rising costs, and retirement planning have forced em-
ployees to take a closer look at what they have and to take more
responsibility for providing what they need. The importance of var-
ious benefits depends on individual needs and preferences. When
evaluating the value of their benefits, however, employees should look
'See "Dental Coverage, Fastest Growing Employee Benefit," Small Business Report
(October 1986): 44-47.
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at their total benefit package, not merely the separate parts. To get
the most from their employee benefits, workers must take the time
to understand their options.
Additional Information
Employee Benefit Research Institute. "Employer-Sponsored Health Insur-
ance Coverage." EBRI Issue Brief 58 (September 1986).
. "Retirement Income and Individual Retirement Accounts." EBRI
Issue Brief 52 (March 1986).
. "Tax Reform and Employee Benefits." EBRI Issue Brief 59 (October
1986).
. "Women, Families and Pensions." EBRI Issue Brief 49 (December
1985).
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Index
A. S. Hansen
flexible compensation survey,
280
Actual deferral percentage (ADP),
113-114
American Society for Training and
Development tuition assis-
tance program participation,
248
Annuities
as distributions of
-defined contribution plans, 71
-individual retirement
accounts, 141
-Keogh plans, 156
-profit sharing plans, 92, 93, 94
death benefits and, 50-51
under ERISA, 33-34
Arizona v. Marioopa County
Medical Society, 204
B
"Benefit banks," 276
Blue Cross/Blue Shield plans see
under Health insurance
Break-in-service rules, 33
C
Cafeteria plans see Flexible com-
pensation plans
Capital gains
under TRA, 42-43, 73, 93, 240
Career-average formulas, 66
definition, 46-47
Cash balance pension plans, 74
Cash or deferred arrangements
(CODAs), 107-119
administration, 117
advantages, 117-118
cafeteria plans and, 110
collectively bargained
agreements, 112
contributions, 110-111, 115
coverage, 111-114
development of, 11, 107-108
distributions, 111, 114-115,
115-117
investments, 110-111
loans, 117
nondiscrimination rules, 111-
114
participation, 114
profit sharing plans and, 91(n),
109
"stand alone" salary reduction
plans, 109-110
tax treatment, 72-73, 107-108,
115-117
thrift plans and, 101(n), 109
types of, 108-110
vesting, 114
withdrawals, 114-115, 116
Chamber of Commerce of the
United States
benefit survey data, 7, 247-248
Child care programs, 263-272 see
also Parental leave
employer involvement, 264-267
-child care centers, 266
-flexible compensation plans,
267
-flexible personnel policies,
266-267
-information services, 266
-reimbursement accounts, 267
federal programs, 267-268
nondiscrimination rules, 268
outlook, 271-272
tax treatment, 268-269
Class-year vesting
definition, 32(n)
effect of TRA, 49
Cliff vesting, 60
Closed-panel plans
dental care, 208-209
legal services, 257-258
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prescription drugs, 214-215
CMPs see Comprehensive medical
plans
COBRA see Consolidated Omnibus
Budget Reconcilation Act of
1985
CODAs see Cash or deferred ar-
rangements
COLAs see Cost-of-living adjust-
ments
Communication see under Em-
ployee benefits
Compensation
definitions for plan purposes, 47
Comprehensive medical plans
(CMPs), 198
Conference Board, Work and Fam-
ily Information Center
child care data, 264-266
Conference of Small Private
Colleges
tuition assistance survey, 249
Consolidated Omnibus Budget
Reconciliation Act of 1985
(COBRA)
effects on health insurance, 176-
177
Cost-of-living adjustments
pension plans, 47-48, 69-70,
162
under Social Security, 21
Coverage see under Pension plans
D
De minimus rule, 39
Death benefits, 50, 238-240 see
also Survivor benefits
Deferred compensation see Cash or
deferred arrangements
Deficit Reduction Act of 1984
(DEFRA)
cost-of-living adjustments, 29,
47
defaulted education loans, 253-
254
Defined benefit plans, 65-74
administration, 71-72
ancillary benefit provisions, 69
benefit formulas, 46-47, 65,
66-67
-late-age hirings, 71
benefit limits, 28-29, 47
cash balance pension plans, 74
costs, 68
definition, 46-47
distributions, 71
employee attitudes, 70
floor plan, 74
funding standards under ERISA,
34, 52
integration plans
-effects of TRA, 85-86
-excess, 79-82, 85
-offset, 75-78, 85-86
investment risk, 68-69
postretirement increases, 69-70
tax treatment, 72-73
terminations of, 35-40, 53, 72
-benefit limits after, 37
vesting, 71, 162
Defined contribution plans, 65-74
administration, 71-72
ancillary benefit provisions, 69
contributions, 65
-limits, 28-29, 47-48
costs, 68
definition, 46, 65
employee attitudes, 70
integration plans
-effects of TRA, 85
-excess, 82
investment risk, 68
lump-sum distributions, 70, 71
postretirement increases, 69-70
target benefit plans, 74
tax treatment, 72-73
vesting, 71, 162
DEFRA see Deficit Reduction Act
of 1984
Dental care plans, 207-211
benefit limits, 210
coinsurance and copayments,
209-210
deductibles, 209-210
evaluation of, 287-289
payment methods, 208-209, 211
plan design features, 209-210
nondiscrimination rules, 211
services provided, 207-208
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Diagnosis-related groups (DRGs)
see under Medicare
Disability benefits see also Disabil-
ity income plans
benefit accrual and, 50-51
group life insurance and, 231-
232
Disability income plans, 241-246
employer-sponsored, 243-245
-long-term, 244-245
-short-term, 243-244, 269-270
evaluation of, 287-288
Social Security, 241-242
state plans, 242
Workers' compensation, 242
Divorced spouse benefits see also
Qualified domestic relations
orders
under Social Security, 20, 236
DRGs see under Medicare
Drug plans see Prescription drug
plans
E
Early retirement
benefit accrual and, 50
survivor annuities under REA,
51
under multiemployer plans, 61
under Social Security, 21
vesting and, 33
EAPs see Employee assistance pro-
grams
Economic Recovery Tax Act of
1981 (ERTA)
child care benefits and, 268
Educational Assistance Act, 252
Educational assistance benefits,
247-254
employer-provided, 247-249
federal programs, 249-251
State Student Incentive Grant
Program, 252
tax treatment, 252-254
Veterans Administration pro-
grams, 252
Eldercare, 168
Employee assistance programs
(EAPs), 221-223, 225 see also
Health promotion programs
confidentiality, 223
services provided, 222-223
Employee benefits see also specific
benefit
accrual under ERISA, 34
communication of, 13-15
-flexible compensation plans
and,278-279
-health insurance and, 186-
187
-use of computers in, 14
costs of, 7-10
-variation by employee age, 10
-variation by employer, 10
coverage, 6, 281
definition of, 2
development of, I
earnings levels and, 6
evaluation of, 281-291 see also
under specific benefit
effects of tax reform, 11-13
fringe benefits, 2
legally required, 2
new forms, 10-11
nondiscrimination rules see
Nondiscrimination rules
part-time employees, 283
purposes of, 3-4, 13
tax-favored
-growth of, 8-10
-size of, 7-8, 9
tax treatment of, 1-3
trends, 1-15
voluntary, 2
Employee Retirement Income Se-
curity Act of 1974 (ERISA),
27-39
administering agencies, 31
appeals procedure, 35
benefit accrual, 34
benefit limits, 28-29
contribution limits, 28-29
development of, 27-28
effects on Keogh plans, 154
fiduciary standards, 34-35
funding standards, 34
joint and survivor annuities, 33-
34
legal services plans, 260
minimum standards, 31-34
overview, 28-29
participation standards, 31-32
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plan termination insurance, 39
prudent man rule, 34-35
reporting and disclosure
requirements, 29-31
scope, 29
spousal benefits, 33-34, 50-51,
163
summary plan descriptions, 30
Employee stock ownership plans
(ESOPs), 121-127
as corporate financing vehicles,
121, 123
contributions, 122, 123
design, 123-124
distributions, 116, 124-125
investments, 123-124, 126
leveraged, 121-122
participation, 126
repurchase liability, 127
salary reduction and, 123(n)
stock bonus plans, 123
stock valuation, 124
tax treatment, 93, 104, 116,
125-126
-under TRA, 43
types of, 121-122
voting rights, 124
Employees
appeals procedure under ERISA,
35
highly compensated
-effect of tax reform, 12-13,
42-43
Employment
part-time, 266-267, 283
past retirement age, 166
EPOs see Exclusive provider orga-
nizations
Equitable Life Assurance Society
of the United States
health care cost survey, 190
ERISA see Employee Retirement
Income Security Act of 1974
ERTA see Economic Recovery Tax
Act of 1981
ESOPs see Employee stock owner-
ship plans
Excess integration plans, 78-83
effects of TRA, 85
Excise taxes on distributions, 73
in individual retirement ac-
counts, 141, 143, 144
in profit sharing plans, 93-94
Exclusive provider organizations
(EPOs), 202
Families
changesin,263-264
Federal employees see also Public
employees
coverage under Medicare, 22
coverage under Social Security,
18-19, 163
retirement programs, 163-164
Fiduciaries
definition, 34
liabilities, 35
responsibilities, 34-35, 52
Final-pay formulas, 66
definition, 46
Flat-benefit excess plans, 79
Flat-benefit formulas, 66
definition, 46
Flexible compensation plans, 273-
280
advantages and disadvantages,
278-279
benefit alternatives, 274-275
cash or deferred arrangements
and, 109-110
communication of benefits, 278-
279
development of, 273-274
establishment of, 277
funding, 276
nondiscrimination rules, 277
reasons for growth, 11
reimbursement accounts, 188-
189,267,275-276
tax treatment, 277-278
Flexible spending accounts see
Flexible compensation plans-
reimbursement
Floor plan, 74
Food stamp program, 166
Forward income averaging
cash or deferred arrangements,
116-117
death benefits, 240
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individual retirement accounts,
143
Keogh plans, 157
profit sharing plans, 93
tax-sheltered annuities, 133
under TRA, 43, 73
401(k) arrangements see Cash or
deferred arrangements
(CODAs)
403(b) plans see Tax-sheltered
annuities
457 plans, 43
Fringe benefits see under Em-
ployee benefits
G
"Gatekeeper" physician, 205
Government employees see Fed-
eral employees; Public em-
ployees
Graded 15-year service rule
definition, 32
Group Life and Health Insurance
Company v. Royal Drug Com-
pany, 204
Group life insurance plans, 227-
234
contract terms, 228
conversion of, 231
coverage levels, 230
dependent coverage, 230-231
development of, 227
disability benefits, 231-232
employee costs, 230
evaluation of, 288-289
nondiscrimination rules, 228-
230
plan provisions, 228-232
tax treatment, 232, 233, 238
universal life, 233
Group universal life programs
(GULPs), 233
GULPs see Group universal life
programs
H
H.R. 10 plans see Keogh plans
Health care see also Long-term
care
preventive, 167, 193
Health care costs, 225
effect of employee age, 10
growth of, 185
management of, 185-192
-effectiveness of measures, 190
-employee incentives, 185,
186-187
-flexible benefit plans and,
186, 188-189
-restricting benefits use, 187-
188
Health insurance, 175-184 see also
Retiree health benefits; spe-
cific plan
adverse selection, 189
basic plans, 179-180
benefit payment plans
-postpaid, 178
-prepaid, 178
Blue Cross/Blue Shield plans,
177-178
coinsurance and copayments,
179, 185, 186, 190 see also spe-
cific benefit
communication of benefits, 186-
187
costs of, 5, 9-10
-management of, 185-190
coverage, 5-6
-continuation of, 176-177
-"first dollar," 187
-levels of, 179-181
deductibles, 179, 185, 187, 190
see also specific benefit
development of, 175-176
employer contributions, 9-10
evaluation of, 285-287
major medical plans, 180-181
maximum benefit levels, 179
nondiscrimination rules, 181-
183
plan operators, 177-178
reimbursement accounts, 3,
188-189, 275
retirement planning considera-
tions, 167-168
same-day surgery, 188
second-opinion programs, 188
self-funded plans, 177-178, 202,
204
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tax treatment, 6
usual, customary and reasona-
ble fees, 178, 208
utilization reviews, 187, 203-
204
Health Maintenance Organization
Act of 1973, 195-197
Health maintenance organizations
(HMOs), 193-199
collective bargaining agree-
ments, 196(n)
cost containment and, 193-194,
198
dual choice option, 196-197
growth of, 193, 197
legislative and regulatory re-
quirements, 195-198
organization of, 193-194
PPOs and, 203
rate requirements, 197
retirement planning considera-
tions, 168
services provided, 195
types, 194-195
Health promotion programs, 221,
223-225 see also Employee as-
sistance programs
types, 223-224
Health Research Institute
EAP survey, 222
Hewitt Associates
benefit costs surveys, 190, 281-
283
HMOs see Health maintenance or-
ganizations
Homeownership
as source of retirement income,
165
Hospital Insurance (HI) see Medi-
care
Housing
retirement planning considera-
tions, 168-169
development of, 137
distributions, 141-142
eligibility requirements, 137-
139
employer-sponsored plans, 141,
142
investments, 144-145
participation in, 6
retirement planning considera-
tions, 164-165
rollovers, 42, 138, 142, 149, 240
tax treatment, 138-139, 141,
142-144, 164
Integration see under Pension
plans; Social Security; spe-
cific plan
Investment savings plans see
Thrift plans
IPAs see Individual practice asso-
ciations
IRAs see Individual retirement ac-
counts
K
Kelso, Louis 0., 121
Keogh, Eugene J., 154
Keogh plans, 153-158 see also
Simplified employee pensions
contributions and benefits, 154,
155-156, 164-165
development of, 153-155
distributions, 156-157, 164-165
eligibility, 155
nondiscrimination rules, 156
participation survey, 158
retirement planning considera-
tions, 164-165
rollovers, 157
tax treatment, 154-155, 156,
157
Key employees
definition, 29
top-heavy plans, 85
I
Individual practice associations
(IPAs), 194-195
Individual retirement accounts
(IRAs), 29, 137-147
contribution limits, 139-140
L
Legal services plans, 255-261
nondiscrimination rules, 260
participation, 260
payment methods, 256-258
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services provided, 256, 258-259
tax treatment, 255-256, 259-
260
Life insurance see also Group life
insurance plans
retirement planning considera-
tions, 166, 231
Loans from employer plans see
under specific plan
Long, Russell, 121
Long-term care
retirement planning considera-
tions, 168
Lump-sum distributions, 70, 162
cash or deferred arrangements
and,116-117
death benefits, 240
individual retirement accounts
and, 42, 142, 143
Keogh plans and, 156-157
profit sharing plans and, 92, 93,
94
tax-sheltered annuities and, 133
under TRA, 42-43, 73
premium rates, 36
Multiemployer plans, 55-64
administration of, 58-59, 62
advantages, 61-63
assets, 57
characteristics, 55-58
contributions, 60
coverage, 56, 63
definition, 55
development of, 55
employment restrictions after
retirement, 61
funding, 58
investment performance, 57-58
nonnegotiated plans, 63
PBGC and, 36-40
pension benefits, 60
-limits after termination, 37
portability, 60, 62
reciprocity agreement, 60
retirement age, 60-61
vesting under TRA, 33, 60
withdrawal from, 38-40
-de minimus rule, 39
M
Maternity leave see under Parental
leave
Medicaid, 168
Medicare
CMPs under TEFRA, 198
costs of, 5
diagnosis-related groups, 190-
191
HMOs under TEFRA, 198
Hospital Insurance (HI), 22, 167
retirement planning considera-
tions, 167-168
Supplementary Medical Insur-
ance (SMI), 22, 24
Medicare supplement insurance,
167
Medigap insurance see Medicare
supplement insurance
Military Retirement System, 164
Money-purchase pension plans, 67
distributions, 70
Multiemployer Pension Plan
Amendments Act of 1980
(MPPAA)
N
National Association of Employers
on Health Care Alternatives
HMO survey, 193
National Institue for Work and
Learning
educational assistance programs
participation, 248
Negotiated provider agreements
(NPAs), 202
Nondiscrimination rules, 44-46
cash or deferred arrangements,
111-114
child care benefits, 268
dental care plans, 211
flexible compensation plans, 277
group life insurance plans, 228-
230
health insurance plans, 181-183
Keogh plans, 156
legal services plans, 260
profit sharing plans, 89-90
simplified employee pensions,
149-150
tax-sheltered annuities, 130
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vision care plans, 219
Nonprofit organizations
employee coverage under Social
Security, 18-19
NPAs see Negotiated provider
agreements
Nursing home insurance, 168
0
OBRA see Omnibus Budget Recon-
ciliation Act of 1986
Offset integration plans, 75-78
effects of TRA, 85
Old-Age, Survivors and Disability
Insurance (OASDI) see Social
Security
Omnibus Budget Reconciliation
Act of 1986 (OBRA)
effects on retiree health benefits,
176-177
Open-panel plans
legal services, 257
prescription drugs, 214
P
Parental leave, 269-271
adoption benefits, 271
maternity, 269-270
paternity, 270-271
Participation see under Pension
plans; specific plan
Pay see Compensation
Payroll-based stock ownership
plans (PAYSOPs), 122
PBGC see Pension Benefit Guar-
anty Corporation
Peer review organizations (PROs),
187
Pension Benefit Guaranty Corpo-
ration (PBGC)
plan termination insurance, 35-
40, 53-54
premiums, 36
responsibilities under ERISA,
31, 35-36
Pension plans, 41-54 see also
specific plan
administration, 51-52
appeals procedure, 35
benefits accrual
-definition, 50
-standards under ERISA, 34
benefits paid out, 5
coverage, 44-46
-effects of TRA, 44-46
-statistics, 5
design, 43-51
development of, 41
distributions, 50-51, 162
-exceptions to penalties, 93,
104, 116, 133
-under TRA, 43
employer contributions to, 5, 8-
9
evaluation of, 284-285
funding of, 34, 52-53
integration, 48, 75-86
-adjustments, 83
-effects of TRA, 85-86
-excess plans, 78-83, 95
-maximum levels, 78-79
-offset plans, 75-78
-top-heavy plans and, 85
loans, 49-50
nondiscrimination rules, 44-46
nonqualified, 43
participation
-growth, 5
-standards under ERISA, 31-
32
-standards under TRA, 49
portability, 60
qualification under internal
Revenue Code, 41-44
recipiency rate, 5
reporting and disclosure re-
quirements, 29-31
retirement planning considera-
tions, 162-163
tax incentives, 5
tax treatment, 42-43
terminations of, 35-40, 53-54
-benefit limits after, 37
vesting see Vesting
Pension Reform Act see Employee
Retirement Income Security
Act of 1974
PPOs see Preferred provider
organizations
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Preferred provider organizations
(PPOs), 188, 201-205
cost containment measures,
203-204,204-205
employee incentives, 201
HMOs and, 203
legal status, 204
organization, 201
types, 202-203
utilization reviews, 203-204
Pregnancy Discrimination Act of
1978, 269-270
Prescription drug plans, 213-216
payment methods, 214-215
services provided, 213-214
Profit sharing plans, 67, 87-97
cash or deferred arrangements
and, 109
collectively bargained agree-
ments, 89
contributions
-employee, 91
-employer, 89-91
coverage, 87, 89
design, 88-89
development of, 87
distributions, 70, 92-94
integration, 90, 95-96
investments, 92
loans, 94
nondiscrimination rules, 89-90,
91, 96
participation, 88-89
rollovers, 94
salary reduction and, 91(n)
tax treatment, 93-95
types of, 88, 96
vesting, 88-89
withdrawals, 92, 93
Prospective payment system see
Medicare-Diagnosis-related
groups
Prudent man rule, 34-35
Public employees see also Federal
employees
coverage under Medicare, 22
coverage under Social Security,
18-19
Public welfare programs, 166-167
Q
Qualified domestic relations order
(QDRO)
distribution of pension benefits,
43, 50, 93, 104, 116
tax treatment under TRA, 43
Quarterly Pension Investment
Report (QPIR), 57-58
R
Reimbursement accounts see un-
der Flexible compensation
plans; Health insurance
Retiree health benefits
bankruptcy and continuation of,
177
coverage, 181
Retirement
attitudes toward, 159
Retirement age
benefit accrual past age 65, 51
employment past, 166
under multiemployer plans, 60-
61
under Social Security, 20-21
Retirement Equity Act of 1984
(REA)
break-in-service rules, 33
participation standards, 31-32
survivor benefits, 33, 163
Retirement income security
advantages of defined benefit
plans, 66, 67
Retirement planning, 159-173
attitudes toward, 159
employer programs, 170-173
estate planning, 170
financial planning, 160-167
health care and, 167-168
interpersonal relationships, 170
lack of, 13
leisure time, 169-170
living arrangements, 168-169
savings formulas, 161
Revenue Act of 1978, 277
Reverse mortgages (RM), 165
"Rule of 45"
definition, 32
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S
Salary see Compensation
Salary reduction plans see Cash or
deferred arrangements
Savings
amounts needed for retirement,
161
pensions as source of, 7
Savings plans see Thrift plans
Self-employed
retirement plans see Keogh
plans; Simplified employee
pensions
Social Security taxes, 23-24
Self-Employed Individuals Tax
Retirement Act of 1962, 153-
154
Separate contract rule, 94
SEPs see Simplified employee
pensions
Simplified employee pensions
(SEPs), 147-152 see also
Keogh plans
administration, 151-152
contributions
-employee, 149-150
-employer, 148-149
design, 151-152
development of, 147-148
distributions, 150
integration, 151
investments, 151
nondiscrimination rules, 149-
150
participation, 148
tax treatment, 150
vesting, 149, 152
Small business
effects of tax reform, 12-13
multiemployer plans and, 62
pension plan coverage, 152
simplified employee pensions
and, 147-148, 152
Social Security, 17-25 see also
Medicare
benefits, 19-20
-formula, 21
-paid out, 5, 22
-taxation of, 21
cost-of-living adjustments, 21
coverage, 5, 18-19, 161, 162
definition, 17-18
disability benefits, 241-242
earnings test, 166
eligibility, 20
food stamp program, 167
funding, 23-24
integration, 48, 75-86
-adjustments, 83
-effects of TRA, 85-86
-excess plans, 78-83, 95
-maximum levels, 78-79
-offset plans, 75-78
-top-heavy plans and, 85
outlook, 24-25
payroll taxes, 23-24
-cash or deferred arrangements
and, 115
-flexible compensation plans,
278
-simplified employee pensions,
150
replacement rates, 76-78, 80-
81, 84
retirement age, 20-21
retirement planning considera-
tions, 160-161, 162
Supplemental Security Income
(SSI), 166-167
survivor benefits, 20, 235-237
see also Survivor benefits
vesting, 160, 162
Social Security Amendments of
1983
cash or deferred arrangements
and, 115
coverage changes, 19
retirement age changes, 20-21
tax rate changes, 23-24
Spousal benefits see Survivor ben-
efits
Step-rate excess plans, 82-83
Stock bonus plans see under Em-
ployee stock ownership plans
Summary plan descriptions, 30
Supplemental Security Income
(SSI), 166-167
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Supplementary Medical Insurance
(SMI) see under Medicare
Survivor benefits, 235-240
death benefits, 238-240
income plans, 236-238
tax treatment, 238, 240
under ERISA, 33-34, 51, 163
under Social Security, 20, 235-
236
T
Target benefit plans, 74
Tax-deferred benefits
definition, 8
Tax Equity and Fiscal Responsi-
bility Act of 1982 (TEFRA)
benefit and contribution limits,
28-29, 47
effects on Keogh plans, 153,
154-155
Medicare and CMPs, 198
Medicare and HMOs, 198
vesting provisions, 49, 100
Tax-exempt benefits, 2
definition, 8
Tax-favored benefits, 2
-growth of, 8-10
-size of, 7-8, 9
Tax incentives
employer-provided pensions
and, 5
Tax Reduction Act stock owner-
ship plans (TRASOPs), 122
Tax Reform Act of 1986 (TRA)
effects on
-benefit and contribution lim-
its, 29, 47-48, 90-91
-child care benefits, 268
-coverage, 44-46, 112
-educational assistance
benefits, 252-254
-employee benefits, 11-13
-flexible compensation plans,
277-278
-health insurance plans, 182-
183
-hardship withdrawals, 115
-highly compensated
employees, 12
-integration, 85-86
-legal services plans, 255-256
-participation, 49
-pension distributions, 93-94
-qualified pension plans, 42-
43,47-48,73
-survivor benefits, 239
-vesting, 33, 48-49, 88-89
Tax-sheltered annuities (TSAs),
129-135
administration, 134
catch-up election, 132
contributions, 131-132
distributions, 133-134
eligibility, 129-130
employee rights, 132-133
funding and investments, 130-
131
nondiscrimination rules, 130
rollovers, 133
salary reduction agreement
plans, 131-133
salary reduction, 130
tax treatment, 129, 133-134
types of, 131
withdrawals, 134
Tax treatment see under specific
benefit
TEFRA see Tax Equity and Fiscal
Responsibility Act of 1982
Ten-year service rule
definition, 32
Termination of pension plans see
under Pension plans
Thrift plans, 67, 99-105, 109
administration, 104
contributions
-employee, 99, 100-101
-employer, 99, 101-102
coverage, 99-100
distributions, 70, 102-103
investments, 102
loans, 103
participation, 100
rollovers, 104
salary reduction and, 101(n)
tax treatment, 103-104
vesting, 100
withdrawals, 102-104, 105
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Top-heavy plans, 85
TRA see Tax Reform Act of 1986
TSAs see Tax-sheltered annuities
U
U.S. Bureau of Labor Statistics
survey
flexible compensation, 274
U.S. Department of Labor
responsibilities under ERISA, 31
U.S. Internal Revenue Service
responsibilities under ERISA, 31
Unit-benefit excess plans, 79, 82
V
Vesting, 32-33, 4$-49 see also un-
der specific plan
break-in-service rules, 33
definition, 32
formulas, 32
under ERISA, 32
under TRA, 33, 48-49, 60, 71
Veterans' pensions, 164
Vision care plans, 217-220
coinsurance and copayment,
218-219
deductibles, 218
evaluation of, 290
nondiscrimination rules, 219
payment methods, 218-219
providers, 217-218
services provided, 218
W
Wages see Compensation
Wellness programs see Health pro-
motion programs
Women
labor force participation, 263-
264
pension plan participation, 15
Workers' compensation, 242
Wyatt Company, The
employer health plan survey,
185
Z
Zero-balance reimbursement
accounts (ZEBRAs), 276
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Selected EBRI and EBRI-ERF
Publications
Fundamentals of Employee Benefit Programs For Education Employees,
1987 (ISBN 0-86643-059-8)
Government Mandating of Employee Benefits, 1987 (ISBN 0-86643-060-1)
Measuring and Funding Corporate Liabilities for Retiree Health Benefits,
1987 (ISBN 0-86643-054-7)
America in Transition: Benefits for the Future, 1987, paperback (ISBN 0-
86643-049-0), hardbound (ISBN 0-86643-057-1)
The Changing Health Care Market, 1987, paperback (ISBN 0-86643-053-9),
hardbound (ISBN 0-86643-055-5)
Spend It or Save It? Pension Lump-Sum Distributions and Tax Reform,
1986 (ISBN 0-86643-046-6)
Medicare Reform: The Private-Sector Impact, 1985, paperback (ISBN 0-
86643-045-8), hardbound (ISBN 0-86643-044-X)
The Changing Profile of Pensions in America, 1985, paperback (ISBN 0-
86643-038-5), hardbound (ISBN 0-86643-043-1)
Retirement Security and Tax Policy, 1984, paperback (ISBN 0-86643-037-
7), hardbound (ISBN 0-86643-040-7)
Employer-Provided Health Benefits: Coverage, Provisions and Policy
Issues, 1984 (ISBN 0-86643-033-4)
Why Tax Employee Benefits?, 1984 (ISBN 0-86643-036-9)
Employee Stock Ownership Plans: A Decision Maker's Guide, 1983 (ISBN
0-86643-031-8)
Employment Termination Benefits in the U.S. Economy, 1983 (ISBN 0-
86643-030-X)
Pension Integration: Concepts, Issues and Proposals, 1983 (ISBN 0-86643-
032-6)
Social Security: Perspectives on Preserving the System, 1982, paperback
(ISBN 0-86643-028-8), hardbound (ISBN 0-86643-029-6)
Economic Survival in Retirement: Which Pension Is for You?, 1982 (ISBN
0-86643-027-X)
America in Transition: Implications for Employee Benefits, 1982 (ISBN 0-
86643-026-1)
Retirement Income Opportunities in an Aging America
Volume I-Coverage and Benefit Entitlement, 1981 (ISBN 0-86643-013-X)
Volume II-Income Levels and Adequacy, 1982 (ISBN 0-86643-014-8)
Volume III-Pensions and the Economy, 1982 (ISBN 0-86643-015-6)
Retirement Income and the Economy: Policy Directions for the 80s, 1981,
paperback (ISBN 0-86643-023-7), hardbound (ISBN 0-86643-025-3)
Retirement Income and the Economy: Increasing Income for the Aged, 1981
(ISBN 0-86643-024-5)
A Bibliography of Research: Retirement Income & Capital Accumulation
Programs, 1981 (ISBN 0-86643-022-9)
A Bibliography of Research: Health Care Programs, 1981 (ISBN 0-86643-
021-0)
Should Pension Assets Be Managed for Social/Political Purposes?, 1980
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Fundamentals of
Employee Benefit Programs
"This primer on benefits is geared mainly to employees.
And, at that it is a great success. . .Could be extremely useful
to benefit managers trying to explain benefits and benefit
changes, both to employees and to company officials...
A good source for up-to-the-minute information.".
-Business Insurance
"Fundamentals of Employee Benefit Programs delivers
what its title promises.. .a great deal of technical informa-
tion in nontechnical prose.. .With that knowledge behind
you, you'll be better able to fight your own battles."
-Working Woman
Fundamentals of Employee Benefit Programs has been
widely acclaimed as a thorough, accurate and readable
primer on the whole range of employee benefits. Tax law
changes in 1986 and new federal regulations have caused
EBRI staff to revise and expand the book to 32 chapters. By
popular demand, new chapters have been added that
provide guidance on how to evaluate an employee benefit
package and an explanation of key benefit programs and
issues, such as simplified employee pensions, preferred
provider organizations and employee assistance and health
promotion programs. A comprehensive index also makes
this book a quick and thorough reference guide.
If you are one of more than 20,000 individuals who have
found Fundamentals to be a valuable resource, you can't
afford to fall behind in the rapidly changing world of
employee benefits.
EBRI
EMPLOYEE BENEFIT RESEARCH INSTITUTE
2121 K Street, NW / Suite 600 / Washington, DC 20037-2121
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