The Pros and Cons of Offering Employees Retirement Benefits
Retirement plans are a valuable benefit that impacts the present and future lives of employees. Because offering retirement benefits can be complicated, the best approach is understanding the pros and cons of offering retirement plan benefits, the types of retirement plan choices and the goals you want to accomplish as an employer offering retirement benefits, for your employees, your business and yourself.
Offering retirement benefits is a great way to enhance the benefits piece of your compensation package. Employees are encouraged to save for retirement through plans set-up at work because it's easy to do. Also important for small business owners in particular, offering a retirement plan as an employee benefit allows you to take advantage of the plan for yourself. However, there are also some definite disadvantages to offering retirement benefits to employees.
The following are some of the pros of offering retirement benefits:
- You can receive some significant tax advantages for your business because Congress wants to encourage employers to provide retirement benefits to employees.
- If the plan is based on profits, the plan may enhance employee motivation and productivity.
- Retirement benefits may give you a recruiting advantage.
- If your business has high start-up costs or little cash on hand, you can use a retirement plan to supplement your compensation package.
- Again, you can use the plan to save for your own retirement.
So what's the downside of choosing to offer this benefit? There are a couple of reasons why you might want to forgo offering a retirement plan:
- Setting up and administering a plan can be time-consuming, complicated, and costly.
- Providing a plan can (and most likely will) require professional assistance, which can be expensive.
If you do decide that you want to offer retirement plan benefits, you are definitely going to want to obtain professional advice and guidance. Pension rules are complex, and the tax aspects of retirement plans can also be confusing.
Before you consult with your accountant or tax advisor, make sure you understand the basic differences in plan types. Then you should try to determine why you want to offer a plan and what your goals are.
Understanding Retirement Plan Basics
All pension plans are either qualified plans or non-qualified plans.
Qualified plans meet the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code and qualify for significant tax benefits:
- The income generated by the plan assets is not subject to income tax, because the income is earned and managed within the framework of a tax-exempt trust.
- An employer is entitled to a current tax deduction for contributions to the plan.
- The plan participants (the employees or their beneficiaries) do not have to pay income tax on the amounts contributed on their behalf until the year the funds are distributed to them by the employer.
- Under the right circumstances, beneficiaries of qualified plan distributions are afforded special tax treatment.
Non-qualified plans are those not meeting the ERISA guidelines and the requirements of the Internal Revenue Code. They cannot avail themselves of the preferential tax treatment. Non-qualified plans are usually designed to provide deferred compensation exclusively for one or more executives.
Retirement plans are further divisible into the broad categories of defined benefit and contribution plans, and hybrid plans.
Because of their tax-advantages, most small business owners choose to offer a plan that is qualified as an employee benefit.
Requirements for a Qualified Retirement Plan
To satisfy the general requirements, a qualified retirement plan must be permanent, meaning it cannot have a planned, definite expiration date. Although the employer may reserve the right to change or terminate the plan or to discontinue operations, abandoning the plan for other than business necessity within a few years is evidence that the plan was not a bona fide program from its inception.
The plan must be a definite written program that is communicated to all employees, and all plan assets must be held in trust by one or more trustees. The plan must be for the exclusive benefit of the employees and their beneficiaries. There can be no reversion of the trust's assets to the employer, other than forfeitures.
The plan must be established and maintained by the employer. Funding can be provided through employer or employee contributions, or both.
Participation/coverage rules. To meet the minimum standards, at least a certain percentage of the non-highly-compensated employees must be covered by the plan, and a certain number of those covered employees must actually be in the plan. The plan cannot discriminate in favor of employees who are officers, shareholders, or highly compensated, by making larger contributions on their behalf or providing them with better benefits.
The plan may condition eligibility on age and service, but generally cannot postpone participation beyond the date the employee attains the age of 21, and the date on which the employee completes one year of service.
Vesting rules. The process of acquiring a nonforfeitable right to the money being set aside for you is called vesting, and means that you have to stick around in order to earn full benefits.
There are two vesting methods:
- five-year cliff vesting in which the participant become fully vested after five years of service (with zero vesting in the first four years)
- seven-year gradual vesting in which the participant becomes increasingly vested (usually 20 percent per year) after three years of service
Although the employer can have vesting rules more lenient than these, the rules cannot be more restrictive. An employee must become fully vested no later than the normal retirement age specified in the plan. The plan must also provide rules on how breaks in service affect vesting rights.
When an employee leaves your business, under certain conditions you may "cash out" the employee's pension benefits if the vested portion of the benefits is less than a specified amount.
Required annual summary. Each year the employer must furnish a document called a Summary Plan Description, written in plain English understandable to the average plan participant, detailing the amount of pension benefits, requirements for receiving those payments, and any conditions that might prevent someone from receiving them.
Integration with Social Security. Many businesses integrate their pension schemes with Social Security. This integration reduces your employer-provided pension benefit by a percentage of the amount of your Social Security benefit. Employers could argue that since they must pay Social Security taxes and also fund the pension program, without integration they are supporting two pension systems. However, although a certain degree of integration is allowed by law, an employee must be guaranteed at least 50 percent of the pension he or she earned when Social Security is merged with the pension.
Assume that an employer-provided pension benefit is $1,400 per month and the Social Security benefit is $1,000 per month. Therefore, the amount actually received from the employer must be at least $900 [$1,400-(50% x $1,000) = $900]. The total amount received monthly may be as low as $1,900 [$1,000 Social Security + $900 pension], rather than $2,400.
What Does it Mean if a Plan is Non-Qualified?
The term "non-qualified," refers to the fact that a plan is not subject to certain federal pension law provisions, such as the ones on nondiscrimination, eligibility, funding, and vesting. As a result, it doesn't get as many tax breaks as regular pension plans do.
Don't be lulled into believing, however, that non-qualified plans are not subject to any of the provisions that govern qualified plans; they are in fact generally subject to all of the provisions except those mentioned above.
Non-qualified plans have a clever and colorful language all their own:
- Top-hat plans. A top-hat plan is an unfunded plan maintained primarily to provide deferred compensation to a select group of management or highly compensated employees. Special reporting and disclosure rules apply.
- Rabbi trusts. A rabbi trust is a non-qualified deferred compensation arrangement in which amounts are transferred to an irrevocable trust to be held for the benefit of executive employees. The funds in the trust can still be reached by creditors of the company; for example, in a bankruptcy.
- Golden parachutes. A golden parachute is an agreement between companies and their key personnel under which the corporation agrees to pay these key individuals certain amounts, often in excess of their usual compensation, if control of the corporation changes. They became popular during the time when hostile takeovers were common.
- Golden handcuffs. A golden handcuff is an agreement between companies and their key executives under which the executives are paid supplemental retirement benefits if they meet certain conditions, such as if they remain with the company until a certain age. Golden handcuffs are designed to encourage long-term employment relationships.
Non-qualified plans are quite different than qualified plans, but may be the right type of retirement benefit plan for some businesses. You may want to provide supplementary compensation for key executives or employees, and you may want to defer payment into the future. For example, you may want to induce a particularly valuable employee to remain with you for a certain number of years ("golden handcuffs"). In that case, you could offer the employee a deferred compensation plan that would pay the employee additional compensation upon the completion of a certain number of years service to you. In other cases, you may want to defer compensation for yourself, or for yourself and your partners, to avoid paying taxes on it this year.
You cannot achieve these goals through a traditional retirement plan (assuming you want the tax advantages) because the laws require you to provide benefits that are uniform and that don't discriminate too much in favor of key executives. The best arrangement, then, for accomplishing these types of goals may be through a non-qualified plan.
Non-qualified plans involve complex pension concepts such as funding and distribution restrictions. The failure to comply with these rules could subject participants who defer compensation through a non-qualified plan to current taxation and/or penalties. Because this area is so complex, you should discuss with your attorney or accountant whether a non-qualified plan is appropriate for you.
The main downside of non-qualified plans is that your business income tax deduction is deferred. Your business is not entitled to a deduction for the deferred compensation until the funds are available to the recipient, which could be years away.
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