“Employee benefits” is a term used to describe the entire concept of compensating employees for their services. Typically, “employee benefits” refers to ways of providing compensation other than current wages, such as providing health, life, or disability insurance, vacation time, or retirement plans. Some employee benefits are frequently overlooked by employees as benefits being received at their employer’s expense. The employer-paid portion of Social Security is an example.
Employee benefits are becoming an increasingly expensive and regulated part of running a business. The two most common, and most expensive and regulated, employee benefits are retirement plans and health insurance. This outline will review some of the major aspects of these forms of benefits.
Two sets of federal laws, the Employee Retirement and Income Security Act of 1974 (“ERISA”) and certain sections of the Internal Revenue Code (the “Code”), govern most private employee benefit plans. A brief description of these laws and the way they affect benefit plans and their participants is included in the discussion of the various forms of benefit plans most commonly offered by employers.
Employee Retirement Income Security Act of 1974 (“ERISA”)
ERISA was enacted in 1974 as a response to perceived abuses in the establishment and administration of retirement plans.
- ERISA provides a comprehensive set of rules that fall into the following categories:
- Reporting and disclosure of information by plan sponsors;
- Participation in the plan and vesting in plan benefits;
- Funding of benefits;
- Fiduciary responsibility of plan trustees and others; and
- Administration and enforcement of ERISA by plan participants and the Department of Labor.
- Reporting and Disclosure. ERISA provides that an employee benefit plan must be in writing. In addition, a description of the plan must be given to each participant so that he or she understands his or her rights and obligations under the plan. Also, the plan administrator must prepare annual reports showing the financial status of the plan. Each plan participant must also receive a statement (at least once every three years for defined benefit plans annually, annually for defined contribution plans that do not have participant-directed accounts, and quarterly for participant-directed defined contribution plans), explaining his or her benefit accrued and the portion of the benefit that is “vested” (nonforfeitable). Defined benefit plans must also provide an annual funding notice that indicates the plan’s funded percentage and other information relating to the plan’s funding status. Other notices relating to the administration of the plan are also required to be provided to participants.
- Participation and Vesting. Certain minimum participation and vesting requirements are mandated by ERISA. Some of these are discussed below under Section II.B.2.
- Funding. ERISA and the Code require that pension plans (profit sharing plans are not pension plans) be adequately funded to provide the benefits they are supposed to provide.
- Fiduciary Responsibility. Plan “fiduciaries” (e.g., trustees) have a very strict code of conduct they must follow because of their ability to deal with “other people’s money.” Penalties are imposed for engaging in “prohibited transactions,” which include transactions involving the plan.
- Administration and Enforcement. ERISA gives plan participants the right to sue plan fiduciaries for breaching their duties to the participants of the plan. Also, the Department of Labor has the right to bring civil and criminal actions against plan fiduciaries.
Internal Revenue Code
ERISA includes provisions that amended the Code by adding sections that deal strictly with retirement plans.
- If a retirement plan complies with all of the applicable provisions of the Code, it is considered a “qualified plan” and enjoys the following tax advantages:
- All employer contributions for the benefit of the participants are deductible by the employer.
- The contributions are not taxable to the participants until they are distributed.
- All interest or other investment gain accumulates tax free to the pension trust.
In other words, tax-qualified retirement plans are tax shelters, in that money accumulates without any tax consequences until the money is actually taken out. In theory, the participant will be in a lower tax bracket at retirement and will, therefore, pay less in taxes because of the deferral (taking the money later instead of now).
- In order to qualify for this tax-favored status, a plan must meet ever-increasingly stringent and complex rules relating to eligibility for participation, vesting, nondiscrimination in favor of highly compensated employees, etc. The following are examples:
- A plan cannot require an otherwise eligible employee to have more than a year of service for the right to participate. Also, the minimum age for participation cannot exceed age 21.
- Normal retirement age cannot be later than age 65 (unless the participant has not reached his or her 5th anniversary in the plan).
- A participant must vest (obtain a nonforfeitable right) in his or her benefit in 7 or fewer years.
- Highly compensated employees (as defined in the Code) cannot receive greater benefits from the plan than other employees.
Types of Retirement Plans
- Defined Contribution. A defined contribution plan is just that – the amount going into the plan for the benefit of each participant is defined. That is, the plan contains a formula that dictates the amount of the employer’s contribution that is to be allocated into an account established in the name of the participant. These plans are sometimes called “account balance plans” because each participant has an account that grows as money is allocated to it and as investment earnings accumulate. Although the amount going into the plan is defined, the amount coming out is anybody’s guess. The amount ultimately distributed to the participant will depend upon the amount contributed by the employer over time and the success of the investments made by the trustee(s). The most common defined contribution plans are the profit sharing plan, the money purchase pension plan, and the “401(k)” plan.
- Profit Sharing Plan – This is a type of plan that gets its name from a former requirement that the contribution comes from the employer’s profits. That requirement no longer exists. However, the employer still has discretion each year with respect to the amount of the contribution and, in fact, whether a contribution will be made at all. Any contribution that is made is allocated to participant accounts based upon a set formula, usually related to the percentage of the participant’s compensation as compared to all participant’s compensation.After the participant has worked for the employer for a period of time, he or she becomes “vested” in the amount of money in the account. This means that if he or she leaves the employer before retirement age, the “vested” amount continues to belong to the participant. When the “vested” amount can be withdrawn depends upon the terms of the plan.
- Money Purchase Pension Plan – This type of plan works essentially the same as a profit sharing plan. The main difference is that the employer’s contribution is not discretionary. The amount of the contribution is fixed each year and it must be made, even if the employer must borrow the funds.
- 401(k) Plan – This is actually not a separate type of plan but, rather a feature that can be added to a profit sharing plan or (less often) a money purchase pension plan.
In a 401(k) Plan, in addition to the contributions the employer makes to the plan, each participant is given the right to have his or her compensation reduced by a certain percentage, and that amount is contributed to the plan. The amount of this “elected deferral” is excluded from the participant’s W-2 compensation and, therefore, is not taxable. The participant ends up with more total money in his or her pockets (although one of the pockets, admittedly, is not available to stick his or her hands into right away) because of the tax savings. Take the following example:
Annual Salary ………………………………………… $40,000
Elective Deferral ……………………………………… – 2,000
Taxable Income ……………………………………… $38,000
If we assume a combined (state and federal) tax rate of 35%, the tax bill on the $40,000 without participation in a 401(k) is $14,000. If the participant elects to transfer $2,000 (5%) into his or her account in the 401(k) plan, the tax bill (35% x $38,000) is only $13,300. The participant has saved $700 by merely shifting some income into an account inside the plan instead of an account outside the plan (e.g., a bank account).
Because a 401(k) is only a feature of either a profit sharing plan or a money purchase pension plan, the same basic plan provisions discussed above continue to apply, such as employer contributions in addition to participant elective deferrals.
o Defined Benefit. Just as a defined contribution plan provides a formula for determining what goes into the plan (without any guarantees about what will come out), a defined benefit plan is set up to direct what comes out of the plan, In other words, a defined benefit plan provides that at some future date (usually normal retirement or early retirement age) the plan will pay a monthly benefit to the participant for the rest of his life. This type of plan is much more complicated than a defined contribution plan because a great deal of projecting into the future is involved. This is what helps keep actuaries in business.
In essence, a defined benefit plan provides that, for example, Peter Participant, who is now 25 years of age, is to receive, for his lifetime, beginning at age 65, $35.00 per month for each year of service with his employer. The question that must be answered is how much money does Peter’s employer have to put into the plan this year to ensure that 40 years from now there will be enough money to pay Peter $35.00 per month for the rest of his life. The answer depends upon a couple of factors. First, we need to know how long Peter is expected to live after age 65, since this affects the total amount that has to be paid. Second, we need to know what the money that is contributed to pay for Peter’s future benefit will earn from investments between now and 40 years from now. Obviously these factors require speculation, and an actuary is required to make the projections necessary to calculate the amount of the employer contribution needed to provide the specified or “defined” benefit.
Health insurance is probably the hottest topic in the field of employee benefits. The reason, obviously, is the astronomical cost of medical care today. These costs are passed to the consumer indirectly through premiums for the insurance that has to pay the medical expenses. Employers are feeling the crunch of skyrocketing premiums and are finding it increasingly difficult to provide this benefit to employees without passing some of the cost to the employees.
The two most common forms of health insurance are group indemnity plans and Health Maintenance Organizations (HMO). The following is a brief discussion of these two types of benefits and the vehicles frequently used by employers to provide these benefits to employees.
- Group Indemnity InsuranceThis is the traditional “Blue Cross/Blue Shield” type of insurance policy. The employer contracts with an insurance carrier to have employee medical expenses paid. The carrier analyzes the employee group and determines, actuarially, the expected medical costs that the group will incur during the contract year. It sets its premiums accordingly and hopes that its underwriting department has “guessed” right so that it can collect more in premiums than it has to pay out in claims. Otherwise, look for a big jump in premiums the following year.
- Health Maintenance OrganizationsAlthough there is no single way that HMOs are organized, typically the health care providers enter into an agreement with the HMO to render medical services to the HMO members for a set fee. One way to structure the payment arrangement is called “capitation.” This means that a doctor, for example, is paid a certain amount each month for each patient who is a member of the HMO. All medical services required by those patients must be rendered by the doctor for no additional fee without prior approval.
- Cafeteria and “Flex” PlansMany employers are now asking their employees to share in the cost of employee benefits, especially health insurance. One way to do this is to have each employee write a check to the employer each month to cover his or her portion of the expense. Under this approach, the employee is paying the cost with after-tax dollars, meaning that he or she must pay taxes on the amount being contributed.
- COBRA Continuation CoverageCOBRA stands for the Consolidated Omnibus Budget Reconciliation Act of 1985. This federal legislation creates a “continuation plan” for participants (and their dependents) of an employer-sponsored health plan who would otherwise lose their coverage because of certain “qualifying events” such as termination of employment, reduction of hours, death, divorce or separation, or loss of dependent status. In essence, COBRA requires that the employer (if the employer has 20 or more employees) and the insurance provider to allow the participant or beneficiary who experiences a qualifying event to elect to continue insurance coverage, at the participant’s or beneficiary’s expense, at the same group rates being paid under the employer’s plan. This coverage can continue for up to 18 months, if the qualifying event is termination of employment or reduction of hours, or for up to 36 months if the qualifying event is the participant’s death, divorce or legal separation from the participant, or loss of dependent status. The 18-mont period may be extended by up to another 11 months in the event of a disability award by the Social Security Administration). A second qualifying event during the initial 18-month period may give the right to up to an additional 18 months. For employees on military leave and who are covered by the Uniformed Services, Employment and Reemployment Rights Act of 1994, the maximum COBRA continuation coverage is 24 months.Upon the occurrence of a qualifying event, the employer must notify anyone who would otherwise lose coverage of their rights to continue coverage under COBRA. The notice must be in writing and mailed to the individual. Each such individual then has 60 days to elect to continue the insurance coverage. If the person elects coverage, he or she must pay the premiums for the period that elapsed before the election was made and for the first month after the election.
The employer has the right to terminate COBRA coverage at the end of the continuation period or if the individual fails to pay any premium on time, if the individual becomes covered by another health plan that does not contain a pre-existing condition exclusion, if the employer terminates all health plans, or if the individual becomes entitled to Medicare.