Rules
Workplace retirement plans can either be qualified or non-qualified. To be considered qualified, a plan must be governed by the Employee Retirement Income Security Act (ERISA) - a retirement plan law discussed below. In particular, ERISA generally governs qualified plans of non-governmental (private) organizations. Qualified plans are eligible for substantial tax benefits for both the employer and employee.
Most qualified retirement plans offer pre-tax contribution ability. Typically, every dollar a person makes at work is taxable. The more one makes, the more taxes due. However, taxation is reduced with pre-tax contributions. Assume you make $100,000 at your job, which is subject to income taxes. If you were to contribute $5,000 to your company’s qualified retirement plan, you’d only be taxed on $95,000 of income for the year. Additionally, most qualified retirement plans allow payroll deductions of work earnings to be directly deposited into a retirement account without being taxed*. The more money placed in a qualified retirement plan, the less taxable income to report. However, retirement plan assets are taxable when distributed later in retirement.
*Not all qualified plans offer pre-tax contributions. Roth 401(k)s are a good example. We will learn more about these accounts later in this unit.
Qualified plans are in high demand due to their tax benefits. Organizations offer access to these plans to stay competitive when attracting potential employees. Certain specifications and requirements must be followed to provide qualified plans to employees. In particular, compliance with the ERISA is required. This legislation protects employee retirement assets from employer misconduct or mismanagement. Qualified plans must meet ERISA standards to be offered, which include the following:
Minimum participation/non-discrimination
- Must offer the plan to all full-time employees
- Cannot offer the plan to executives only (this would be discrimination)
- To be considered full-time, an employee must be:
- Age 21 or older
- Working 1,000 hours+ annually
Reporting and disclosure
- Details of retirement plan available in writing
- Employees provided annual updates
Funding
- Defined benefit plans (discussed below) must be funded appropriately
Vesting
- Employees must earn employer-provided benefits in a reasonable amount of time (five years or less)
- For example, employer-matched contributions*
- Employee contributions are always 100% vested
*Some employers match employee contributions as a workplace benefit. For example, a company offers to match 100% of employee contributions, up to 5% of their salary. If an employee saves 5% of their salary, the employer matches the contribution (allowing the employee to effectively save 10% of their salary). Employers usually apply vesting periods of five years or less, which means an employee quitting their position within the vesting period loses part or all of the employer match.
Every qualified plan is governed by a plan document that must be created before it is offered to employees. This document identifies the rules of the plan, including:
- Who can contribute to the plan
- Employer-provided benefits (e.g., matching contributions)
- Vesting schedules
- Investment options
- Beneficiary designation rules
- Distribution guidelines
If you’re interested, here’s a link to a boilerplate plan document. Knowing the minor details of a plan document is unnecessary, but viewing an example may help build real world context.
A fiduciary administers the qualified plan according to the rules in the plan document. The Internal Revenue Service (IRS) defines a fiduciary as:
“A person who owes a duty of care and trust to another and must act primarily for the benefit of the other in a particular activity.”
The fiduciary’s job is to ensure the qualified plan functions as intended according to the plan document. Their ultimate responsibility is representing the plan participants (employees with plan access) and placing their interests above those of the employing organization. Several entities could fill the fiduciary role, including organization employees (usually an executive or board member) or unaffiliated third parties.
After the plan document is created and a fiduciary is appointed, the organization must submit the plan documents in writing to the IRS for approval. Once approved, the qualified plan may be offered to employees.
ERISA Section 404(c)
Section 404(c) of ERISA allows employers offering qualified plans and their fiduciaries to avoid liability for poor investment decisions. Most employer-sponsored retirement plans today are “self-driven” by the employee. Meaning, employees generally decide how much to invest, how their money is invested, and the risk they expose themselves to.
Employers and plan fiduciaries can potentially face legal liability if the plan does not provide specific tools or resources. For example, employees could sue their employer if they experienced significant losses in their workplace retirement plan due to a lack of investment choices.
ERISA Section 404(c) lays out several protocols to be followed by employers and fiduciaries to avoid liability. They include:
- Making proper disclosures
- Offering diversified investment choices
- Allowing frequent investment changes
Making proper disclosures
Many disclosures must be made available to plan participants. These disclosures include:
- The plan document
- Description of the available investments
- Investment disclosures (e.g., a prospectus)
- Fees or costs associated with the plan
- Account statements
- Contact information for the plan fiduciary
Offering diversified investment choices
Section 404(c) requires plans to provide access to enough investments to allow plan participants to create diversified portfolios. At least three investment alternatives must be provided, each with a unique risk and return profile. Legal analysts generally agree offering a broad-based* equity (stock) fund, a broad-based bond fund, and a money market fund meets this standard.
*Broad-based funds are well diversified, covering various industries and geographic regions. The Vanguard Total Stock Market Index Fund (ticker: VTSAX) is a good example. The fund has exposure to nearly 4,000 stocks across 11 major industries in the U.S. Conversely, funds that focus specifically on one industry (e.g., a technology fund) are considered narrow-based.
Allowing frequent investment changes
Plan participants must be allowed to change investments at least quarterly (once every three months). If the plan allows investments into volatile securities, the frequency should be more often than quarterly.
If Section 404(c) protocols are followed, employers and plan fiduciaries are generally shielded from legal liability.
Investment policy statements
An investment policy statement (IPS) is a formal document describing investment parameters a client imposes on their adviser or portfolio manager. Properly investing client assets pragmatically and suitably is challenging, but an IPS serves as a roadmap. In particular, this document typically outlines the client’s:
- Time horizon
- Risk tolerance
- Return objectives
- Asset allocation ranges
- Investment restrictions
- Preferred management style
A basic IPS could look like this:
Time horizon
- 20 years
Risk tolerance
- Low-to-moderate risk
Return objectives
- Capital appreciation and income
Asset allocation ranges
- 50-60% equities
- 30-45% debt
- 5-10% money market
Investment restrictions
- No speculative investments
- No high-risk derivatives
Preferred management styles
- Pursue active management
- Consider rebalancing every 3-4 months
In addition, an IPS typically specifies the adviser or manager’s roles and responsibilities. These could include outlining how they’ll fulfill their fiduciary duty, reporting requirements, investment selection criteria, and client consultation obligations (when they’ll reach out to the client to discuss strategies). Any deviation from the protocols established in the IPS can result in legal liabilities for the adviser or manager.
Most administrators of ERISA-governed qualified plans implement an IPS. It provides a clear set of guidelines to the assigned portfolio manager, which is especially important for plans that manage assets for participants. For example, a financial professional overseeing a Teacher’s Union pension* worth over $1 billion invests according to the established IPS. Their goal is to manage the Union’s assets to ensure payments can be made to qualifying retirees for life.
*Defined benefit pension plans, which are covered in the next chapter, make payments to qualifying retirees until death. For example, a teacher retires after 30 years of employment, and their union sends them monthly retirement payments for the rest of their life.
An IPS is typically established for employee-driven plans as well (e.g., 401(k) plans). These plans don’t maintain a super-detailed IPS, as the participant usually establishes the investment strategy and allocates their retirement funds to investments they identify. However, the employer (or the party managing the plan) must determine a default investment. Formally known as the qualified default investment alternative (QDIA), this is where contributions are invested if the participant provides no investment instructions. For example, a corporate employee contributes 5% of their salary to their 401(k) plan but doesn’t elect a specific investment for their contributions.
The Department of Labor (DOL), which enforces ERISA rules, establishes these requirements for QDIAs:
- Must be managed by an investment manager or investment company
- Must be diversified
- May not be the employer’s securities
- May not impose penalties for transferring to another investment
The DOL generally recommends one of the following to serve as a qualified plan’s QDIA:
- Life cycle (target date) fund
- Balanced fund
- Professionally managed account
For a fund, an IPS is a formal document that outlines the fund’s investment objectives, strategies, and guidelines. It typically includes the fund’s goals, such as:
- Income generation or capital appreciation
- Types of investments it will hold
- Asset allocation targets
- Risk tolerance
- Performance benchmarks
The IPS also details investment restrictions, such as avoiding specific industries or asset classes. It is essential to know that the IPS helps ensure that the fund’s management adheres to a consistent investment strategy, aligns with its stated objectives, and provides transparency and accountability to investors. The Employee Retirement Income Security Act of 1974 (ERISA) does not require one, but it is considered good practice.
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