Rules

Workplace retirement plans can be either qualified or non-qualified. A plan is considered qualified when it meets the requirements of the Employee Retirement Income Security Act (ERISA), a federal law that sets standards for many retirement plans. ERISA generally governs qualified plans offered by non-governmental (private) organizations. Qualified plans are eligible for substantial tax benefits for both the employer and the employee.

Most qualified retirement plans allow pre-tax contributions. Normally, every dollar you earn at work is taxable, and higher income generally means higher taxes. Pre-tax contributions reduce your taxable income.

For example, assume you earn $100,000 and it’s all subject to income tax. If you contribute $5,000 to your employer’s qualified retirement plan, you’re taxed on $95,000 for the year. In addition, most qualified plans allow payroll deductions to be deposited directly into the retirement account without being taxed at the time of contribution*. The more you contribute pre-tax, the less taxable income you report. However, those retirement plan assets are generally taxable when they’re distributed later in retirement.

*Not all qualified plans offer pre-tax contributions. Roth 401(k)s are a good example. We’ll cover these accounts later in this unit.

Qualified plans are in high demand because of their tax benefits. Employers often offer them to stay competitive when recruiting and retaining employees. To offer a qualified plan, an organization must follow specific rules - most importantly, it must comply with ERISA. ERISA is designed to protect employee retirement assets from employer misconduct or mismanagement.

Qualified plans must meet ERISA standards, including the following:

Minimum participation/non-discrimination

• A qualified plan can’t discriminate in favor of highly compensated employees or owners
  • For example, it can’t be offered to executives only (this would be discrimination)
• The plan doesn’t have to cover every employee - an employer can exclude certain groups (by job classification, location, etc.), as long as the plan still passes the IRS’s minimum coverage tests
• An employer can’t make employees wait longer than certain limits to become eligible. At most, it can require an employee to be:
  • Age 21 or older, and
  • Employed for one year (working 1,000 hours+ in that year)
  • These are maximum conditions, not minimums - a plan can allow participation sooner (e.g., immediate eligibility or a lower age), but can’t impose stricter requirements

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
  • Typically 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, which must be created before the plan is offered to employees. The plan document spells out the plan’s rules, 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. You don’t need to memorize the details of a plan document, but seeing an example can help build real-world context.

A fiduciary administers the qualified plan according to 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.”

In a qualified plan, the fiduciary’s job is to make sure the plan operates as intended and in accordance with the plan document. The fiduciary’s ultimate responsibility is to represent the plan participants (employees with plan access) and put their interests ahead of the employer’s interests. The fiduciary could be an employee of the organization (often an executive or board member) or an unaffiliated third party.

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 made by plan participants. Most employer-sponsored retirement plans today are participant-directed. That means employees generally decide how much to contribute, how to invest their money, and how much risk to take.

Even in participant-directed plans, employers and fiduciaries can face legal exposure if the plan doesn’t provide certain tools and protections. For example, employees might claim they suffered significant losses because the plan offered too few investment choices.

ERISA Section 404(c) describes protocols employers and fiduciaries can follow to reduce or avoid liability. They include:

• Making proper disclosures
• Offering diversified investment choices
• Allowing frequent investment changes

Making proper disclosures
Plan participants must have access to key information about the plan and its investments, including:

• 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 offer enough investment options for participants to build diversified portfolios. At least three investment alternatives must be provided, each with a different risk-and-return profile. Legal analysts generally agree that 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 in volatile securities, the plan should allow changes more frequently 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 the investment parameters a client sets for their adviser or portfolio manager. Investing client assets in a prudent and suitable way can be complex, and an IPS serves as a roadmap. It 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

An IPS also typically defines the adviser’s or manager’s roles and responsibilities. For example, it may describe how fiduciary duties will be met, what reporting will be provided, how investments will be selected, and when the adviser will consult with the client. Deviating from the IPS can create legal liability for the adviser or manager.

Most administrators of ERISA-governed qualified plans implement an IPS. It gives the portfolio manager clear guidelines, which is especially important when the plan manages assets on behalf of 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 so 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 used for participant-directed plans as well (e.g., 401(k) plans). These plans usually don’t maintain a highly detailed IPS for each participant, because the participant chooses the investment strategy and allocates contributions among the available options. However, the employer (or the party managing the plan) must select a default investment.

This default is formally called the qualified default investment alternative (QDIA). It’s where contributions are invested if the participant gives no investment instructions. For example, an employee contributes 5% of salary to a 401(k) plan but doesn’t select any investments.

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’s important to know that an IPS helps ensure the fund’s management follows a consistent investment strategy, aligns with its stated objectives, and provides transparency and accountability to investors. ERISA does not require an IPS, but it’s considered good practice.