Workplace retirement plans can be either 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 general, ERISA 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 plans allow pre-tax contributions. Normally, every dollar you earn at work is taxable, and the more you earn, the more tax you owe. Pre-tax contributions reduce your taxable income.
For example, assume you earn $100,000 and that income is subject to income taxes. If you contribute $5,000 to your company’s qualified retirement plan, you’re taxed on $95,000 of income for the year. Most qualified retirement plans allow payroll deductions to be deposited directly into a retirement account before taxes are applied*. The more you contribute to a qualified plan, the less taxable income you report today. However, 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 offer them to stay competitive when attracting 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
Reporting and disclosure
Funding
Vesting
*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 about 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:
If you’re interested, here’s a link to a boilerplate plan document. You don’t need to know the minor 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.”
The fiduciary’s job is to make sure the plan operates as intended under the plan document. Their ultimate responsibility is to represent the plan participants (employees with access to the plan) and put participants’ interests ahead of the employer’s interests.
Several parties can serve as the fiduciary, including employees of the organization (often 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.
Section 404(c) of ERISA allows employers offering qualified plans, and their fiduciaries, to avoid liability for poor investment decisions under certain conditions.
Most employer-sponsored retirement plans today are participant-directed (often described as “self-driven”). That means employees generally decide:
Even in participant-directed plans, employers and fiduciaries can face legal liability if the plan doesn’t provide required tools, choices, or information. For example, employees might claim they suffered significant losses because the plan offered too few investment options.
ERISA Section 404(c) lays out protocols employers and fiduciaries must follow to reduce or avoid that liability. They include:
Making proper disclosures
Plan participants must have access to key information about the plan and its investments, including:
Offering diversified investment choices
Section 404(c) requires plans to offer enough investment choices 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, changes should be allowed more frequently than quarterly.
If Section 404(c) protocols are followed, employers and plan fiduciaries are generally shielded from legal liability.
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 practical and suitable way can be complex, and an IPS serves as a roadmap.
An IPS typically outlines the client’s:
A basic IPS could look like this:
Time horizon
Risk tolerance
Return objectives
Asset allocation ranges
Investment restrictions
Preferred management styles
In addition, an IPS typically specifies the adviser’s or manager’s roles and responsibilities. For example, it may describe how they’ll fulfill their fiduciary duty, what reporting they’ll provide, how investments will be selected, and when they’ll 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 for plans that manage 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 established for employee-driven plans as well (e.g., 401(k) plans). These plans usually don’t maintain a highly detailed IPS because the participant typically chooses the investment strategy and allocates contributions among the available options.
However, the employer (or the party managing the plan) must still choose a default investment. Formally, this is the qualified default investment alternative (QDIA) - the investment used when a participant provides no investment instructions. For example, an employee contributes 5% of their salary to a 401(k) plan but doesn’t select where those contributions should be invested.
The Department of Labor (DOL), which enforces ERISA rules, sets these requirements for QDIAs:
The DOL generally recommends one of the following to serve as a qualified plan’s QDIA:
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:
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.
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