CHAPTER OBJECTIVES

When you have finished this chapter, you should be able to

• Explain the general nature of annuities and describe the manner in which they can help to deal with the retirement risk
• Discuss the tax treatment of annuities, and explain the ways in which this tax treatment is advantageous to the purchaser
• Differentiate among the various classes of annuities, and explain the distinguishing characteristics of each class
• Explain the way in which employer contributions to a qualified pension plan are treated under federal tax laws and the way in which this treatment benefits workers covered under such plans
• Identify and explain the difference between the defined contribution and defined benefit approaches in qualified retirement plans
• Describe the basic features of qualified retirement plans, including benefits and vesting
• Explain the provisions of the Internal Revenue Code (IRC) relating to Individual Retirement Accounts (IRAs) and explain the benefits that arise both from deductible and nondeductible contributions to IRAs

In this chapter, we leave our extended discussion of life insurance and examine other products sold by life insurers: annuities. In addition, we will examine a related topic, pension benefits under qualified retirement plans, which generally make use of the annuity principle. Our discussion of pensions in this chapter focuses on those features of qualified retirement plans that are particularly relevant to the employee's retirement planning. The administration and funding of qualified plans will be discussed in Chapter 23.

ANNUITIES

Annuities have been called upside-down life insurance, and in a sense they are a reverse application of the law of large numbers as it is used in life insurance. Whereas life insurance is a method of scientifically accumulating an estate, an annuity is a device for scientifically liquidating an estate.

An annuity is a contract that provides periodic payments for a specified period of time, such as a number of years or for life. The payments may begin at a stated or contingent date and may be payable for a specified number of years or for the duration of a person's life or the lives of more than one person. The person whose life governs the duration of the payments is called the annuitant. If the payments are to be continued for a specified period but only for as long as the annuitant lives, the contract is known as a temporary life annuity. Because the temporary life annuity is used infrequently, our discussion of annuities will concentrate on life annuities.

The basic function of a life annuity is that of liquidating a principal sum, regardless of how it was accumulated, and it is intended to provide protection against the risk of outliving one's income. It may involve liquidating a sum derived from a person's savings (including the annuity or the cash value of life insurance policies) or liquidating life insurance death benefits to provide a life income to the beneficiary of the policy.

To illustrate the principle involved, let us assume that the ubiquitous Mr. X attains age 65, retires, and has $100,000 to provide for his needs during the balance of his lifetime. How much of this $100,000 can he afford to spend each year so the principal will be used when he dies but not before? Because X is uncertain as to how long he will live, he cannot answer the question.

If X decides to use the interest on his $100,000, he might obtain $7000 or $8000 a year, which is inadequate for his needs. He decides he must invade the principal, but the question is, at what rate? If he decides to draw $5000 plus the interest on the principal each year, he will have about $12,000 or $13,000 per year initially, but the interest component will diminish as the capital is consumed. Moreover, he will have enough money to last only until age 85; what will he do then?

If X uses his $100,000 principal as a single premium to purchase a life annuity, he will be guaranteed an income for life with a payout rate that will maximize his withdrawals without premature dissipation of his capital. His income from this contract will be guaranteed at a rate of $8000 a year (and could be as much as $12,000), but more important, it will be guaranteed for the rest of his life regardless of how long he lives.

Under the annuity principle, the law of averages operates to permit a guaranteed lifetime income to each annuitant. Some people who reach age 65 will die before they reach 66. Others will live to be 100. Those who live longer than average will offset those who live for a shorter period than average. Those who die early will forfeit money to those who die later. Every payment the annuitant receives is part interest and part principal. In addition, each payment is part survivorship benefit, in that it is composed in part of the funds of group members who have died. Insurance companies have found that annuitants live longer than most people. This is a result of adverse selection. People who feel they have short life expectancies do not normally purchase annuities, whereas the individual whose parents and grandparents all lived to be 115 years old will probably look on an annuity as a good investment. The annuity principle favors the long-lived, and on the whole, these are the people who purchase these policies. For this reason, insurance companies use different mortality tables for computing the cost of annuities than they use for life insurance. Because the company promises to pay an income for the life of the annuitant, the longer he or she is expected to live, the higher will be the cost for a given amount of annual or monthly income. The older the annuitant, the lower the cost for a given amount of monthly income.¹ There is no requirement that the annuitant be in good health.

In addition to their function in liquidating an accumulated principal, annuities may also serve as investment instruments through which the principal may be accumulated. When the commencement date for annuity payments is set at some time in the future, the annuity principal may be accumulated by the periodic payment by the annuity purchaser. As in the case of life insurance, the investment income on the growing fund accumulates on a tax-deferred basis. The increments to the fund arising from investment income are not taxed until they are paid out to the annuitant.

If the annuitant dies during the accumulation period (i.e., before the contract is annuitized) a death benefit is payable to a beneficiary or to the insured's estate. Therefore, annuities represent a part of the individual's protection against premature death. The most common approach is to provide for a return of gross premiums without interest, or the cash value (whichever is larger).

Classification of Annuities

Annuities may be classified in various ways. Traditionally, annuities have been classified according to the following distinctions:

• Individual versus group annuity
• Fixed-dollar versus variable annuity
• Immediate versus deferred annuity
• Single-premium versus installment annuity
• Single life versus joint life annuity
• Pure life annuity versus annuity certain

Individual versus Group Annuities Annuities, like life insurance, are sold on an individual and a group basis. Group annuities often serve as a funding mechanism for the qualified retirement programs discussed later in this chapter. Although the discussion that follows focuses primarily on individual contracts, the basic principles are similar.²

Fixed-dollar and Variable Annuities Second, the annuity may be a fixed-dollar annuity or a variable annuity. Under the variable annuity, premiums are generally invested in a portfolio of stocks although policyholders may have the option of directing their investment to a bond fund or a money market fund. Variable annuities are discussed in greater detail later in the chapter.

Immediate versus Deferred Annuities Annuities may be grouped according to when payments are to commence. With the immediate Annuity, the first annuity payment is due one payment interval from the date of purchase, or it may be a deferred annuity, meaning there is a spread of several years between the date of purchase and the beginning of the annuity payments. An immediate annuity is purchased at retirement from funds accumulated in other investment instruments. A deferred annuity is purchased before retirement, and the purchase price is augmented by investment income during the interval between the time of purchase and the time the benefits commence.

A more recent development is longevity insurance, the term given to deferred annuity products that promise to pay a guaranteed income beginning at an advanced age, e.g., age 85. Longevity insurance typically has no death benefit and does not allow withdrawals before the commencement of benefits. Thus, the contracts can offer a higher guaranteed income for a given investment.

Single-Premium versus Installment Annuities Annuities may be classified according to the method of premium payment. They may be purchased with a single premium (the annuity to begin immediately or at some future date), or they may be purchased on an installment basis over a period of years. Installment premium annuities are deferred annuities, whereas a single-premium annuity may be an immediate or deferred annuity.

Single Life versus Joint Life Annuities Annuities may be classified according to the number of lives that determines the duration of the payments. This classification covers the single life and the joint-and-survivor annuities. An annuity may provide payment for the lifetime of a single individual or it may provide payment until two (or more) annuitants have died. The amount payable after the death of the first annuitant may be the same as during the lifetime of both annuitants or it may be lower.

Joint-and-Last-Survivor Annuity Annuities may be designed for special purposes just as life insurance contracts have been. One specialized annuity form is the joint-and-last-survivor annuity, which is computed on the basis of two lives. Under the joint-and-last-survivor annuity, the insurance company promises to make payments until both annuitants have died, an especially attractive form of annuity for a retired couple. If, as is likely, one predeceases the other, annuity payments will be continued for the rest of the other's life. A variation of this form provides for a reduction in the income payments at the death of the first annuitant, with lower annuity payments (usually two-thirds of the original income payments) being continued until the death of the second annuitant.

Joint Life Annuity The joint life annuity is similar to, but should not be confused with, the joint-and-last-survivor annuity. Under the joint life annuity, payments cease on the death of the first annuitant; the other annuitant then receives no further benefits under the program. This form is useful when there is a secondary source of income that is sufficient to support one, but not both, of the annuitants.

Pure Life Annuities versus Period-Certain Annuities Finally, annuities may be classified according to the nature of the insurer's obligation. Under a pure life annuity, payments are made only for the balance of the annuitant's lifetime, regardless of this period's length. The annuity is considered liquidated at the annuitant's death, with nothing payable to his or her estate. However, the annuity may contain some refund feature, with a specified amount to be paid to the estate or beneficiary if the annuitant should die shortly after the payments begin. Even though the pure life annuity provides the maximum income per dollar of principal, some people object to placing a substantial sum into a contract that promises no return if death should occur shortly after the annuity payments begin. As a consequence, insurers have added refund features to annuities to make them more salable. One of the most common refund features is found in an annuity with a certain number of payments guaranteed, whether the annuitant lives or dies. With a principal of $100,000 at age 65, a man can purchase a pure life annuity yielding a monthly income of about $1000 for life (guaranteed rate). For the same $100,000, a woman aged 65 will receive $925 per month for life. With a 10-year period certain, the man will receive $960 per month, and the woman will receive $900 per month, but the payments are guaranteed for the 10-year period. If the annuitant should die at age 70, the insurance company will be obligated to continue the payments to a designated beneficiary or to the annuitant's estate for 5 more years. If the annuitant survives the guarantee period, the payments will continue for the balance of his or her lifetime.

Today, guarantee periods are available for 5, 10, 15, and 20 years. The longer the guarantee period, the greater the cost of the annuity. For example, if you purchase an annuity with 20 rather than 10 years certain, the guaranteed annuity income will be reduced from the amount payable with a 10-year period certain.

Another popular refund feature is one that provides for annuity payments at least equal to the annuity's purchase price. The balance will be paid to a beneficiary or to the annuitant's estate in a lump sum or on an installment basis. If the balance is paid in continued installments, the contract is referred to as an installment refund annuity. If it is paid in a lump sum, the contract is a cash refund annuity. Under an installment refund annuity, $100,000 will provide about $970 per month to a male annuitant and $890 per month to a female annuitant.

Income Tax Treatment of Annuities

As in the case of life insurance, investment income earned on annuities during the accumulation period is not taxable until distributed to the policyholder. Distributions are taxed to the extent that payments exceed the contract's investment. In addition, a 10-percent premature penalty is imposed on early withdrawals from annuities. A premature (or early) withdrawal from an annuity is any distribution made prior to the time the annuitant reaches age 59½. The penalty on premature distributions does not apply if the contract holder becomes disabled or if the distribution is over the life of the annuitant.

The taxation of distributions requires apportioning the amounts received between recovery of capital and income. This is accomplished through an exclusion ratio formula, which excludes from taxable income the portion of each payment that the investment in the contract has to the expected return under the contract. The expected return is the annual amount to be paid to the annuitant multiplied by the number of years of life expectancy using annuity tables prescribed by the Internal Revenue Service (IRS). Separate tables are used for single life annuities and for joint-and-survivor annuities. The exclusion ratio formula is the following:

To illustrate the operation of the formula, assume that Brown has purchased an annuity for $60,000 and he is to receive $500 per month for life. He is 65 years old and has a life expectancy of 15 years, which means that he “expects” to receive $90,000 ($6000 per year for 15 years). Applying the exclusion ratio formula to the $6000 benefit Brown receives in the first year, we get the following:

The $4000 is a nontaxable return of capital and $2000 is taxable income. Once the annuitant has recovered the full amount of his or her investment in the contract, the exclusion ratio no longer applies and subsequent payments are fully taxable. If the annuitant dies before his or her basis is recovered, the unrecovered basis may be deducted from the decedent's final tax return. (In the case of contracts annuitized before January 1, 1987, the exclusion ratio applies to all payments, including those made after the annuitant's basis has been recovered.)

For variable annuities, the amount excluded from taxable income each year is also the total investment divided by the number of years the annuitant is expected to live. However, if losses on the underlying portfolio result in payments less than the excludable amount for that payment, the investment in the contract for future payments is recalculated. The amount of nontaxable return of principal that was not deductible is factored into the taxable gain computation for future installments. Suppose, for example, that Brown is receiving a distribution under a variable annuity in which his basis is $300,000. He is 65 years old and his life expectancy is 15 years. Brown may exclude $20,000 of the variable payment he receives each year. After receiving benefits for 4 years, the variable benefit in the fifth year drops to $15,000, which is less than the excludable $20,000. The $5000 exclusion is not lost. At this point, Brown is 74 years old and has a life expectancy of 10.1 years. The $5000 exclusion that was not taken may be added to the initial $20,000 exclusion over the 10.1 years ($495.05 per year) making the new excludable amount $20,495.05.

If the contract holder dies after annuity payments have begun but before the entire interest has been distributed, the remaining portion of the annuity must be distributed at least as rapidly as the original method of distribution and will be taxable to the beneficiary. If the contract holder dies before the annuity starting date, the entire interest must be distributed within five years after the date of death or be annuitized within one year unless the beneficiary of the annuity is a spouse. For a spousal annuity, the annuity contract may be continued (and the tax on the earnings deferred) until distribution of the benefits to or the spouse's death.

Annuities and the Federal Estate Tax

Under a straight life annuity, there is no remaining value at the annuitant's death. However, if the annuity provides a survivor benefit (as under a refund life annuity, a joint-and-survivor annuity, or a period-certain annuity), the remaining value may be subject to estate tax. The specific treatment depends on whether the survivor benefit is payable to the decedent's estate or to a named beneficiary and, in the case of benefits payable to a named beneficiary, who purchased the annuity:

• If the annuity is payable to the decedent's estate, the value of any survivor benefits is includable in his or her gross estate as a property interest owned at the time of death. Payments included under this provision include lump-sum or annuity payments under a guaranteed period-certain or cash-refund contract.
• If survivor benefits are payable to a named beneficiary (under a joint-and-survivor annuity or under a period-certain or refund annuity), the inclusion or exclusion of the survivor benefits from the decedent's estate is determined by a premium payment test. Under this test, if the decedent purchased the annuity, the value of the survivors' benefit is includable in the estate. If the decedent contributed only a part of the annuity's purchase price, the value of the survivor benefits is includable in the decedent's gross estate only in the proportion that he or she contributed to the purchase price of the annuity.

Special rules apply to employee annuities under qualified pension and profit-sharing plans and to Individual Retirement Accounts (IRAs).

Specialized Annuities

As in the case of life insurance contracts, insurers have developed specialized and innovative annuity contracts. The following are some of these specialized annuity contracts:

Single-Premium Deferred Annuity The single-premium deferred annuity (SPDA), like single-premium life, has enjoyed a rush of popularity since 1986, when the Tax Reform Act of 1986 (TRA-86) eliminated many tax shelters. As the appeal of other investments diminished, SPDAs became increasingly popular. Under current law, the SPDA enjoys the same tax treatment as other annuities, the principal feature of which is that earnings accumulate tax free until distributed. Some insurers sell SPDAs with a deposit premium as low as $2500, but a more common minimum is $10,000.

Market-Value-Adjusted Annuities Market-value-adjusted annuities are fixed annuities that expose the annuity holder to some investment risk if the contract is surrendered. The interest rate is fixed for a specified period, but the cash surrender value fluctuates with the market value of the underlying securities. At set intervals, such as every 5 or 10 years, a window opens, permitting withdrawals without a market-value adjustment.

Two-Tier Annuity The two-tier annuity, which appeared on the market in the late 1980s, is a dual-value, dual interest-rate contract. The two values are an accumulation value and a surrender value. The accumulation value is equal to premiums paid plus interest, and the surrender value is less. The surrender value is subject to a permanent, increasing surrender charge, designed to discourage lump-sum withdrawals. In contrast, in a conventional annuity, at the end of the surrender charge period, the surrender value is the same as the accumulation value. The accumulation value is available only under an annuity payout option. To receive the accumulation payout, the two-tier annuity must be annuitized over a minimum of 5 years. Insurers argue that purchasers' long-term commitment of funds permits them to credit higher investment earnings on the accumulation fund. Critics argue that the abnormal surrender charge, if the policy is terminated prior to being annuitized, prevents the purchaser from withdrawing funds to take advantage of more attractive alternatives that appear.

Index Annuities Index annuities (formerly known as equity-indexed annuities) first appeared in early 1996 and captured a significant portion of the annuities market. In 2006, index annuity sales were estimated to be $25 billion, more than a third of all fixed annuity sales.

An index annuity is a fixed annuity that earns interest or provides benefits linked to the performance of an equity index, such as the Standard & Poor's 500 (S&P500) index. Generally, the crediting rate is a function of the index's relative change, the participation rate (i.e., the percentage of the index growth passed on to policyholders), and any caps imposed on the crediting rate. These annuities typically have minimum interest guarantees and comply with the minimum nonforfeiture law.

Because of the variety in terms and conditions of index annuities, individuals purchasing these products should consider the design features. This includes the indexing method, the participation rate, any rate caps, whether the annuity pays compound or simple interest, and any administrative fees assessed. Consumers should consider whether the equity index recognizes dividends paid on stock. Typically, it does not, resulting in a lower interest rate than would be received if dividends were considered.

Because of the complexity of index annuities, the NAIC produced a buyers' guide in 1998 and encouraged companies to make it available to consumers considering a purchase.

Reversionary or Survivorship Annuity The reversionary life insurance policy (also called a survivorship annuity) form is seldom used, but in certain circumstances, it meets a special need better than any other form of life insurance. Basically, the reversionary policy is life insurance on one person, with benefits in an amount required to provide a lifetime annuity to another person. The premium is based on the life expectancy of both persons. The two individuals on whose lives the premium is based are referred to as the annuitant and the nominator. The nominator is the individual insured, and the annuitant is the beneficiary of the policy. If the beneficiary dies before the insured, the policy expires without value. When this policy is written with a young person as the nominator and an older person as the annuitant or beneficiary, the premium is low since the beneficiary is likely to die before the nominator. In addition, since the amount of insurance required to provide a life income to the annuitant decreases as the annuitant grows older, the protection is written on a decreasing term basis. In computing the premium for this policy, the company estimates the life expectancy of the annuitant and then computes the premium on a decreasing term policy at the age of the nominator. The amount of the decreasing term policy will be the sum necessary to provide a life income to the annuitant at any given time, should the nominator die.

The Variable Annuity Although we have mentioned the variable annuity briefly, given the importance of this annuity form, a few additional comments seem in order. After all, it was the variable annuity that set the pattern for many of the innovative life insurance contracts that followed. It is a classic example of an imaginative approach to a critical problem.

As we noted in Chapter 12, the variable annuity was designed as a means of coping with the impact of inflation on individuals' attempts to save for retirement. Under a fixed-dollar annuity, premiums paid by the annuitant are converted into a lifetime payout and the annuitant is guaranteed a fixed number of dollars monthly or annually for the rest of his or her life. While the number of dollars payable is guaranteed, those dollars may have reduced purchasing power. Under a variable annuity, the premiums are invested in common stocks or other investments and maintained in separate accounts by insurers. (Insurers have greater discretion with respect to the investment of funds in separate accounts.) The underlying philosophy of the variable annuity is that while the value of the dollar will vary over time, the value of a diversified portfolio of common stocks will change in the same direction as the price level. Variable annuities may be variable during the accumulation period and fixed during the payout period or variable during both the accumulation period and the payout period.

History of the Variable Annuity The variable annuity as we know it today was developed by the Teachers Insurance and Annuity Association of America (TIAA), a nonprofit organization founded in 1918 by the Carnegie Foundation to provide college professors with retirement programs.³ In 1952, TIAA created a companion organization, called the College Retirement Equity Fund (CREF). The fund issued its first variable annuity in 1952, and now serves over 3 million participants. Following CREF's innovative lead, private insurance companies became active in the field. The first variable annuities written by a private insurer were issued in 1954 by the Participating Annuity Life Insurance Company of Little Rock, Arkansas, which operated strictly on an intrastate basis. Late in 1955, the Variable Annuity Life Insurance Company (VALIC) was formed in Washington, D.C., and became the first interstate company (other than CREF) in this field. The two most active companies in the early stages of the variable annuity's development were VALIC and the Prudential Insurance Company of America. Their entry into the variable annuity field prompted the SEC to intervene, leading to considerable litigation. The most important issue was whether variable annuities were insurance (and as such exempt from federal regulation under Public Law 15) or, as the SEC contended, securities. The litigation was eventually settled when the U.S. Supreme Court ruled that the variable annuity was a security and so subject to SEC regulation. This decision was vital to the SEC and established the pattern for control of the variable annuity. Variable annuities are regulated by the SEC and the state insurance departments.⁴

Agents who sell variable annuities must be licensed by state insurance departments for the sale of life insurance products and must be registered with the Financial Industry Regulatory Authority (FINRA).⁵

Operation of Variable Annuities Premiums paid into a variable annuity by the purchaser are converted into accumulation units as they are received by the insurer. The number of accumulation units credited to the purchaser depends on the current value of the accumulation units. The value of the accumulation units is determined in much the same way as the value of shares in a mutual fund: dividing the current value of all securities in the insurer's accumulation fund by the total number of accumulation units outstanding. Over time, the value of the accumulation unit rises and falls with the securities' market price held by the insurer. By contributing a fixed amount each month regardless of the fluctuations of the securities' value, the annuity purchasers make use of the principle of dollar averaging.

Many companies selling variable annuities offer self-directed annuities, in which the purchaser has a choice of investments. Under a self-directed annuity, the insurer gives the purchaser a choice among several stock, bond, and money portfolios. The purchaser can allocate his or her premiums among the stock and bond options and can transfer the funds from account to account as conditions change. As the stock and bond markets change over time, the annuity's value changes.

When the annuitant reaches retirement age, the accumulation units are usually be converted into a fixed or variable payout, using a special mortality table for annuitants. Under the variable payout, the number of annuity units does not change over the annuitant's life, but the income produced by each unit will reflect changes in the investments' value, with the current value of the annuity unit determining the annuitant's income.

How Well Has It Worked? As a pioneer in the field of variable annuities, CREF has established a 60-year-plus record that is helpful in appraising the performance of variable annuities. The period since the inception of the CREF program has been marked by continued inflation. As an indication of the program's performance, the value of the CREF accumulation unit since 1952 is presented in Table 18.1.

Although the value of the CREF accumulation unit has increased over time, there have been periods when it fell. Between 2007 and 2009, the accumulation unit value fell 36 percent, reflecting the impact of the recent financial crisis. At times, the accumulation unit's value can fall when inflation occurs. Between 1972 and 1974, for example, the value of the accumulation unit fell 43 percent while the Consumer Price Index (CPI) increased 18 percent. The accumulation unit value did not reach its 1972 level until 1979; during the same five-year period, the cost of living had increased by 74 percent. Declines in the value of a variable annuity are unwelcome, but they are especially so during periods of rising consumer prices. These examples are a stark reminder to many annuitants that under the variable annuity, the annuitant assumes the investment risk even though the insurance company guarantees a lifetime income.

TABLE 18.1 Value of CREF Accumulation Unit, 1952–2006

Variable Annuities with Guaranteed Benefits In response to concerns about the possible decline in the annuity's value if investment performance is poor, insurance companies offer a number of performance guarantees. Generally, these fall into two broad types: guaranteed minimum death benefits (GMDBs) and guaranteed living benefits (GLBs).

GMDBs are received only if the the annuity contract's owner or the covered annuitant dies. They provide the policyholder with a guaranteed death benefit at the time of death regardless of the investment performance. The insurer may promise a return of premiums paid, a return of premiums with some guaranteed minimum return, or a return of the highest annual account value during the term of the policy. GLBs guarantee a minimum payout on the variable annuity in the future regardless of the investment performance. These take one of three forms. Guaranteed minimum accumulation benefits guarantee the minimum accumulation value in the future, e.g., after 10 years. Guaranteed minimum income benefits guarantee a minimum income stream when the contract is annuitized. This is composed of two guarantees. The insurer guarantees a minimum account value at annuitization, coupled with guaranteed rates that are used to calculate the annuity payout on that account value. Finally, guaranteed minimum withdrawal benefits allow the policyholder to withdraw a specified percentage of the guaranteed account value (e.g., 5 percent) over a specified period. The withdrawal period is typically a number of years (e.g., 20). Some policies offer withdrawals for life. Because of the risks to the insurer that the account value will not be adequate to support the guaranteed benefits, insurers charge additional fees for the guarantees.

In the mid-2000s, U.S. insurance regulators devoted considerable energy to updating requirements for reserves and risk-based capital standards to recognize the risk insurers were assuming in these products. Even so, losses were unexpectedly large when the equity markets fell during the global financial crises in 2008 and 2009, stressing some life insurer capital positions. Since the crisis, life insurers have redesigned their products to make the guarantees less generous and, hence, less risky for the insurer.

The Contingent Deferred Annuity A new development is the contingent deferred annuity (CDA), which is used to provide guaranteed lifetime income if “covered assets” are inadequate to do so. In contrast to a variable annuity, however, the insurer may not hold the assets. Thus, for example, the insured could combine a CDA with a separate mutual fund to guaranty a lifetime income. In that sense, the CDA provides something comparable to the guarantees on a variable annuity but without the underlying assets, and it is sometimes referred to as “wrapping” the mutual fund. Not surprisingly, given their exposure to decreases in the value of the assets, insurers that market CDAs have strict conditions on the type of assets they will wrap.

There are a number of regulatory issues surrounding CDAs. Many regulators and others worry that the risks in CDAs are too great for the industry. Some even question whether they qualify as insurance. If the product is permitted, regulators need to address reserving requirements, risk-based capital, solvency safeguards, and consumer protections related to marketing and disclosure. In 2012, the NAIC formed the Contingent Deferred Annuities Working Group to study the issues and make recommendations.

Annuities as Investments for Retirement

The return that will be earned over an annuity's life depends on a variety of features. The three most important of these are the interest rate, the surrender charge, and administrative expenses. In general, these features are similar to those discussed in connection with single-premium life. For example, a “current” rate of interest is guaranteed for a specified number of years during the accumulation period, after which the interest rate may be changed but subject to a guaranteed minimum interest rate. The guarantee period may range from 1 year up to 10, and some insurers offer the buyer a choice as to the period for which the current rate will be guaranteed. Usually, the longer the period for which the rate is guaranteed, the lower the rate. In the case of an annuity, a guaranteed settlement option rate and a current settlement option rate are available during the payout period. The guaranteed rate is a contract minimum and is the interest assumption on which the minimum monthly installments are computed. If the current settlement option rate is higher than the guaranteed rate, the annuity benefit will be proportionately higher. The guaranteed settlement option rate is set on a conservative basis, usually 2 to 4 percent today. Actual payments reflect the higher earned rate, generally in the range of 7 to 9 percent over the past decade.

As in the case of other investment vehicles, a part of the premium for deferred annuities purchased on an installment basis goes to pay expense charges. Although some insurers still charge a front-end sales fee of 4 or 5 percent of the premium, most insurers have eliminated front-end commission charges on annuities and use a surrender fee for early withdrawals. The surrender fee usually begins at a high level (8 to 10 percent) and then diminishes until it disappears after a specified period (ranging from 7 to 15 years). In addition to the surrender charges, there is usually an annual maintenance fee of from $25 to $50 to cover administrative costs. For variable annuities, asset management fees similar to those levied by regular stock and mutual fund accounts are assessed. These fees may range from 0.25 to 2 percent of the accumulated assets. The administrative fees are automatically deducted from the investment account.

Regulation of Annuity Sales

As the baby boom population began to focus on planning for retirement, sales of annuity products by life insurers exploded. By 2011, annuity premiums accounted for more than half of the premiums collected by life insurers, compared to 20 percent from sales of life insurance.⁶ Reserves for annuities and related contracts accounted for nearly two-thirds of total reserves in 2011.

This increased market activity led to increased interest from regulators, including the SEC, NASD (FINRA's predecessor organization), and state insurance regulators.⁷ Stories of senior citizens who were sold annuities in their 70s and 80s focused regulatory attention on the need to address improper sales.

Recall that variable annuities are securities and thus subject to federal securities regulation as well as to state insurance regulation. FINRA rules on securities sales mandate that recommendations must be “suitable.” That is, the agent is required to obtain information about the customer, including his or her financial and tax status and investment objectives, and make recommendations that are “suitable” for that consumer. These suitability rules apply to the sales of variable annuities and variable life insurance.

In June 2004, the SEC and the NASD issued a joint report on their findings from a series of examinations into variable annuity sales practices, recommending that regulators focus more on the suitability of variable products sales.⁸ Following up on the report, in 2005, the NASD proposed a rule that would establish specific requirements for deferred variable annuities, including suitability, supervisory review and approval of a sale, and training requirements. The proposed rule was amended several times and adopted by FINRA in September 2007.⁹

Other recent activity has focused on the sale of index annuities (also known as equity-index annuities). In 2009, the SEC adopted Rule 151A, requiring index annuities to be treated as investments and filed with the SEC as variable annuities are. Insurers selling index annuities sought to overturn the rule, arguing the annuities are not variable and, hence, are not subject to SEC oversight. In 2010, the U.S. Court of Appeals for the D.C. circuit vacated the rule, finding that the SEC had not conducted a required impact analysis. Subsequently, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) settled the confusion by including a provision requiring the SEC to treat index annuity and life insurance products as not being securities if they meet certain conditions. Subsequently, the SEC withdrew Rule 151A.

Simultaneously, state insurance regulators have been engaged in their own efforts to enhance consumer protection. In 2003, the NAIC adopted the Senior Protection in Annuity Transactions Model Regulation, which extended suitability requirements to variable and fixed annuities, including index annuities. Industry resistance to the model in 2003 led to a compromise under which the requirements would apply only to recommendations made to individuals age 65 and older. In June 2006, the NAIC amended the model to apply at all ages and renamed it the Suitability in Annuity Transactions Model Regulation. It was further revised in 2010 to make the requirements more consistent with FINRA suitability requirements, to provide more details on how an insurer should comply with the requirements, and to introduce a specific training requirements for agents selling annuities. By mid-2013, the model had been adopted in more than 20 states.

The NAIC model requires an insurance producer (i.e., agent or broker) to make reasonable efforts to obtain information on the consumer's financial status, tax status, investment objectives, and other relevant information. The producer must have reasonable grounds for believing his or her recommendation is suitable for the consumer, based on the consumer's financial situation and needs. Insurers are required to establish systems to supervise the recommendations of producers.

In addition to suitability, the NAIC is working to improve disclosures to prospective annuity buyers. In 2011, the NAIC revised its Annuity/disclosure Model Regulation, originally adopted in 1999. The Model Regulation requires insurers to provide an Annuity Buyers Guide and a Disclosure Document to an annuity applicant, and it establishes time frames for their delivery. The 2011 amendments added standards for any policy illustrations the insurer decides to use. In 2013, the NAIC was updating its Annuity Buyers Guide.¹⁰

QUALIFIED RETIREMENT PLANS

Although private pension plans in the United States have existed since the late 1800s, their greatest growth has taken place since World War II. In 1940, about 4 million people (i.e., fewer than 20 percent of all employees in government and industry) were covered by private pensions. By 2011, 61 million persons, including nearly half of all workers in private business and three-fourths of all government workers, were enrolled in retirement programs other than Social Security. Qualified retirement plans are established by employers, and sometimes jointly by unions and employers, to provide individual workers with a retirement income that will supplement Social Security retirement benefits. The plan may be set up for the employees of a particular firm, or it may be a “multi-employer” plan, serving workers from several unrelated firms.

Retirement plans may be noncontributory, in which case the employer bears the entire cost of the pensions, or they may be contributory, with employees making contributions in addition to those of the employer. Employee contributions may be voluntary, or they may be required for participation. Although employee contributions are not usually deductible by the employees, the investment income on such contributions is exempt from federal taxes until distributed, which makes savings plans a form of tax-deferred compensation.

A General Overview of Qualified Plans

A qualified retirement plan is one that conforms to the requirements of federal laws and for which the Internal Revenue Code (IRC) provides favorable tax treatment. Employer contributions are a tax-deductible expense at the time they are made, and the employee is not taxed on the employer's contributions until benefits are received (usually at retirement). Also, during the accumulation period, investment income on accumulating funds is not subject to taxation and will be taxed when paid out to the employee. This means funds in a retirement plan will accumulate to a larger amount on an after-tax basis than will unlike funds held in other (non-tax-deferred) forms.

Federal Regulation of Private Retirement Plans Private retirement plans are regulated by the federal government. The major law relating to private plans is the Employee Retirement Income Security Act of 1974 (ERISA). ERISA prescribes which employees must be included in a plan, establishes minimum vesting requirements, specifies the amounts that may be contributed, and sets forth minimum funding requirements. The act also requires extensive reporting and disclosure information about pension and welfare programs, their operations, and their financial conditions to the Secretary of Labor, the IRS, and to those covered by the plan and their beneficiaries.¹¹

Qualification Requirements For the IRS to qualify a plan, it must conform to certain standards specified in the IRC. In general, to be qualified, the plan must be designed for the exclusive benefit of employees and their beneficiaries, must be in writing and communicated to the employees, and must meet one of several vesting schedules. Contributions and benefit formulas cannot be designed to discriminate in favor of officers, stockholders, or highly compensated employees, and the plan must provide for definite contributions by the employer or for a definite benefit to the worker at the time of retirement. (Profit-sharing plans are an exception in which the contributions vary with the profits of the firm.) Life insurance benefits may be included in the plan only on an incidental basis.¹² Finally, top-heavy plans are subject to special requirements designed to guarantee they provide minimum benefits or contributions for rank-and-file workers.¹³ (Top-heavy plans are ones that provide a disproportionate share of their benefits to owners or other highly paid executives.)

Basic Types of Qualified Plans

The IRC recognizes several types of qualified plans, including corporate plans, plans for self-employed persons and their employees and several “simplified” plans for small employers. In addition to the various plans offered by employers, federal tax law also provides tax-deferred treatment to Individual Retirement Accounts (IRAs), under which individuals may accumulate funds for retirement. IRAs are used as funding vehicles for several types of simplified employer-sponsored qualified plans under which employers make contributions to an IRA plan on behalf of their employees. Finally, IRAs provide a basis for portable pensions. Regulations permit persons who terminate employment and receive a lump-sum distribution from a qualified plan to “roll over” the distribution into an IRA. This defers taxation until the proceeds are withdrawn from the IRA at a later date.

The various types of employer-sponsored plans differ in eligibility and in permissible limit on contributions imposed by the IRC. Although these plans may differ in design, the amount of benefits received by the employee at retirement under all plans is based on a formula applicable to all employees. All employer-sponsored plans fall into one of two basic benefit formula categories: the defined contribution approach and the defined benefit approach.

Defined Contribution Pension Plan A defined contribution plan (also called money purchase plans), works as its name implies. The employer's contribution to the plan is set as a percentage of compensation, for example, 5 percent or 10 percent of the employee's wages. The employee's retirement benefit is the amount that the contributions and investment earnings on those contributions will provide at retirement age.

Defined Benefit Pension Plan Under a defined benefit pension plan, the employer promises to pay the employee a specific income at retirement. The benefit the employee will receive at retirement is specified in a benefit formula, and the employer's contribution is the amount that will be required, together with the investment earnings on the contributions, to provide the specified benefit and to pay the expenses of the plan. Benefit formulas for defined benefit plans are usually based on the employee's salary, the benefit accrual rate, and the employee's years of service. Under final average salary plans, the benefit depends on the salary earned in the later years of employment. For example, a plan may promise a monthly benefit equal to 1 percent of the average monthly salary during the last three years of employment for each year worked. An employee who worked for the employer for 40 years would receive a benefit equal to 40 percent of the final three-year average salary. Other plans are career average salary plans, and the benefit is a function of the salary earned in all years of employment.

Significance of the Nature of the Employer's Promise

Defined contribution plans and defined benefit plans vary in the manner in which the employer's contribution is determined, but this difference creates other differences from the employee's perspective.

Investment Risk Under a defined contribution plan, the employer promises to make contributions to an account that earns investment income. The employer does not make any guarantee concerning the retirement benefit amount. The accumulated contributions will be available to provide a benefit to the employee, and the amount of the benefit will depend on the level of contributions and the amount of investment income. If investment income is less than anticipated, the accumulation will be less than expected and the retirement benefit will be lower. Similarly, a higher investment income will increase the retirement income available to the employee. Because the employer promises to make contributions to the plan but does not guarantee any benefits level, the employee bears the investment risk in a defined contribution plan. Since the employee bears the investment risk in a defined contribution plan, he or she is likely to have some say in how the funds are invested. Employers may provide a number of investment options from which the employee may choose. In a defined benefit plan, the employer's promise is to provide a certain level of retirement benefits to the employee, starting at normal retirement age. The employer determines the required contributions to the pension fund by making assumptions about the number of employees who will reach retirement age, the time for which benefits will be paid, and the rate of investment income earned on the pension fund. The higher the assumed investment income, the lower the employer's required contribution. If, however, investment income goes down and is inadequate to fund the benefits, the employer must increase the contributions because the employer's obligation is to provide the promised benefits.

Advantages to Younger and Older Employees In addition to the difference between who bears the investment risk, defined benefit and defined contribution plans differ in their relative advantages to young and older employees. In general, a higher proportion of the retirement benefits are earned in the early years of participation in a defined contribution plan. This is because the contribution in early years will accumulate with investment income for a longer period than the contribution in later years. Hence, the accumulation at retirement will be larger, and the benefits it can purchase will be greater. On the other hand, the present value of the benefits promised to a young worker under a defined benefit plan tends to be small compared with the present value of the benefits promised when the worker is closer to retirement.

Job Mobility As indicated earlier, in a typical defined benefit pension plan, benefits are based on the employee's average earnings over his or her career or are based on earnings in some final years of service (e.g., the last three). As a worker continues to work, and his or her salary increases, the value of previously accrued benefits increases. However, if the employee leaves to work for another employer, the amount of the benefit payable at retirement stops increasing. Benefits are frozen at the salary level the employee was earning when he or she terminated. In contrast, the value of an employee's defined contribution plan will increase as investment income is earned. Thus, defined contribution plans tend to be more valuable for younger workers.

Forfeitures Defined contribution and defined-benefit plans may differ in how they deal with amounts forfeited by employees who terminate before being fully vested. In a defined contribution plan, amounts that are forfeited by employees who leave before being fully vested may be used to reduce future employer contributions, or they may be reallocated among remaining participants on a nondiscriminatory basis. In a defined benefit plan, gains from employee termination may be used only to reduce future employer contributions.

Protection for Inflation Given the long period between the time an employee begins to work for an employer and the time retirement benefits are paid, the employee would be wise to consider how the plan protects against the risk of inflation during the working years. Similarly, the individual may be retired for many years, and the effect of inflation during retirement on the purchasing power of the benefits should be considered.

Defined benefit final-average-salary plans provide the greatest protection against inflation during the employee's working years since the retirement benefits are based on the employee's earnings during the period immediately preceding retirement. Career-average salary plans, on the other hand, base the benefits on the employee's salary throughout his or her career. Inflationary periods will reduce the value of the salary paid in early years and, hence, the benefits based on those early salaries. Defined contribution plans have, to some extent, a built-in protection against the risk of inflation since the investment earnings on the funds are likely to be higher in inflationary periods.

Some private plans provide cost-of-living adjustments (COLA) during retirement years to protect against decreases in the purchasing power of benefits after retirement. This benefit tends to be uncommon, however, and even when offered, the adjustment is subject to an annual cap.

The Shift to Defined Contribution Plans Since the 1970s, there has been a significant shift toward defined benefit contribution plans. In 1979, 38 percent of private sector employees participated in a defined benefit plan, either alone or in conjunction with a defined contribution plan. By 2011, it had fallen to 14 percent. The percentage of employees participating in a defined contribution plan, meanwhile, grew from 17 percent to 42 percent over that time period.¹⁴ There are several reasons for the shift to the defined contribution approach. The first was passage of the ERISA, which required that employers insure defined benefit plans with the Pension Benefit Guaranty Corporation (PBGC), thereby increasing their cost.¹⁵ Changes to pension accounting rules are also factors. The low interest rate environment following the recent financial crisis increased plan deficits and employer costs. Finally, Section 401(k) accounts were created in 1978, and changes introduced by Economic Growth and Tax Reconciliation Act of 2001 (EGTRRA-2001) made them more appealing to employers and employees. Section 401(k) plans are discussed later in this chapter.

Other Types of Qualified Plans

Cash Balance Plans A cash balance plan is a special form of defined benefit plan that looks like a defined contribution plan. In most cash balance plans, the benefit is defined in terms of a “hypothetical account.” The account is hypothetical because it is a bookkeeping entry to track an employee's accumulated benefit, and no assets are deposited into the account. The participant's hypothetical account is credited each year with a pay credit (e.g., 5 percent of compensation) and an interest credit. Interest may be credited at either a fixed rate or variable rate tied to some index (such as the one-year Treasury bill rate).

As with a defined contribution plan, the employee's benefit at retirement is a function of the account value. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity. The annuity might pay approximately $10,000 per year for life. In many cash balance plans, the participant is given the option of instead taking a lump-sum benefit equal to the account balance (with consent from his or her spouse).

Because these plans have characteristics that are similar to defined contribution and defined benefit pension plans, they are sometimes called hybrid plans. However, for regulatory purposes, they are treated as defined benefit plans because the employer bears the investment risk. The employer contributes assets to a pension fund, but investment earnings do not affect the interest credited to the plan participant.

In the last decade, a number of plans have converted from a traditional defined benefit pension plan to a cash balance pension plan. These conversions were criticized as harming older workers because the value of the benefits earned in later years of employment under a cash balance plan tended to be lower than those under a traditional defined benefit pension plan.¹⁶ As a result, in recent years, most employers have permitted their older employees the option of staying under the old plan or have automatically grandfathered longer-serving employees into the old plan.

Current law sets standards for plans converting. Generally, a participant's benefit after conversion must be at least as large as the benefit under the prior plan formula as of the date of conversion plus the benefit under the new plan for prior service. The plan must maintain any early retirement benefit or subsidy that had been earned under the prior plan. A plan will not be considered to discriminate against older workers as long as benefits are fully vested after three years of service, and interest credits do not exceed a market rate of return. Also, the participant's accrued benefit must not be less than the accrued benefit of any other employee similarly situated in all respects except age.¹⁷

Qualified Profit-Sharing Plans A qualified profit-sharing plan is a form of defined contribution plan since ultimate benefits depend on the amount contributed by the employer. A major difference between a qualified profit-sharing plan and a defined contribution pension is that the contribution under a profit-sharing plan need not be fixed; employers may vary the contribution yearly (theoretically, according to profits). Although a profit-sharing plan does not require annual contributions, the IRS does require that recurring and substantial contributions be made (generally interpreted to mean that a contribution should be made at least once every three years). In addition, the plan must provide a formula for allocating the contributions made among employees on a nondiscriminatory basis. The most common approach is to allocate contributions according to the ratio of each employee's earnings to the earnings of the group.

Profit-sharing plans may be contributory or noncontributory. Because it is an oxymoron to speak of “employee contributions to a profit-sharing plan,” when employees contribute their own funds into a plan, the plan is usually called a thrift or savings plan.

Section 401(k) Plans Section 401(k) plans, also called cash or deferred plans, derive their name from the IRC section that outlines the rules for these plans. A Section 401(k) plan is a special type of profit-sharing or stock bonus plan that permits employees to make contributions to the plan on a pretax basis. These plans provide a mechanism for accomplishing two apparently conflicting goals: increasing the retirement income of some employees while increasing the current compensation of others. This is accomplished through a profit-sharing plan under which employees individually elect whether to receive their contributions currently or have them deferred. In practice, the employees elect to contribute a portion of their income into a profit-sharing plan and instruct their employer to make contributions on their behalf. The IRC provides that the amounts an employee elects to defer under Section 401(k) are treated as contributions by the employer rather than by the employee. This makes all monies set aside in the plan deductible by the employer, and the contribution and its earnings are tax free to the employee until withdrawal. Although deferrals are subject to Social Security and Medicare taxes, they are not included in the employee's taxable income for income tax purposes.¹⁸

Unfortunately, in spite of their increasing importance, many employees fail to participate in their employer-sponsored 401(k) plans. Given the diminishing prevalence of defined benefit pension plans, public policymakers have sought to encourage increased participation rates. One option that was suggested was to permit employers to automatically defer a portion of the employee's salary, subject to allowing the employee to opt out. The PPA-2006 established standards for qualified plans to do this. The employer must give proper notice to employees who are automatically enrolled, including notice of their right to opt out and an explanation of how the contributions will be invested if the employee does not choose an investment option. Unless the employee chooses otherwise, the contributions must be invested in default investment options that comply with rules established by the U.S. Department of Labor.

The act created a new automatic enrollment safe harbor called a Qualified Automatic Contribution Arrangement, which is excluded from nondiscrimination tests and top-heavy rules.¹⁹ Under this arrangement, unless the participant chooses otherwise, the default deferral rate must be at least equal to the following percentages: 3 percent in the first year, 4 percent in the second year, 5 percent in the third year, and 6 percent in the fourth year. In addition, plan sponsors must make one of the following contributions: automatic 3 percent for all eligible non–highly compensated employees (NHCEs) or a match for NHCEs of 100 percent of deferrals up to 1 percent of compensation plus 50 percent between 1 percent and 6 percent.

Employee Stock Ownership Plan An employee stock ownership plan (ESOP) is a qualified stock bonus plan related to the qualified profit-sharing plan. The principal difference is that under an ESOP the employer gives employees part of the firm in the form of stock in the corporation instead of giving them a part of the firm's profits. Although contributions to an ESOP may be made in cash or in stock, the accumulation in the employees' portfolio is based on the value of the employer's stock.

Keogh Plans Keogh plans are qualified retirement plans for self-employed persons and their employees. Self-employed persons are permitted to make tax-deductible contributions to a retirement plan, provided the plan includes coverage for all other eligible employees on a nondiscriminatory basis. A Keogh plan may be established as a defined benefit plan, a money purchase plan, or a profit-sharing plan, subject to similar limitations, deductions, and benefits that apply to corporate pension or profit-sharing plans.

Simplified Employee Pension (SEP) Plans A simplified employee pension (SEP) permits employers to provide retirement benefits under a less complex arrangement than a qualified pension plan. Under a SEP, the employer contributes to a traditional IRA (or individual retirement annuity) that the employee owns and controls. The employer makes contributions to the financial institution where the IRA is maintained. Employee contributions are not allowed, and employer contributions are immediately vested.

Section 457 Plans These plans are similar to Section 401(k) plans but are designed for state and local governments and their employees. They permit contributions to a tax-deferred retirement savings plan established for the benefit of employees.

DB(k) Plans The PPA-2006 created a new type of plan known as the DB(k) plan, limited to businesses with 500 or fewer employees. This hybrid plan contains defined contribution and defined benefit elements, combining a traditional defined benefit pension plan with a 401(k) savings plan. Employers are required to provide a defined benefit equal to 1 percent of the employee's final average pay for up to 20 years of service.²⁰ Under the defined contribution portion, the employer must automatically enroll employees at 4 percent of their salary and offer a 50 percent, immediately vested, match on that amount. Remaining amounts in the defined benefit portion of the plan must be 100 percent vested after three years. The motivation for DB(k) plans was twofold: to encourage employers with few employees to offer some element of defined benefits, which tend to provide greater retirement security for employees, and to simplify the administrative effort required to supplement those benefits with a 401(k) plan.

Section 403(b) Plans for Employees of Nonprofit Organizations The employees of certain nonprofit organizations (referred to in the IRC as Section 501(c)(3) organizations) are permitted to make before-tax contributions to tax-sheltered annuities under what are called 403(b) plans. As in 401(k) plans, the employee makes an agreement with the employer to reduce his or her salary by an amount equal to the contribution to the retirement plan.

SIMPLE Plans The Small Business Job Protection Act of 1996 (SBJPA) introduced a new plan type, known as a savings incentive match plan for employees (SIMPLE) plan. SIMPLE plans are available only to employers with 100 or fewer employees, and they may be structured as either a 401(k) plan or IRA. (Most plans are SIMPLE IRA plans.) In either case, the key feature is their exemption from many of the complicated rules applicable to other qualified plans, such as the top-heavy rules and other complex nondiscrimination rules. All employees with two years' earnings of at least $5000 in each year and compensation of at least $5000 for the current year must be eligible to participate. Eligible employees make annual voluntary salary deferral contributions up to a statutory dollar maximum, regardless of their compensation level. The employer must match employee contributions up to 3 percent of annual compensation or must make nonelective contributions for all eligible employees of 2 percent of compensation.

Other Requirements for Qualified Retirement Plans

Qualified retirement plans must conform to certain standards specified in the tax code and ERISA. Some of these requirements are discussed in Chapter 23, but the significant ones that directly affect the employee are discussed next.

Vesting Requirements The term vesting refers to the right of a covered employee to retain a claim to the benefits accrued even though his or her employment terminated before retirement. Under current law, qualified retirement plans are generally subject to one of two sets of vesting standards, depending on the plan type. Under either set of standards, a cliff option and a graded vesting option are available. The minimum vesting standards for employer contributions are given in Table 18.2. These vesting schedules are minimum requirements, and an employer may provide vesting at a more rapid rate. Whenever the plan requires employee contributions, the employee contributions are always 100 percent vested.

Limits on Contributions and Benefits Because of the tax advantages of qualified plans, the following limits are placed on the allowable benefits and contributions:²¹

TABLE 18.2 Minimum Vesting Standards

• There is a limit on the maximum compensation that may be taken into account when calculating allowed contributions or benefits. In 2013, the limit was $255,000. It is indexed for inflation in increments of $5000.²²
• The annual addition to all of an employee's defined contribution plans is limited to 100 percent of compensation, subject to a dollar maximum.²³ The dollar maximum was $51,000 in 2013 and is indexed for inflation in increments of $1000. This limit applies to all contributions to the account, including salary deferrals and employer contributions, but does not include permitted catch-up deferrals (described below).
• The maximum benefit allowed in a defined benefit pension plan is 100 percent of the employee's earnings in the person's three consecutive years of highest earnings, subject to a dollar maximum. In 2013, the maximum annual benefit permitted was $205,000. This is indexed for inflation in increments of $5000. The maximum benefit is the amount that may be paid to participants age 62 to 65. If benefits are paid earlier, the maximum is reduced, and if later, it is increased.
• The limit on elective deferrals in Section 401(k), 403(b), and 457 plans is 100 percent of compensation up to a maximum of $17,500 in 2013.²⁴ In addition, participants who are age 50 or older are permitted to make additional catch-up deferrals. In 2013, the annual limit on catch-up contributions was $5,500. Both limits are indexed for inflation in increments of $500.
• The maximum employer contribution to a SEP or defined-contribution Keogh plan is the lesser of 25 percent of employee compensation or $51,000.
• The limit on elective deferrals to a SIMPLE IRA was $12,000 in 2013, with an additional catch-up contribution of $2500 permitted for individuals age 50 and older.

These limits mean, for example, that a defined contribution plan that provides an employer contribution equal to 10 percent of compensation would provide a $10,000 contribution for a person earning $100,000 but only $25,500 for a person earning $300,000. The benefit and contribution limits are intended to limit the tax advantages received by the highest-income individuals and the resulting impact on federal revenues.

For plans covering self-employed individuals, a special definition of earned income is used to make contributions by a self-employed person correspond to those for a common-law employee. First, the self-employed business owner's net earnings must be reduced by the income tax deduction for half the owner's self-employment (Federal Insurance Contribution Act or FICA) tax. In addition, the contribution percentage applies to the owner's net income excluding the contribution itself. For example, if a partnership establishes a 25 percent defined contribution Keogh plan and a partner earns $100,000, the deductible contribution on his or her behalf will be $20,000 (25 percent of earned income of $80,000), not $25,000.²⁵

Roth Contributions to 401(k), 403(b) and SAR-SEP Plans Beginning in 2006, Section 401(k) plans and Section 403(b) plans could include provisions for after-tax employee contributions to the plan. These contributions are referred to as Roth contributions, after Senator William Roth of Congress who introduced the concept of after-tax IRA contributions. The contributions and investment income on the accumulation may be withdrawn tax-free after the employee has completed five years of service and reaches age 59½.²⁶

Permitted Disparity Although the rules of the tax code require the benefit design be nondiscriminatory, employers may recognize the FICA payments made on behalf of employees and consider benefits under Social Security in establishing the plan's benefit formula. This allowance is known as permitted disparity (formerly integration). Defined benefit and defined contribution plans may recognize Social Security.

Because Social Security benefits are based on an employee's compensation only up to the wage base and replace a lower percentage of income at higher income levels, permitted disparity rules allow the employer to provide higher benefits at higher compensation levels. In a defined contribution plan, the employer reduces the contribution to the pension plan on a part of the wages subject to the FICA tax. In a defined benefit plan, the benefit formula replaces a higher percentage of earnings in excess of some level than is provided for earnings below that level.

Savers Tax Credit for Employee Contributions EGTRRA-2001 introduced an entirely new feature applying to qualified retirement plans: a tax credit for certain low-income workers.²⁷ Contributions may be made to an employer-sponsored pension plan or to a traditional or Roth IRA. The credit is equal to a percentage of the first $2000 of the individual's annual contribution to a qualified retirement plan and varies inversely with the individual's income. For 2013, the income limits and associated credit rates were as follows:

If the taxpayer does not have a tax liability prior to the application of the credit, the credit is lost. These limits will be indexed for inflation in future years.

Other Benefits

Although the basic purpose of a pension plan is to provide retirement benefits, some plans include other features such as death benefits and disability benefits.

Preretirement Death Benefits A death benefit prior to retirement of the employee is an optional feature in pensions except in the case of a contributory plan, in which the employee's contribution is payable as a death benefit. Some employers provide for a death benefit before retirement based on the employer's contributions. Federal regulations require that a qualified plan must provide that if a vested participant dies before the annuity starting date leaving a surviving spouse, benefits will be paid in the form of a qualified preretirement survivor annuity. In addition, some plans include preretirement death benefits via life insurance. As a rule, a defined contribution plan (e.g., a money purchase pension or a profit-sharing plan) can provide (1) term insurance, as long as the premiums are less than 25 percent of the allocation to the employee's account or (2) permanent insurance, as long as premiums are less than 50 percent of the allocation.²⁸

Postretirement Death Benefits Postretirement death benefits may be provided by annuities with joint-and-survivor options or by annuities with period-certain payments.

Required Joint-and-Survivor Option

ERISA required any participant who has been married for at least one year specifically to decline or else default to accepting a joint-and-survivor option of at least 50 percent of the participant's retirement benefit. The Retirement Equity Act of 1984 extended this requirement, mandating that qualified retirement plans provide automatic survivor benefits to the surviving spouse of a retiree or to the surviving spouse of a vested participant who dies before retirement. Spousal consent is required for a participant to elect out of joint-and-survivor annuity or preretirement survivor annuity coverage. Since 2007, plans have been required to offer a joint and 75 percent survivor annuity.

Period-Certain Payments

It is possible to arrange the benefits under a pension plan so a benefit is payable for some minimum time period, regardless of the beneficiary's death. So-called period-certain arrangements require the plan to pay for the life of the beneficiary or for a specified time period (such as 5 or 10 years), whichever is longer. Election of the period-certain option reduces the amount payable to the beneficiary on a lifetime basis.

Disability Benefits Some pension plans make provision against the contingency of the employee's total and permanent disability. A plan may provide for the payment of disability benefits, as long as the cost of such benefits, when added to any life insurance protection provided by the plan, are subordinate (less than 50 percent of cost) to the retirement benefits. Under some plans, disability is treated as a form of early retirement, with a reduced retirement benefit payable. A more favorable approach provides for continued contributions to the plan on behalf of the disabled employee. The contributions are based on the compensation the employee would have received if he or she was paid the compensation earned immediately before becoming totally and permanently disabled.²⁹

Distribution Requirements

The provisions that limit contributions and the accrual of benefits are supported by requirements regarding the time at which benefits may commence, the time at which they must commence, and by a tax on excess contributions.

Commencement of Benefits The IRC generally requires that distributions from a tax-qualified retirement plan commence no later than April 1 of the calendar year following the calendar year in which an employee attained age 70½. Distributions may be deferred to actual retirement if later.³⁰ If deferred, the eventual distributions must be actuarially increased to take into account the period after age 70½ in which the employee was not receiving distributions.³¹

When distribution begins, it must be made over one of the following periods:

• The life of the participant or the lives of the participant and a designated beneficiary
• A period not extending beyond the life expectancy of the participant and his or her beneficiary

Under the first option, the accumulation is annuitized, and the plan administrator makes payments for the entire lifetime of the participant (and beneficiary if the joint life option is selected). The annuity may be based on one or two lives, and the annuitant may elect a minimum guaranteed number of payments. The key feature is that benefits are payable based on a life contingency.

Under the second option, distributions are based on the life expectancy of the individual (or the individual and his or her spouse) but cease when the funds are exhausted. If the entire accumulation is not paid out before the individual dies, the balance is paid to the designated beneficiary or the decedent's estate. The key feature in this arrangement is that the accumulation is distributed based on a life expectancy but is not guaranteed for life.

Distributions from SIMPLE IRAs Generally, the same tax results apply to distributions from a SIMPLE IRA as to distributions from other plans. However, a special rule applies to a payment or distribution received from a SIMPLE IRA during the two-year period beginning on the date on which the individual first participated in a SIMPLE plan. Taxable distributions during this period are subject to a 25 percent penalty rather than the 10 percent penalty applicable to other plans. Also, during the initial two-year participation period, transfers from a SIMPLE IRA are permitted only to another SIMPLE IRA. Transfers to an IRA that is not a SIMPLE IRA do not qualify as rollover contributions.

Premature Withdrawals A 10 percent penalty applies to premature withdrawals that are made before the individual reaches age 59½. The penalty does not apply to withdrawals that are rolled over into another qualified plan or an IRA. The penalty does not apply if (1) the distribution is made on account of the employee's death or disability; (2) the distribution is used to pay deductible medical expenses; (3) the distribution is pursuant to a qualified domestic relations order, (4) the distribution is received as an annuity over the employee's life or under a joint life annuity including a beneficiary; (5) the individual is at least age 55 and meets the requirements of a plan that permits retirement at his or her age; or (6) the distribution is made to certain public safety employees from a government plan.³²

The PPA-2006 added another option for penalty-free withdrawals from an IRA, 401(k), or other qualified plan. This option applies to a taxpayer who was a member of the reserves and was called to active duty for 180 days or longer. The taxpayer may withdraw funds without tax or penalty and has up to two years after the end of his or her active-duty period to recontribute the amount withdrawn and avoid tax on the distribution.

Taxation of Distributions

Distributions from a qualified pension are taxable to the recipient when received, under special rules. In addition, if the participant dies, a distribution to his or her dependents is taxable as income and, in some cases, is subject to estate taxes.

Income Taxes Most retirement plans provide for optional methods of receiving distributions. For example, a participant may receive plan benefits in a lump sum or in installments over his or her life. The method of distribution determines the taxation.

Installment Distributions Retirement benefits have traditionally been paid to participants as lifetime annuities. Amounts distributed in installments will generally be taxable to the distributee under special annuity rules of IRC Section 72. Installment distributions are taxable only to the extent they exceed the employee's investment in the contract. Every payment, beginning with the first, is considered part taxable income and part nontaxable. The nontaxable part consists of the portion of the payment that represents the employee's nondeductible contribution and is referred to as the exclusion ratio.³³

Lump-Sum Distributions An employee who receives a lump-sum distribution may choose from among several alternatives. He or she may roll the distribution over into an IRA or another qualified retirement plan, in which case there is no tax on the distribution until it is received from the IRA or other plan. Alternatively, taxpayers with an adjusted gross income (AGI) of less than $100,000 may roll over distributions into a Roth IRA.³⁴ If the distribution would have been taxable had it not been for the rollover, it is included in the individual's gross income, but no tax will be on later distributions. Finally, within 60 days of receiving a lump-sum distribution, an employee may use the distribution to purchase a single-premium nontransferable annuity, and the distribution will be taxed under annuity rules.

Death Benefits If all or part of a plan's death benefits are payable from the proceeds of a life insurance policy, the excess of the policy's face amount over its cash surrender value is excludable from the beneficiary's income (as life insurance proceeds). The distribution resulting from the death of a covered employee is usually taxed to the beneficiary in the same manner as it would have been to the deceased worker.

A beneficiary may roll all or part of a lump-sum death benefit distribution received due to the deceased employee's death over to an IRA. The amount rolled over is not includable in taxable income but will be taxed as ordinary income when it is distributed.³⁵

If an employee dies before his or her entire interest is paid and a joint-and-survivor option is not in effect or if payments are being made to a surviving spouse who dies before the entire interest is received, the balance will have to be distributed to beneficiaries within five years.

Estate Taxes Distributions from qualified plans are not subject to the estate tax if the benefits are paid to a surviving spouse. Other distributions are includable in the estate and are subject to the estate tax.

Limitations on Loan Transactions The substantial funds accumulation in qualified pension plans has been an appealing source of loans to the plan participants. Such loans, however, are subject to restrictions imposed by the IRC. A loan from a qualified plan to an employee is treated as a distribution (and is taxable) to the extent that it exceeds prescribed limits. Furthermore, a loan to a participant may not exceed the lesser of $50,000 or half of the participant's vested accrued benefit (but not less than $10,000). The loan must be repaid within five years, and the repayment must be on an amortized basis. An exception to the five-year payback rules applies to a loan used to acquire the principal residence of the participant.³⁶

INDIVIDUAL RETIREMENT ACCOUNTS

The Individual Retirement Account (IRA) was created by the Pension Reform Act of 1974. At that time, it represented the first new concept in pension planning since the introduction of Keogh plans in 1962. Although IRAs are not an employee benefit per se, they were originally intended as substitutes for employer-provided pensions. The original purpose of the IRA was to permit persons who were not covered under a qualified pension plan or government plan to establish their own pension program and accumulate funds for retirement on a tax-favored basis. The annual contributions to an IRA by an eligible individual were made tax-deductible by the individual, and the tax on investment earnings was deferred until withdrawal after age 59½.

IRA eligibility rules have been changed several times. From 1974 through 1981, IRAs were available only to individuals who were not participants in another pension plan. From 1982 until 1986, eligibility was extended to all persons with income, whether or not they were covered by an employer-sponsored plan. The Tax Reform Act of 1986 (TRA-86) established a new set of eligibility rules, with limits on the deductibility of contributions by persons who are covered by an employer-sponsored plan. The Tax Reform Act of 1997 (TRA-97) created a new type of IRA, called the Roth IRA, which has been available since 1998. The distinguishing feature of the Roth IRA is that contributions are made only on a nondeductible basis and the tax benefit is realized when the funds are withdrawn. All earnings on the contributions compound tax-free as long as they are not withdrawn for at least five years, and there are no taxes due when the funds are withdrawn for retirement (i.e., after age 59½).

Traditional IRAs

The maximum annual contribution to an IRA in 2013 was $5500, and it is indexed for inflation in $500 increments. In addition, individuals age 50 or older are permitted to make catch-up contributions of $1000 per year. Unlike the catch-up contributions for 401(k) plans, 457 plans, SEP IRAs, and SIMPLE IRAs, the catch-up contribution for traditional and Roth IRAs is not indexed for inflation. It will remain at $1000 in future years.

Traditional IRA Eligibility Under the current rules, a person who is not covered by an employer retirement plan can make deductible contributions to an IRA up to the lesser of the statutory maximum or 100 percent of compensation. A person who is covered by an employer-sponsored plan may still be entitled to a deduction depending on his or her income. The deduction begins to decrease when the taxpayer's AGI rises above a certain level and is eliminated altogether when it reaches a higher level.

In 2013, the deduction phased out between $59,000 and $69,000 for single taxpayers and heads of households and between $95,000 and $115,000 for married filing jointly. These income limits are indexed for inflation.

The formula for computing the permissible deduction for an individual who is covered by an employer plan and whose income is within the AGI phase-out range is as follows.³⁷

For example, if Mr. Smith, age 45, has an AGI of $94,000 in 2013 and files a joint return, his deductible contribution for 2013 is $2200:

Maximum contribution:	$5,500
Upper income limit:	$102,000
Adjusted gross income:	$94,000
Income below limit:	$8,000
Upper limit − lower limit:	$20,000

A spouse who is not employed outside the home can make tax-deductible IRA contributions even if his or her partner is covered by an employer's retirement plan, and the income limits above do not apply to the nonemployed spouse. The deduction for spousal contributions phased out for married couples with incomes between $178,000 and $188,000 in 2007.

Nondeductible Contributions to Traditional IRAs Taxpayers whose income exceeds the AGI phase-out levels for traditional or Roth IRAs can make nondeductible contributions to a traditional IRA up to the statutory maximum or 100 percent of compensation, whichever is less. Earnings on the contributions are not taxed until distributed.

If an individual contributes more to an IRA than the legal maximum, a 6 percent penalty is imposed on the excess contributions. The 6 percent tax is imposed each year until the excess contribution is withdrawn or the taxpayer reduces the contribution to absorb the amount of excess contributions.

Tax Treatment of IRAs The tax on deductible contributions to an IRA and the investment income on deductible and nondeductible contributions is not eliminated: It is deferred until distribution. Deductible contributions and investment income are taxable when distributed, and premature distributions (i.e., distributions before age 59½, death, or disability) are subject to a 10 percent tax penalty. However, until December 31, 2013 (unless extended), an individual age 70½ or older may contribute up to $100,000 a year directly from an IRA to a qualified charity without including the contributed amounts in taxable income.

At the time of distribution, a tax is imposed on the deductible contributions and on earnings that have not been taxed (i.e., earnings from deductible and nondeductible contributions). Nondeductible contributions, however, are tax-free when distributed. When the IRA is funded in part by deductible contributions and in part by nondeductible contributions, withdrawals are considered to consist of deductible and of nondeductible contributions.

As a general rule, early withdrawals from an IRA are subject to the 10 percent penalty under the same circumstances as early withdrawals from other qualified plans. There are some exceptions, however. For example, since 1998, penalty-free (not income tax-free) withdrawals have been permitted for qualified first-time home buyers or for the first home purchase by a spouse, child, or grandchild (subject to a $10,000 lifetime limit) and for qualified higher education expenses for individuals, their spouses, children, or grandchildren penalty-free withdrawals may be made to cover potentially devastating medical expenses. The medical costs must be that of the taxpayer, spouse, or dependents, and the expenses must exceed 10 percent of the taxpayer's AGI. The amount withdrawn is subject to income tax, but if the taxpayer itemizes, the income can be partially offset by the itemized deduction of the medical expense.

In addition, unemployed individuals may withdraw amounts for the payment of health insurance premiums without incurring the 10 percent penalty. The 10 percent floor does not have to be met if the individual has received unemployment compensation for at least 12 weeks and the withdrawal is made in the year that such unemployment compensation is received or in the year immediately following. The exception ceases to apply once the individual has been reemployed for a period of 60 days.³⁸

IRAs as Portable Pensions A special provision in the regulations applicable to IRAs creates a collateral benefit of the IRA by establishing a basis for portable pensions. A unique privilege under the act permits individuals who terminate employment and receive a lump-sum distribution from a qualified plan to avoid taxation on such proceeds until they withdraw it from an IRA in the form of benefits at some later date. Thus, an employee who receives a lump-sum distribution may establish an IRA and avoid immediate taxation.

Partial IRA Rollovers Partial IRA rollovers have been permitted since 1982. Prior to that time, a taxpayer receiving a lump-sum distribution from a qualified pension could defer taxation on that distribution only by rolling over the entire distribution. Under the new law, the taxpayer can roll over a part of the distribution and escape taxation on the portion rolled over. Only the part of the distribution not rolled over is taxed.

Deductible contributions and investment income are taxable when distributed, and premature distributions (i.e., distributions before age 59½) are subject to a 10 percent tax penalty. When the IRA is funded by deductible and nondeductible contributions, withdrawals are considered to consist of deductible and of nondeductible contributions, with the nondeductible contributions exempt from tax on the distribution.

Generally, IRA accounts may be funded with any investments acceptable for other tax-qualified plans. The most common funding instruments are custodial accounts established by banks and retirement annuities. The IRC forbids IRAs to invest in life insurance contracts.

The Roth IRA

Contributions to a Roth IRA are nondeductible. However, all earnings accumulate tax-free, and no taxes are due when the funds are withdrawn for retirement (i.e., after age 59½). In contrast, a taxpayer may deduct his or her contributions to a traditional IRA, but the later distributions are taxable. Unlike traditional IRAs, there is no requirement that withdrawals commence at 70½, and contributions to a Roth IRA may continue after age 70½, as long as the individual or spouse has earned income.

Annual contributions to a Roth IRA are limited to the lesser of 100 percent of compensation or a statutory maximum that phases out at higher income levels. The basic maximum is the same as that for a traditional IRA: $5500 in 2013. Catch-up contributions of $1000 are permitted for individuals age 50 or over, as with a traditional IRA.

Permissible contributions are phased out at higher incomes. In 2013, single taxpayers with a modified AGI of up to $114,000 were permitted to make contributions, but the allowable contribution was reduced to zero at incomes between $112,000 and $127,000. For married couples filing jointly, permitted contributions phased out between $178,000 and $188,000; for married filing separately, they phased out between 0 and $10,000. These amounts will be indexed in future years.³⁹

Taxpayers may convert a traditional IRA into a Roth IRA. Income taxes are due on the amounts converted, but there is no premature penalty. Once converted to a Roth IRA, the funds will continue to accumulate tax-deferred until withdrawn. This may be an attractive strategy for individuals who may face a higher tax rate in the future.

There is no penalty on early withdrawals of the after-tax contributions to a Roth IRA. Under the IRC provisions applicable to Roth IRAs, the first money taken out of the account is considered the after-tax contributions rather than earnings. Premature withdrawals of earnings (i.e., before age 59½) are taxable income, subject to a 10 percent penalty except in the event of death, disability, or a first-time home purchase. The first-time homeowner withdrawal is subject to a $10,000 one-time limit.

Individuals can have a traditional IRA and a Roth IRA, but they cannot contribute more than the statutory maximum for a given year between both accounts. Individuals who are ineligible for deductible contributions to a traditional IRA or contributions to a Roth IRA may make nondeductible contributions to a traditional IRA.

A CONCLUDING NOTE

This discussion of qualified retirement plans and IRAs illustrates the enormous complexity facing individuals as they consider their options in planning for retirement. This is a highly technical area. It is complicated because a significant body of law applies to the plans' design. It is further complicated because this law frequently changes, particularly as it applies to IRC requirements. This discussion is an overview, intended to acquaint students with the general characteristics of these plans and important elements to consider in evaluating their own retirement programs.

IMPORTANT CONCEPTS TO REMEMBER

fixed-dollar annuity

variable annuity

immediate annuity

deferred annuity

joint life annuity

joint-and-last-survivor annuity

installment refund annuity

cash refund annuity

qualified retirement plans

vesting

ERISA

defined benefit plan

defined contribution plan

profit-sharing plan

employee stock ownership plan (ESOP)

Keogh plan

simplified employee pension (SEP) plan

Section 401(k) plan

Section 403(b) plan

SIMPLE IRA

funding

final-average-salary plan

career-average salary plan

maximum benefit limitations

Social Security integration

Individual Retirement Accounts (IRAs)

Roth IRA

QUESTIONS FOR REVIEW

1. It has been stated that an annuity is “upside-down” life insurance. Explain what this means.

2. Identify the various ways in which annuities may be classified and list the different types of annuities in each classification.

3. Describe the variable annuity and explain the theory on which it is based. To what extent have the results produced by variable annuities been consistent with the theory?

4. Describe the tax treatment of annuities during the following periods:

1. The accumulation period.
2. When distributed.

5. Distinguish between joint and last survivor annuity and the joint-life annuity.

6. Briefly distinguish between a defined benefit pension plan and a defined contribution plan. Which of these would a variable annuity be?

7. Describe what is meant by “vesting.” What are the basic vesting requirements that apply to qualified plans?

8. Describe the rationale for (a) maximum limits on contributions and benefits in qualified plans and (b) permitted disparity rules.

9. Distinguish between a traditional IRA and a Roth IRA.

10. Describe the various provisions that may be included in a pension plan with respect to death or disability of a plan participant.

QUESTIONS FOR DISCUSSION

1. A successful college athlete has signed with a professional team and has received a $500,000 bonus. Prudently, he plans to invest the money, and his advisor suggested he put the money in a single-premium deferred annuity. What are the advantages and disadvantages of this course of action?

2. Assume that you have reached age 65 and are about to retire. You have accumulated a fund of $300,000 and are considering the purchase of an annuity. A straight life annuity will pay you $1800 a month for life, and a life annuity with a 20-year-certain period will pay you $1650 a month. Which would you select and why?

3. You are considering employment with two corporations and, among other things, you would like to compare their pension plans. What features of the two plans would you be most interested in?

4. Over the past 40 years, Carl's employer-funded defined contribution retirement program has been invested in a variable annuity. Now that he has reached retirement age, he is elated that the value of the accumulation exceeds $1 million. He anticipates the investment income on the accumulation will be between 7 and 8 percent annually. Because this amount is sufficient for his and his wife's needs, he looks forward to leaving his two children approximately half a million dollars each. Advise him.

5. The trend toward defined contribution plans, such as Section 401(k) plans, has been characterized as a movement from employer responsibility for employee welfare to increased individual responsibility. How do 401(k) plans place greater responsibility on the individual employee?

SUGGESTIONS FOR ADDITIONAL READING

Allen, Everett T., Joseph J. Melone, Jerry S. Rosenbloom, and Dennis F. Mahoney. Retirement Plans, 11th ed. New York: McGraw-Hill, 2013.

Bajtelsmit, Vickie L. Personal Finance: Planning and Implementing Your Financial Goals. (Hoboken, N.J.: John Wiley and Sons, 2005).

Beam, Burton T., Jr., John J. McFadden, and Karen Stefano. Employee Benefits, 7th ed. Brookfield, Wis.: Dearborn Real Estate Education, 2012.

Black, Kenneth, Jr. Harold D. Skipper, and Black KennethIII Life and Health Insurance, 14th ed. Lucretian, LLC, 2013.

McFadden, John. Qualified Retirement Plans. Bryn Mawr, Pa.: The American College, 2007.

Palmer, Bruce A. Equity Indexed Annuities: Fundamental Concepts and Issues. New York, N.Y.: Insurance Information Institute, October 2006.

Rosenbloom, ed. The Handbook of Employee Benefits, 7th ed. New York: McGraw-Hill, 2011.

WEB SITES TO EXPLORE

American Benefits Council	www.americanbenefitscouncil.org
Employee Benefit Research Institute	www.ebri.org.
Insurance Information Institute	www.iii.org/individuals/annuities
Insurance Retirement Institute	www.irionline.org
NAIC InsureU	www.insureonline.org
International Foundation of Employee Benefit Plans	www.ifebp.org/

¹Since women live longer than men on average, life annuities are more expensive for women. The amount of monthly income produced by a given amount for a female at age 65 is approximately the amount produced for a male who is 60 years old.

²Group annuities are discussed in Chapter 23.

³The TIAA originally wrote conventional fixed-dollar annuities, until several faculty members at Harvard University, realizing how vulnerable their retirement program was to inflation, decided to invest a part of their retirement dollars in the Harvard Endowment Fund, which bought mainly common stocks. With a part of their retirement dollars in TIAA and a part in the Harvard Endowment Fund, these faculty members hedged against inflation and deflation. Shortly thereafter, TIAA began a study of the possibility of equity-funded retirement programs as a hedge against inflation. The conclusions of the study were published in 1951, Greenough William C., A New Approach to Retirement Income (New York: Teachers Insurance and Annuity Association of America, 1951).

⁴Although the SEC has granted some exemptions in the case of certain group variable annuities, in general, the commission treats the variable annuity as a security. Registration with the SEC is required before a variable annuity may be marketed, and a prospectus must be furnished to the buyer. The seller must be registered with the SEC as a broker-dealer and must comply with the rules of the commission or FINRA.

⁵FINRA registration requires passing either the FINRA Series 6 limited registration examination or the Series 7 general securities examination.

⁶The remaining 27 percent of premium receipts represents sales of health insurance policies sold by life insurers.

⁷Joint SEC/NASD Report on Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products.

⁸The NASD was a self-regulatory organization that regulated the activities of broker-dealers and was overseen by the SEC. In July 2007, the NASD and NYSE Member Regulation merged to create the Financial Industry Regulatory Authority of FINRA. As was the case with NASD, FINRA must file its proposed rules for approval by the SEC.

⁹Under index annuities, the insurer promises a crediting rate that varies with the performance of an index. Because the insurer bears the risk that its investment return cannot support the crediting rate, insurers and insurance regulators argue these products are fixed, rather than variable, annuities.

¹⁰The Annuity Buyers Guide originally applied to fixed annuities only and was called the Buyers Guide for Fixed Deferred Annuities. The 2011 amendments to the model expanded its application to include variable annuities, and the Buyers Guide is being revised and renamed.

¹¹Pension plans are also subject to various provisions of the Internal Revenue Code (IRC) and the Civil Rights Act of 1964. The application of these statutes to qualified retirement plans is discussed in greater detail in Chapter 23. Here, we are concerned with qualified retirement plans from the perspective of the participant.

¹²Qualification requirements are discussed in greater detail in Chapter 23.

¹³Generally, a plan is top-heavy if at least 60 percent of the account balances or accrued benefits are allocated to a group of participants known as the key employees. A key employee is any plan participant employee who, during the preceding plan year, was (1) an officer earning over $130,000, (2) a 5 percent owner, or (3) a 1 percent owner earning over $150,000. EGTRRA-2001 simplified the definition of key employees, and these changes were made permanent by the Pension Protection Act of 2006 (PPA-2006). See Chapter 22.

¹⁴Pension Plan Participation, “Employee Benefit Research Institute Fast Facts #225, March 28, 2013. In November 2012, the American Benefits Council released a six-point plan to address the decline in defined benefit plans.

¹⁵The insurance of pension plans by the PBGC is discussed in Chapter 23.

¹⁶A number of lawsuits alleged the conversions violated federal laws against age discrimination. As a result, the IRS announced in 1999 it would impose a moratorium on the issuance of determination letters on conversions from a traditional defined benefit plan to a cash balance plan until regulations addressing age discrimination had been issued. (In determination letters, the IRS provides its opinion on the qualified plan status.) A key case was concluded in 2006 when the U.S. Supreme Court declined to hear an appeal in Cooper et al. v. IBM Personal Pension Plan. In that case, the U.S. Court of Appeals for the Seventh Circuit found that IBM did not discriminate against older employees when it adopted its cash balance pension plan. The PPA-2006 was another significant development for cash balance plans as it explicitly recognized cash balance pension plans. It provided age discrimination protection on a prospective basis (effective as of August 17, 2006) so long as interest credits do not exceed the “market rate of return” and the pay credit is the same for all employees with similar pay and service regardless of age. The U.S. Treasury is charged with defining the “market rate of return.” The IRS lifted its moratorium on determination letters in January 2007, by which time it had approximately 1200 cases to be resolved.

¹⁷That is, another employee with the same compensation, years of service, and other factors that would affect accrued benefits must not have a higher accrued benefit. The test for whether the benefit accrual is comparable may be based on a number of options, for example, an annuity payable at normal retirement age, a hypothetical account balance, or the current value of the accumulated percentage of the employee's final average pay.

¹⁸Because the cash or deferred plan is based on voluntary contributions by employees, Section 401(k) plans have been referred to as salary reduction plans. For obvious reasons, at least from the employer's perspective, the term cash or deferred is a more appealing designation. Employees are likely to misconstrue the nature of the plans and perhaps be turned off by the designation “salary reduction plan.”

¹⁹There was also a 401(k) safe-harbor plan available prior to the PPA-2006 that exempted the plan from nondiscrimination and top-heavy rules. This plan required the employer to make a contribution of 3 percent for each eligible employee or a matching contribution of up to 100 percent. Unlike with the Qualified Automatic Contribution Arrangement, employer contributions were required to vest immediately at 100 percent.

²⁰Final average pay is defined as the average pay in no more than the five consecutive years of highest earnings. Alternatively, the plan may use an “age-adjusted” benefit formula, under which the pay credit varies increases with age, from 2 percent for employees age 30 or younger to 8 percent for employees age 50 or over.

²¹Regardless of the allowable contribution on behalf of any given participant, an employer may not deduct more than percent of total employee compensation, not including employee elective deferrals.

²²In 1993, employers could consider up to $236,000 in employee compensation when computing pension benefits and contributions. The 1993 legislation cut the maximum to $150,000. Because of inflation adjustments, it had increased to $225,000 by 2007, still below the amount allowed in 1993.

²³The annual additions consist of the employer's contributions as well as amounts that are redistributed from the forfeited accounts of unvested participants who have left the plan. This limit applies to all defined contribution–type plans, including qualified profitsharing, ESOPs, Section 403(b) plans, and Section 457 plans.

²⁴This limit also applies to Section 403(b) and Section 457 plans. A self-employed individual may make 401(k) contributions as both employee and employer. In addition to the elective deferral, the individual may contribute up to 25 percent of earned income, using a special definition of earned income. Total contributions may not exceed the overall limit that applies to all plans ($51,000 in 2013). The individual may also contribute catch-up contributions if eligible.

²⁵For a common-law employee, the employer's contribution to a qualified retirement plan is added to earned income, creating a maximum for taxable income and nontaxable deferred income equal to 125 percent of earned income. This means 80 percent of total compensation is taxable, and 20 percent is a nontaxable deferral. A self-employed person qualified for the 2007 maximum contribution of $45,000 if he or she had $225,000 of earned income [25 percent of ($225,000–$45,000)].

²⁶Individuals may convert an existing 401(k) plan into a Roth 401(k) if their employer permits. The individual must treat the amount converted as taxable income in the year of conversion but will avoid taxes on future investment income. Prior to the American Taxpayer Relief Act of 2012, conversions were only available if the individual was 59½, dead, disabled, or had terminated employment. These requirements were eliminated in the ATRA.

²⁷This tax credit was made permanent by the PPA-2006.

²⁸The cost of permanent life insurance protection is treated as a distribution from the plan and is taxable income to the employee for the year in which the premium is paid. The cost taxable to the participant is determined using one-year term insurance rates published by the IRS. In 2001, the IRS issued new rules regarding the tax treatment of life insurance under qualified plans and released a new table for the imputed cost of life insurance in such plans. The 2001 table replaced the previous P.S. 58 rates, which were somewhat higher than the new rates.

²⁹The election to continue deductible contributions on behalf of a disabled employee cannot be made for a disabled employee who is an officer, owner, or highly compensated employee.

³⁰However, deferrals are not permitted for employees who are 5 percent owners.

³¹The required minimum distributions generally are determined by using life expectancy tables established by the IRS in its regulations. A provision in EGTRRA-2001 required the IRS to revise the life expectancy tables used in computing the minimum distributions after age 70½ (or after retirement, if later) to reflect longer life expectancies.

³²A domestic relations order is a judgment, decree, or order (including an approval of a property settlement agreement) that relates to the provision of child support, alimony payments, or marital property rights. The exception for distributions to public safety employees was added by the PPA-2006.

³³Annuity payments beyond the individual's life expectancy will be fully taxable. Should the retired person die before reaching full life expectancy, his or her heirs may take a deduction on the deceased's final return for the amount of any unrecovered contributions. The PPA-2006 excluded from income up to $3,000 in distributions from a government plan to pay for health or longterm care insurance premiums of a retired public safety officer.

³⁴The Tax Increase Prevention and Reconciliation Act eliminated the $100,000 limit, effective in 2010.

³⁵Prior to the PPA-2006, only surviving spouses were allowed to roll over the distribution to an IRA. The PPA-2006 extended this option to nonspousal beneficiaries.

³⁶Prior to EGTRRA-2001, loans from qualified plans to owner-employees were not permitted, but EGTRRA-2001 made owner-employees eligible to receive loans from qualified plans subject to the same limitations as other participants.

³⁷The result is rounded to the next higher multiple of $10. If the amount is less than $200, a $200 deduction is permitted.

³⁸IRC Section 72(t).

³⁹Modified AGI income is defined by the IRS for purposes of Roth IRAs. It is an individual's AGI, as shown on the tax return, with certain additions and subtractions. For more information, see the IRS Web site, http://www.irs.gov/publications/p590/ch02.html