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Insurance and Employee Benefits
Chapter 01-OVERVIEW


This text discusses the role of insurance in the providing of employee benefits.  It is immediately apparent that considerable attention is paid to the federal taxation of these insurance products used for the providing of employee benefits by an employer.  As everyone is aware, taxation can be, and generally is, rather complex and regulations can change dramatically from time to time.  Therefore, one should be advised that this text is not to be used as the most up-to-date or complete authority on taxation of benefits or of the effects of taxes on employers and employees although tax laws and regulations effective as late as 1/1/2006 are used as reference and often quoted.  In many cases, however, the best service that can be provided to a client is to encourage them to obtain professional tax assistance if the situation is at all confusing or complex and/or entails a sizeable employee benefit program.

Please note that throughout this text, the masculine gender is used (he, his, him, etc.) for simplicity purposes only and it should not detract from the contributions, service and expertise of those of the female gender—it is just less confusing and easier-to-read if, for instance, "he" is used in a sentence, instead of "he/she," or "he and or she," etc.




The relationship between insurance and employee benefits is simply that of financing—employee benefits can be financed through insurance.  These benefits are usually broken into five broad categories:

  1. pension plans for retirement;
  2. group life insurance for death benefits;
  3. group health insurance for illness and accident;
  4. group disability income insurance for loss of income due to illness or accident;
  5. accidental death and dismemberment.

For those in the insurance profession, these benefits are usually referred to as group health insurance, group life insurance, and pensions (including group annuity plans).

Group accidental death is usually provided under a group health plan, but life insurance plans are used as group life insurance and some pension plans.  Life insurance may be either yearly renewable term insurance or permanent types of insurance (or some combination thereof).

The employer always bears part of the cost and some may pay it all, and the amounts of the benefit coverage are determined by formula that attempts to avoid selection against the insurance company—therefore, those employees in poor health are not allowed to choose the largest amount of insurance.

Dental insurance, eyeglass insurance, and legal expense insurance may be included.

These plans are provided for employee morale purposes, to reduce turnover of the workforce, and for tax purposes—contributions are usually deductible as business expenses to employers and not currently taxable income to employees—with some exceptions as noted in the text.

As discussed in the text, there are certain other benefits that are often provided under the Cafeteria Plans, wherein the employee pays for the entire benefit, but with pre-tax dollars. 


ERISA (Employee Retirement Income and Security Act of 1974) is the prime federal regulation of employee benefits, and will be discussed in detail.  While ERISA is concerned mostly with protecting employee benefit interests and expectations, and expanding plan coverage, there were many areas in the regulation of benefits that were either lightly addressed, or simply not addressed.  As such, ERISA has been amended many times since 1974.

In 1978, for instance, legislation was passed authorizing SEPs and CODAs (described in more detail later).  In 1980, the Multiemployer Pension Plan Amendments Act (MPPAA) was passed which actually revised ERISA in order for ERISA to be able to deal with the special problem of multiemployer plans.

In 1982, an important act, the Tax Equity and Fiscal Responsibility Act (TEFRA) was introduced.  It addressed the "top-heavy" plan—defined as a plan in which the proportion of benefits or contributions for key employees is high, providing for special rules in these situations.

The Retirement Equity Act of 1984 (REA) amended ERISA that addressed specifically those special problems involving women, among other things. 

The Tax Reform Act of 1986 (TRAC) actually amended ERISA in order to speed up the statutory vesting schedules.

The Single Employer Pension Plan (SEPPA) of 1986 rather strongly revised the plan termination systems in order to prevent abuse, actual or perceived.  Also, legislation enacted in 1992 discouraged employees from cashing out their employee plan interests when they leave their employment before retirement.

The Small Business Job Protection Act of 1996 (SBJPA) established SIMPLE plans and accomplished several things, among which was changing some rules regarding distributions.  It also responded to a Supreme Court decision regarding the applicability of fiduciary law to insurance companies, plus several other changes which had the welcome effect of simplifying changes in ERISA. 

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) amended Title I of ERISA, addressing primarily the portability of health coverage.  This has had a more recent effect on employee benefits, and is addressed in some detail in this text. 

The Taxpayer Relief Act of 1997 (TRA '97) made changes affecting reporting procedures, IRAs, plan distributions and other situations.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made several changes in respect to contributions, plan distributions, top-heavy plans, IRAs and other matters.


ERISA has often been amended, as indicated above, and it still is considered as the basic law of employee benefit plans.  Note, however, it is not a law of employee benefits, but of benefit plans.  If pension or welfare benefits are offered in any other fashion other than a plan, then ERISA, as a general rule, will not apply.  Therefore, the starting point in understanding ERISA is to understand exactly what an employee benefit is.

One might expect that the regulations would be very precise and specific as to the definition of an employee benefit plan, actually, it does not define "plan" or other such criteria—it takes into consideration the assumption that everyone must known what a "plan" is.  However, the provisions of ERISA obviously reflect just what the "plan" is supposed to be.  For instance, ERISA interprets plans basically as employer programs (even though some plans may be union formed or maintained).  The closest definition in ERISA is an indication in the wording that a plan is a regularly conduced, employment based program or practice, whose existence is solely to provide certain kinds of benefits to employees.1

Further, ERISA assumes that a plan is just not a part of an employer's business as it is unique in providing regulations for a plan to be created as a legal entity different and distinct from the employer or any other sponsor.  It provides for unique situations, such as a plan can be sued or sue, enter into contracts, go to court or have judgments rendered against it, hire employees, hire attorneys to represent it, etc.2As one would expect, like a corporation, a plan is an artificial individual.


While employee benefits, per se, can be divided into several different types, ERISA divides employee benefits into pension (benefit) plans and welfare (benefit) plans.  Pension plans provide retirement income for the participant, or provides for the deferral of income until the termination of the employment of the participant and/or beyond.  Welfare plans provide medical and some other non-pension benefits to employees and their beneficiaries.3

Pension Plans

ERISA specifies two categories of pension plans: defined benefits plan and defined contributions plan.

The defined benefit plan is where employees are promised a level of retirement income according to a formula. The formula may use as a factor, the employee's years of service—thereby referred to as a unit benefit plan.  A formula of this type could be something like:  "Years of Service x final average salary x 1.5%."

This is called a "final average" formula, as it is based on the final average salary.  Another type could be the "career average" formula which credits a unit of benefit each year based upon the compensation for the year.  An example of the final average formula could be an employee that retired after 30 years with a final average salary of $50,000 over the specified average period.  He would receive 30 times $75,000 times 1.5%  = $33,750 per year.

A defined benefit plan where the formula is independent of years of service is a flat benefit (or fixed benefit) plan and it would provide either a fixed dollar amount or a fixed percentage of the final or average pay on retirement.

When a defined benefit plan is established by an employer, the employer must contribute the necessary funds to pay the benefits as promised to the employee, and to contribute these funds on a regular, ongoing basis.  If the plan, as many if not most do, invests these funds, the investment gains or losses affect only the employer's obligations to contribute in future years and has no impact, one way or the other, on the level of benefits to which the participants are entitled.

In a defined contribution plan (a.k.a individual account plan) the participants are not promised a particular level of retirement benefits, but each participant has an account in the plan to which the employer's contributions are directed.  The participant's benefit is, therefore, the total of this account when he retires as determined by the history of the contributions.  With this type of plan, the employer is not obligated to make sure that the plan has enough money to fund any specific or specified benefit, but his only obligation is to make the promised contributions.

Another type of pension plan is the defined contribution plan or individual account plan.5 Participants are not promised a particular level of retirement benefits, but each participant has an account in the plan and the employer allocates contributions to this account.  The benefit to the participant is the value of that account at retirement, such value determined by the contribution history and the experience of the investments in which the funds are contributed.  The employer has no obligation to guarantee that the plan has enough money to fund any specific benefit, but has only the obligation to make the contributions that he has promised to make. 

One type of defined contribution plan is the money purchase plan, where the employer is obligated to contribute a specific amount every year to each participant's account. 

Another type is the target benefit plan, which has the attributes of both the defined benefit plan and the defined contribution plan.  The employer determines a level of benefits and then determines the amount of contribution that is (actuarially) adequate to fund those benefits.  Once this level is determined, then it may or may not be changed to reflect investment experience as the level of benefits is only a projection, not a guarantee.

The most common form of defined contribution plan is the profit sharing plan which provides for annual employer contributions (if any) and the allocation of those funds to participant's accounts under a pre-determined formula.  The employer's contributions can either be as determined by formula, or they can be at the discretion of the employer—often with specified limits, however.  In spite of the connotation of "profits," the contributions of the employer does not necessary have to come from present or accumulated profits.

A stock bonus plan is a profit-sharing plan that distributes stock as benefits.6An employee stock ownership plan (ESOP) is a stock bonus plan or combination stock bonus and money purchase plan, designed specifically to invest primarily in the stock of the employer.7

A Cash Or Deferred Arrangement [CODA or 401(k) plan] is a profit sharing plan or stock bonus plan that gives participants the choice of having the employer contribute money to their accounts in the plan or pay the same amount to them in the form of compensation.  (These plans are described in detail later in the text.)8  This plan is attractive to the participant because any money contributed to the plan is not included in taxable income for the year.

Another plan that is much like the defined contribution plan is the cash balance plan,where the benefit for each participant is calculated by reference to a hypothetical account, to which the participant is credited with hypothetical allocated amounts plus interest on the allocation at a predetermined rate.  The eventual benefit to the participant is not affected by any investment gain or loss, but simply are items in a formula used to calculate the benefit.  This can also be used as a "phantom stock" profit-sharing plan.

For those interested in minutiae or specificity, in Title I of ERISA, the labor provisions, and Title II, (tax-related provisions), there is some slight difference in terminology of plans.  The IRS defines a pension plan as a retirement plan in which benefits are "definitely determinable"—meaning they are fixed by formula or "fixed without being geared to profits."9  Therefore, this definition would include defined benefit and money purchase plans, but would exclude profit sharing and stock bonus plans.  The IRS (under ERISA Title II) makes a difference between plans that provide pensions from those that defer income.  But for purposes of this text, Title I terms are used.

Welfare Plans

ERISA includes a wide array of benefit programs in its definition of "welfare plans," as plans providing hospital care, severance pay, prepaid legal service, or scholarship programs to its employees are considered as welfare plans.  Basically, however, ERISA limits welfare benefits and welfare plans to those that are in the form of money and/or services provided to employees on an individualized basis.  Excluded are company cafeterias (not to be confused with "Cafeteria Plans"), non-compensatory benefits such as rights due to seniority of the right not to be terminated without cause.  On the other hand, day-care centers are not excluded.

Typically bureaucratically, the drafters of ERISA assumed that any covered plan is either a welfare plan or pension plan, with nothing in-between, except that a single plan can provide both pension and welfare benefits.  But, one might ask, a plan that provides medical benefits to retired employees, for instance, is neither welfare nor pension (or both)—medical care is a welfare benefit, but since they are provided to retirees, this is a form of retirement income.  Under the law in effect now, however, these plans would be welfare plans, but problems can arise as putting a plan into either welfare or pension plans can make a big difference as ERISA regulates the two kinds differently. 

Multiemployer plans

Multiemployer plans are usually established because of collective bargaining agreements, and are plans that are maintained in accordance with a (or more than one) collective bargaining agreements, and to which more than one employer is required to contribute.10  (Not to be confused with a multiple employer plan where employees of more than one employer is covered.)  These multiemployer plans are most common in industries with many small companies and industries—such as construction where work is irregular and employees often move from employer to employer.  A multiemployer plan can be either a welfare or pension plan.


Contrary to what one might gather, ERISA does not govern every plan that provides pension and welfare benefits, and some plans are excluded strictly on the basis of the benefits that are provided.

Title I

Title I was enacted by Congress pursuant to their right to regulate interstate commerce, therefore it only covers plans that are established and/or maintained by employers that are engaged in commerce or whose industry or activity affects commerce, unions that represent employees engaged in interstate commerce, or in any industry or activity affecting commerce.11 

The subject of Title I is "Protection of Employee Benefit Rights" and consists of two parts, Subtitle A - "General Provisions;" and Subtitle B - Regulatory Provisions."  This is broken into seven parts, as listed below:

  1. Rules governing information on plans that must be supplied to regulators, participants and beneficiaries.
  2. Participation entitlement to pension benefits of the plan, including minimum standards for employee eligibility to participate, and other restrictions.
  3. The funding of defined benefit plans.
  4. Fiduciary responsibility and related matters.
  5. Includes criminal civil enforcement provisions, including the provision that preempts nearly all state laws that relate to employee benefit plans.
  6. Requirements relating to group health insurance (added to ERISA through later amendments).
  7. Group health plans and group health insurance coverages, covering such items as preexisting conditions, eligibility standards, benefits for mothers and new-borns, etc.

ERISA does not apply to any state or local governmental plan—and there are many of them.  Some states have statutes that protect employees of such plans, but some are underfunded—not a good situation for those anticipating pensions upon retirement from the plan.  Some states actually use the pension funds of their employees for other state expenditures—a situation that ERISA was designed to eliminate.

Excluded from ERISA provisions are churches and church associations, plans maintained "solely for the purpose of complying with workmen's compensation laws, unemployment compensation or disability insurance laws."  Another exclusion is for plans that are maintained outside of the US primarily for the benefit of persons substantially all of whom are nonresident aliens.12

Another exclusion seems to state that ERISA maintains that employees who are well paid can take of themselves and do not need statutory provisions, as unfunded excess benefit plans are excluded (defined as a plan providing a high level of benefits to highly compensated employees, and are, therefore, not entitled to the tax advantages given to pension plans).13

Title II

Since pension plans involve income and expenses, the basic concept of Title II is plan qualification.14  For the plan to qualify, it must comply with a multitude of standards, but if it does qualify, then the plan, employer and all employees receive favorable tax treatment regarding their plan-related income or expenses.

Title II also provides rules for tax treatment of plan-related income, and expenses, including the distribution to participants and beneficiaries and deductibility of employer contributions, and other tax-related matters.  It concerns itself only to pension plans, with little attention paid to welfare plans, but the plans are among those best known to the general public.

Keogh plansfor self-employed persons are covered under Title II, even where the plan does not include any common-law employees.15  Title I only addresses plans established by employers or labor organizations for employees, and excludes the Keogh plan which only involves owners of a business.

Title II also regulates Individual Retirement Accounts (IRAs),which are tax-favored savings or investment accounts basically for those persons not covered by pension plans by providing a method of saving for retirement.  It also covers individual retirement annuities—certain tax-favored annuities used as retirement savings vehicles.  IRAs are not considered as "plans" under ERISA, so they are excluded from Title I coverage.

Title II also covers simplified employee pensions (SEPs) and savings incentive match plans for employees (SIMPLE) plans.16  The SIMPLE plan may be either a SIMPLE IRA or a SIMPLE 401(k) plan, in either case employees make contributions voluntarily on a tax-deferred basis and the employer makes either matching or non-elective contributions.  SIMPLE plans can be available only for employers having 100 or less employees whose compensation is $5,000 or more.17

Title II also allows state and local governments, churches and church organizations and certain other tax-exempt organizations to establish plans subject to its rules and which will then receive favored tax treatment.

Title IV

The next pertinent section of ERISA is Title IV which deals with problems relating to the termination of defined benefit plans because of insufficient assets to pay all benefits that were promised by the plan.  This section sets up a system of plan-termination insurance and requires employers to contribute to the funds.

Title IV also regulates the voluntary termination of defined benefit plans, in particular underfunded plans and makes provisions for mandatory termination of financial troubles plans, and makes the sponsor liable for underfunding when termination occurs.

It regulates the withdrawal of employers from multiemployer plans, plus it established a federally chartered corporation, the Pension Benefit Guaranty Corporation (PBGC) to oversee the termination process and to supervise such actions.


ERISA plans can be quite complex and individuals can be associated with the plan in many ways.  ERISA uses certain terms and definitions to describe the role that the individual may have in the plan.

Participant is the person that the ERISA rules protect, and is defined as "any employee or formerly employee …, or any member of an employee organization who is or may become eligible to receive a benefit" from a plan, or "whose beneficiaries may be eligible to receive any such benefit."18This definition uses the common-law meaning (i.e., the meaning as derived from judicial edict/definitions, and not from statutes or regulations.  (For purposes of this text, it has little meaning but is mentioned only because the regulations so define the term.)

A person (or his beneficiaries) may become eligible to receive a benefit from a plan if he has a "colorable" (appearing to be true, valid or right) expectation that he will prevail in a suit for benefits or that he will fulfill benefit eligibility requirements in the future.19  A beneficiary is someone who is either actually or potentially, entitled to receive plan benefits other than the participant.20

The plan sponsor is the individual employer or employee organization that establishes or maintains the plan.  When there are multi-employers or plans established by more than one employer, the plan sponsor is the committee, board or whatever group of representatives of the entities that establish and/or maintain the plan.21

Fiduciaries are individuals responsible for the operation of the plan, and can also be called named fiduciaries, investment managers or administrators.  Named fiduciaries are persons that are specifically named in the plan that have the authority to control and manage the operation and administration of the plan.22  ERISA has a rather complete definition of a plan fiduciary as one that exercises discretionary power/control over management of the plan or disposition of its assets, a person who renders investment advice with the authority to do so, or has any discretionary responsibility of the administration of the plan.  A fiduciary has very stringent standards.

Another class of persons defined by ERISA is parties in interest.  These are people who can influence plan affairs, or whose dealings can involve a conflict of interest and which include employees, officers, legal counsel of the plan, service providers, employee organization, owners (directly or indirectly) of the employer and employee organizations.  These are mentioned as they are subject to scrutiny under the prohibited transaction rules.


ERISA is a complex animal, and can be a regulatory nightmare as there are three federal bodies that have enforcement and oversight responsibilities: the Department of Labor, the Department of the Treasury, and the PBGC.  As an indication of the problem is the fact that Title I is under the jurisdiction of the Department of Labor (mostly) and Title II is under the jurisdiction of the Treasury Department (mostly), and they have many identical provisions.  However, recognizing the problems and potential problems, the ERISA Reorganization Plan of 1978 made a determined effort to avoid confusion in these matters, and determined that the Treasury Department will be primarily responsible for participation, vesting and funding standard.  The Labor Department will have primarily responsibility for fiduciary regulations and prohibited transactions.  Also, it provided that there shall be coordination in certain matters.

There are three ERISA regulators who have worked, and continue to work, to avoid problems and have provided standardized forms for plan reporting.  They rely upon each other's regulations, and they cooperate on policy statement in respect to various important matters.




Present Value of Future Benefits

The basic idea of pension plans is the ability to put aside funds that will grow through investment— either by the individual, insurer or other parties—until there are sufficient funds available at a predetermined retirement age or at some other designated time in the future.

The major question for those first exposed to pension plans, is how much money is it going to take to reach the retirement goal—what amount must be invested today in order to have exactly the amount needed after specified years.  This is simply determining the worth today of the future necessary funds by determining how much should be invested today, compounded at prevailing interest rates for the length of the investment period so as to create the sufficient fund.  This is accomplished by determining the present value of the necessary amount at retirement.

(One can purchase a financial calculator for under $25 that will provide present value  calculations.)  A person is actually interested in determining the present value of a stream of future payments made over a certain period, rather than just one payment at one future date.  There are mathematical calculations that one can use to determine this amount—practically, though, these calculations are performed by actuaries and their statistics. 

These present value calculation formulas are used to value pensions from defined benefit pension plans, and actuaries do so, but there is one point that should be kept in mind—while pensions may not seem important to younger workers and they may be more willing than workers that are closer to retirement, to trade pensions for current income——the closer a worker becomes to the time of starting to receive pension benefits, the greater is the present value.  To state it in another way, the younger one starts funding a pension, the lower the amount one has to put into the fund to realize the necessary funds that are available at retirement.

Individual Taxes

Simply put, if a plan is qualified, then the participant is not subject to tax on the employer's contributions when they are made.  Further, neither the plan nor the participant is subject to tax on the plan's investment gains.  Generally speaking, the participant is generally subject to tax in respect to his pension, only when he receives it from the plan.  This provides for two tax advantages to the participant.

One advantage is that marginal tax rates are progressive—the higher the income, the higher the percentage of the income that must be paid in taxes.  This means that an individual during his higher earnings years—while he is actively working—his tax bracket will be higher than during his retirement years—when his total income is less.  The more progressive the marginal tax rate, the more the difference in taxation between producing years and "spending" years.

Secondly, investments in a qualified pension plan are not taxed.  Again, without using formulae that can be confusing, but looking at it logically, if you are taxed each year on the total income, that would reduce the total amount that can be invested, dramatically (one of the advantages of Cafeteria Plans is purchasing benefits on pre-tax basis, which "ignores" taxes until benefits are paid).  There is no additional tax when the individual withdraws the money at retirement.

If the amount that is paid into a qualified pension plan by the employer instead of being paid to the employee instead, such payment is not taxed when contributed and it accumulates interest in the plan without taxes. It is taxed to the individual only when it is withdrawn.

For example, if interest rates are 10% (for simplicity purposes) and the tax rate is 10%, $1,000 placed in a taxable savings account for 20 years will yield $5044.  However, a qualified plan will yield $6055 after tax—20% more.  At a tax rate of 25%, a qualified plan will yield 58% more.  Look further and one will note that at a tax rate of 33%, it will yield 84% more.

Tax Advantages to the Employer

The tax advantages to participants as a result of the qualification of the plan, can be also received by the employer in the form of lower salaries or wages.  This can best be understood by an example:

An employee has annual salary of $20,000, the interest rate is 10%, and the tax rate is 25%.  If the employee wants to save half of his salary for retirement, he can put it into a savings account. If he invests that $10,000 for 10 years and then retires, he will have accumulated $15,458 (according to present value formulae)

The employer would have to contribute only $7,946 to a qualified plan to provide the same $15,458 to the employee at retirement.  Therefore, the employee would note that $7,946 contributed to the plan is the same as $10,000 in salary, and he would treat the two as equal compensation.  The employer would look at the $7,946 contributed to the plan, as a savings of $2,054 over what would otherwise have been paid in salary.  This means, that with a qualified plan, the employer can save $2,504 while still providing the employee with a pension plan equal to what the employee would have had to pay without the plan. 

There is also another tax advantage—an employer who establishes a qualified plan receives the advantage because contributions to the plan are deductible when made, instead of when the employee is subject to tax.  This is a real benefit because of the time value of money.  This also points out the difference between a qualified plan and non-qualified plan: taxation principles are such that the year in which the employee receives the employer contribution (as a pension) in his taxable income, and the year in which the employer deducts the corresponding payment from its taxable income, should be the same, and the IRS requires this matching of the employer deductible and employee inclusion in taxable income.


The economic effects of ERISA pension plans have a decided affect on all parties concerned.  For the participant, the ERISA plan could be a provider of retirement security or compensation in a form other than immediate cash.  For the employer, it is an arrangement that helps to manage the workforce and at the same time, invest corporate assets.  And for public policymakers, imagine what chaos there would be if there were no pension plans and elder citizens had to depend upon Social Security or other government body to provide security and health coverage.  Also, retirement plans are powerful forces in financial markets that help to keep our country afloat.

Prior to ERISA, pension rights vested only after thirty or more years of continuous service.  In today's mobile world, few workers would ever receive a pension under those plans.  For the business, a pension plan complements systematic retirement as while retirement would eliminate the undesirable workers, the prospect of a pension attracts, motivates and helps businesses to retain desirable workers. 

ERISA requires that after a few years, a pension plan becomes substantially nonforfeitable, which, in a way, does not help the retention of some employees as after a few years with an employer, they can take their vested pension and go to work with another company, building up credits to vesting in that plan.  Today, many persons retire with several retirement checks because they have changed plans for whatever reasons.  Further, the Age Discrimination in Employment Act (ADEA) has nearly outlawed employer-mandated retirement.  This means that employers can no longer use pension plans to weed out the older workers.

On the positive side, ERISA does encourage the use of employee stock ownership plans, which give employees a stake in the business, thereby enhancing productivity and morale, and encouraging employees to remain loyal to the business.  Many new, nice, boats are bought with funds derived from retirees cashing in their company stock…

One cannot ignore medical benefit plans, as in some ways they are more important than the pension plans as hospital and medical costs have increased to unaffordable levels to many workers, even the middle income class of worker.  With the medical benefits medical benefit plans have been transformed into attractions for new workers and quite powerful inducements for current employees to stay.  Nearly everyone knows someone who "sticks" to a job they would rather not do, just so that they can have the medical benefits for themselves, and quite often, for their family.

Social Effects of ERISA Plans

Economists agree that the level of plan coverage today is substantially attributable to the tax advantages of qualified plans.  The policy of the federal government takes the approach that pension plans must continue to be a source of retirement income and should be encouraged by the tax laws, but still left voluntary on the part of the employer.

The Treasury Department estimates that the tax revenue that is lost due to preferential treatment of pension plans for fiscal year 2004 was over $123 Billion.  The estimated tax expenditure for employee contributions relating to employee health care, on the other hand, is over $120 Billion.  Of course, those politicians who are for tax increases wonder whether it is economically and socially justified.  One of the points that is raised is that tax benefits relating to plans go disproportionately to those who need them less, as evidenced by the fact that (in 2001) 76% of employees who earned $50,000 or more worked for an employer that sponsored a retirement plan, and 72% of employees earning $50,000 or more actually participated.  Conversely, only 39% of those earning $10,000 to $14,000 worked for an employer that sponsored a plan, and only 21% participated.  However, one must keep in mind that if not for the tax incentives which benefits the higher income workers, which result in the overall demand for such plans, there would be fewer plans that cover the lower income employees.  And, in a capitalistic society, those lower-paid workers work hard so that their income will increase and they can then afford to take part in these retirement plans. 

The question arises, naturally, whether the government should become involved in pension plans, and to what extent.  They already are, as they have long been integrated with Social Security, and will continue to be so with the blessings of ERISA.

One more statistic in this respect:  In 2001, employers spent $5.87 Trillion on compensation.  Of this amount, $921 Billion (about 16%) consisted of employee benefits.  Contrast that to 1970, where $617 was spent on compensation of which $66 billion (11%) consisted of employee benefits.  A large part of this increase in benefits has, undoubtedly, been attributable to increases in medical benefits, rather than pensions.


Pension plans are independent entities that are closely interconnected with the financial aspects of the employer, particularly when the plan is a defined benefit plan.  The promised benefits are the responsibility of the employer who funds pension liabilities on an ongoing basis and is liable for a substantial part of the plan's unfunded liabilities upon termination.  Therefore, it behooves the wise investment manager to avoid risky or volatile investments backing up the pension plan.  ERISA requires plans to be independent entities so as to force a separation between the plan assets and finances and the employer assets and finances.

This raises the question as to the extent that an employer can use plan assets in the business.  This can happen if the employer needs working capital and wants to borrow funds from the plan, or issue treasury stock to the plan in exchange for cash or to satisfy current contribution obligations, or to terminate the fund if it is overfunded and retain the unnecessary funds—all of which are generally prohibited or restricted by ERISA, except in some specific cases.

One, indirect, way that an employer can use plan assets is by using the plan's tax-related advantages.  For instance, a plan is not taxed on its investment income.  The return to it on the bonds is higher than the return to most investors who are taxed on interest income.  An employer may wish to capture some of this excess return through arbitrage by issuing bonds, interest payments on which are deductible from taxable income, to fund plan investment in bonds.  Needless to say, there are sophisticated strategies available to maximize the employer's tax advantage without suffering much financial risk, and so far, these plans have not been tested.  One reason is that very few pension plans invest heavily in bonds—which is not understood by some who wonder why.

Still, employer liability for pensions and other benefits, and the current costs to employers of those benefits, must be recognized on employer financial statements—which resulted in the Financial Accounting Standards Board developing standards requiring unfunded pension obligations to be reflected on the employer's balance sheet as a liability and prepaid pension expenses as an asset.  This standard also provides for the measurement of the employer's net periodic pension cost, which must be charged as an expense against income.  This allows, among other things, markets to properly take pension liabilities into consideration when valuing the firm's financial instruments.  The standards also require a company's unfunded liabilities for retired health benefits to be reflected in the firm's financial statements.

Financial Markets

Employee benefit plans are extremely important in investment markets. For instance, in 2001, the total amount of assets in private and public pension plans and IRA accounts, was $10.7 Trillion.  Pension plans own a large part of all publicly traded stocks, corporate equity, and taxable bonds, and a bunch of real estate.

There has been an increasing amount of stock in pension plans, and the financial markets feel it.  Under ERISA's rules, the fiduciary rules govern the investment practices of the plans and they seem to promote strategies of seeking short-term gains.  This has had the effect of disturbing the ability of corporate financial managers to maximize long-term gains.  All-in-all, this has contributed to some volatility in the financial markets and has helped make financial markets too unstable for the small investor.

In actual practice, however, while stock ownership involves the right to participate in decisions about corporate policies and control, this economic power has little influence on corporate management and policies—probably because plans usually vote in favor of management.


One of the principal purposes of ERISA was to make retirement benefits nonforfeitable through the process of vesting.  Congress was undoubtedly concerned about pension benefits that were not vested until retirement, or vested after a long period of time (such as 30 years), which could be considered as an inducement to discharge employees so that benefits would not have to be paid—resulting in the strangulation of job mobility.  Rules pertaining to vesting needed to be created, as well as other plans beyond vesting.

Vesting Requirements-Normal Retirement Benefit

The simplest method for vesting would have been to make the plans all vest on the first day of work, but Congress realized that would increase costs, deter the formation of pension plans, and undermine the ability of employers to use those funds for anything else. 

Under the Age Discrimination Act (ADEA), an employer cannot impose as mandatory retirement age on its employees,23but a plan may identify a normal retirement age as a standard for determining retirement benefits.  The result is that the "normal" retirement age can be defined in many ways, such as age 60 with 5 years of service, etc.

ERISA, however, provides that normal retirement age is the later of age 65 or the fifth anniversary of plan participation—or any earlier retirement age specified in the plan, with medical and certain disability benefits excluded. 

One of ERISA's vesting rules is that a participant's right to his normal retirement benefit must become nonforfeitable upon his attaining normal retirement age.24  This rule makes a difference only for those who leave the employer's service on or after the normal retirement age.

Vesting of Accrued Benefits

For those employees who leave the employment before the normal retirement age, the rule requires that a plan's schedule for the vesting of accrued benefits be at least as rapid as one of two alternative schedules set out in the statute.

A vesting  schedule can be understood only if one understands the difference between the vesting of benefits and the accrual of benefits.  The degree of vesting in a benefits is the determination of the extent to which it is nonforfeitable, and is measured by percentage of benefit—0% meaning no vesting, to 100% which means all, full, or complete vesting.  A 50% vesting in a benefit means that half the benefit (half of its value) is nonforfeitable.  Conversely, an accrual schedule specifies the rate at which a fully vested benefit increases over time.  Therefore

F the value of the participant's nonforfeitable (vested) benefit at any time is equal to the accrued benefit at that time, multiplied by the nonforfeitable percentage at that time.

The vesting concept is rather simple as the years of service in the schedule relate to the nonforfeitable (vested) percentage. 

A couple of points:  An employee is always fully vested in benefits derived from his own contributions  A schedule under which benefits jump from full forfeitability to full nonforfeitability is called "cliff vesting."  

There is an alternative, whereby a plan may provide that the extent of nonforfeitability of accrued benefits attributed to employee contributions, increase steadily over time.  ERISA requires that the percentage of nonforfeitability at any time be at least as great as follows:

Years of Service                                                                            Nonforfeitable Percentage

3                                                                                                                20%

4                                                                                                                40%

5                                                                                                                60%

6                                                                                                                80%

7                                                                                                               100%

      (This is called "graded vesting.")

For the vesting of employer matching contributions to a cash or deferred arrangement, the contributions must vest either by a 3-year cliff vesting, or a graduated vesting starting at 2 years of service and 20% vested, increasing each year of service by 20% until there is 100% vesting after 6 years of service.

"Years of service" is defined as any consecutive 12-month period so stated in the plan, generally either calendar year or fiscal year, during which the participant has completed at least 1,000 hours of service.  Any year of service with the employer must be counted toward vesting, except in a few instances, such as before the employee turns age 18, or years of service before the employer maintained the plan.  The plan always has the right to be more generous.

Break-in service is defined as a period in which employment with the employer is interrupted, which is treated in ERISA in detail as it has been a major obstacle to vesting in many cases where the work is cyclic or layoffs are common.  A one-year break in service is defined as a calendar year or other 12-month period designated by the plan, during which the participant has not completed more than 500 hours of service (excluding time for pregnancy, maternity or paternity leave that may be counted as up to 501 hours of service).  Years of service before a one-year break in service must be counted for vesting purposes, but not until the completion of one year of service after the employee returns. 

However, ERISA says, a participant with no vested rights can irrevocably lose credit for years before a break in service if the length of the break exceeds five years or the total number of years of service before the break, whichever is greater.25

Forfeiture of Benefit Rights

The most common situation of nonforfeitable permits becoming forfeitable occurs on the death of the employee, because, obviously, the employee no longer needs retirement income.  But in the case of a survivor annuity, this forfeiture is not waived.

A plan may provide for the suspension of benefits during a period when the employee is re-employed after his benefits have started.  Also, it may provide for the forfeiture of accrued benefits that are attributed to employer contributions, but the benefits may be reinstated if the employee repays the withdrawn amount with interest.26

There is another type of forfeiture provision—the "bad-boy" clause—where benefits are lost because of prohibited conduct, such as the employee's engaging in illegal acts or competing with the employer after leaving his employ (such as a non-compete clause).  The rules do allow for one vesting schedule for employees who indulge in such prohibited conduct and another for those who do not so indulge.  As one might expect, it is not allowed for one such schedule to use the 5-year cliff vesting plan and the other to satisfy 7-year graded vesting.

To avoid any back-door amending of schedules, an amendment changing a vesting schedule cannot have the effect of reducing the vesting percentage of any employee's accrued benefits.  And to take it one step further, when a vesting schedule is amended, every participant with 3 or more years of service must be permitted to elect to have his nonforfeitable percentage determined under the old schedule. 27

Termination Vesting

A qualified plan must provide that when it is terminated, or partially terminated, the rights of all affected employees to all of their accrued benefits become nonforfeitable to the extent that is funded or credit to their accounts.  Even those plans that to which the minimum funding standard do not apply, must provide for vesting of all accrued benefits of all employees upon the complete discontinuation of contributions.  The purpose of these  requirements is to prevent discrimination, as, for example, it would not allow the termination of a plan for a small business at the time when the president has just retired and most other employees are only partially vested. 

"Freezing the plan" is where no additional employees are allowed to participate and no further contributions are made, but the plan is continued to distribute vested benefits on retirement, and should not be considered as a "termination" or "partial termination."  At times this can be confusing, with the result that often courts have to determine whether the plan is terminated, fully or partially, or if it is simply "frozen."

Partial terminations may occur through amendment to or replacement of a plan that either excludes covered employees or adversely affect the right of participants for vesting in their benefits.  They may occur when plants close or there are other reductions in the workforce.  In determining whether there has been a partial termination, the IRS considers whether there has been a "significant percentage" of the plan's participants that have been affected—as a general rule, however, a reduction of 20% or less is not sufficient by itself for a finding of partial termination.28  Terminations are discussed further in Chapter 13

Discriminatory Vesting

The Code addresses top-heavy plans and produced rules to prevent discrimination thereof.  A plan is determined to be top-heavy for a given year if the present value of accrued benefits for key employees—or in the case of defined contribution plans, the total value of the accounts for key employees—exceeds 60% of the values of the accrued benefits or accounts for all employees.  A key employee is a 5% owner (or more), or one of certain other highly paid officers or other owners.29 

For plans that are top-heavy, the 5-year cliff vesting standard is replaced with a 3-year cliff vesting provision, and the 7-year graded vesting standard is replaced with a schedule starting with 2d year of service and 20% nonforfeitable percentage, graded by 20% each year to full vesting at end of 6th year.  This schedule applies only for years in which a plan is top-heavy and can revert back if the plan satisfied the non-top-heavy requirements for vesting, but in any event no participant's nonforfeitable percentage may be reduced. 30

Nonforfeitable Benefits

ERISA's vesting standards only apply to pension plans (as contrasted to welfare plans) and do not include top-heavy plans, plans established by labor unions which do not provide for employer contributions, excess benefit plans, and some other retirement or deferred-compensation arrangements.  In some cases, severance plans and retiree medical plans (welfare plans) have been argued in court that they contain important features and should have benefit rights.  However, courts have usually rejected such arguments, holding these rights to be forfeitable unless there are special circumstances.

Severance benefits are paid on account of an employee's separation from employer's service and share the same benefit as providing benefits when separated from service.  Still, severance benefits are welfare benefits and do not, therefore, fall under the ERISA protective umbrella.  They can be eliminated through plan amendment or termination, at any time.

Retiree medical benefits are quite similar to pension benefits as they are also provided to retirees as forms of retirement financial support.  However, since they are welfare benefits, they are forfeitable under ERISA.  In recent years this has produced considerable litigation as because of the high cost of health care, many employers have had to modify or eliminate retiree health benefits.  Courts have also held that retiree benefits should become nonforfeitable under federal common law.31  However, retiree medical benefits under a given plan may be nonforfeitable under the terms of the plan document or collective bargaining agreement, or because of special factors.

When an employer seeks protection of a bankruptcy court, it may petition to modify or terminate payment of retiree health benefits.  A court may order a modification if it is necessary for the reorganization of the company, assures that all interested parties are treated fairly and equitably, and is "clearly favored by the balance of the equities."32



1.  The relationship between insurance and employee benefits is

      A.  that of financing, employee benefits can be financed through insurance.

      B.  regulations.

      C.  participants.

      D.  cost.


2.  With employee benefit plans, the employer

      A.  always contributes to some or all of the cost.

      B.  never contributes to the cost.

      C.  always contributes all of the cost.

      D.  is not allowed by law to contribute more than the employee to the cost.


3.  The principal federal regulation of employee benefits is

      A.  HIPAA.

      B.  TEFRA.

      C.  ERISA.

      D.  LIMRA


4.  A plan where the participants are not promised a particular level of retirement benefits, but each participant has an account in the plan to which the employer's contributions are directed

      A.  is a deferred compensation account plan.

      B.  is a defined contribution plan.

      C.  is a defined benefit plan.

      D.  is always a profit sharing plan.


5.  Plans that provide hospital care, severance pay, prepaid legal services or scholarship programs, ERISA considers as

      A.  illegal benefit programs.

      B.  non-regulated employee programs.

      C.  welfare plans.

      D.  multiemployer plans.


6.  Individuals responsible for the operation of an employee benefit plan are

      A.  participants.

      B.  employees.

      C.  plan directors.

      D.  fiduciaries.


7.  Simply put, if a plan is qualified, then

      A.  the participant is taxed on the employer's contribution.

      B.  the participant is taxed on both his contribution and that of his employer.

      C.  the participant is not subject to tax on the employer's contributions when they are made.

      D.  there is never any taxation on any contributions or earnings by the employer or employee.


8.  A tax advantage to an employer in a qualified plan is

      A.  lower salaries or wages.

      B.  higher salaries or wages.

      C.  that he may take deductions for both his contribution and employee's contribution.

      D.  he automatically pays his taxes at capital gain rates.


9.  One of the principal purposes of ERISA was

      A.  making retirement benefits nonforfeitable through the process of vesting.

      B.  to provide portability to employees covered under group health plans.

      C.  to increase the tax rate on corporations.

      D.  to establish federal dominance over state regulation of insurance.


10.  An employee retirement plan where the employee is always vested in his own contributions and a schedule where benefits can immediately jump from full forfeitability to full nonforfeitability, is

      A.  graded vesting.

      B.  post-employment vesting.

      C.  cliff vesting.

      D.  a nonforfeiture benefit plan.



1A     2A     3C     4B     5C     6D     7C     8A     9A     10C

Insurance and Employee Benefits