ERISA and Qualified Plans
The Employee Retirement Income Security Act of 1974 (ERISA) established federal standards for private-sector retirement plans. Understanding ERISA and qualified plan characteristics is essential for Series 7 representatives advising clients on retirement investing.
What is ERISA?
ERISA (Employee Retirement Income Security Act) is federal legislation that:
- Sets minimum standards for pension and retirement plans
- Requires disclosure of plan information to participants
- Establishes fiduciary responsibilities
- Provides remedies for violations
- Created the Pension Benefit Guaranty Corporation (PBGC)
What ERISA Covers
| Covered | Not Covered |
|---|---|
| Private-sector employer plans | Government employee plans |
| Union pension plans | Church plans (unless they opt in) |
| Most 401(k), 403(b) plans | IRAs (separate IRS rules) |
| Profit-sharing plans | Social Security |
Key Point: ERISA primarily covers employer-sponsored retirement plans in the private sector. Government and church plans have different regulatory frameworks.
Qualified vs. Non-Qualified Plans
Qualified Plans
Qualified plans meet IRS requirements and receive favorable tax treatment:
| Benefit | Description |
|---|---|
| Employer Deduction | Contributions are tax-deductible for the employer |
| Tax-Deferred Growth | Earnings grow tax-free until distribution |
| Employee Deferral | Pre-tax contributions reduce current taxable income |
| Creditor Protection | ERISA plans generally protected from creditors |
Requirements for Qualified Status
To maintain qualified status, plans must meet several requirements:
- Written Plan Document — Must be in writing and communicated to employees
- For Employee Benefit — Must be established for exclusive benefit of employees
- Nondiscrimination — Cannot favor highly compensated employees
- Participation Requirements — Must cover broad employee groups
- Vesting Schedules — Must meet minimum vesting requirements
- Contribution/Benefit Limits — Must comply with IRS limits
Non-Qualified Plans
Non-qualified plans don't meet IRS requirements and don't receive the same tax benefits:
- No immediate tax deduction for employer
- May discriminate in favor of executives
- No ERISA protections
- Examples: Deferred compensation, executive bonus plans
Key Point: Non-qualified plans are often used for executive compensation because they can discriminate in favor of highly compensated employees.
Vesting Schedules
Vesting determines when employees gain ownership of employer contributions. Employee contributions are always 100% vested immediately.
ERISA Vesting Requirements
Plans must use one of two approaches for employer contributions:
| Type | Schedule |
|---|---|
| Cliff Vesting | 0% until year 3, then 100% |
| Graded Vesting | 20% per year starting year 2, 100% at year 6 |
Example: Graded Vesting Schedule
| Years of Service | Vested Percentage |
|---|---|
| Less than 2 | 0% |
| 2 | 20% |
| 3 | 40% |
| 4 | 60% |
| 5 | 80% |
| 6+ | 100% |
Key Point: Employers can always be more generous than the minimums (e.g., immediate vesting), but not more restrictive.
Fiduciary Responsibilities Under ERISA
Plan fiduciaries have strict legal obligations:
Key Fiduciary Duties
| Duty | Description |
|---|---|
| Prudence | Act with skill, care, and diligence |
| Loyalty | Act solely in participants' interests |
| Diversification | Diversify investments to minimize risk |
| Plan Documents | Follow the plan's governing documents |
| Pay Only Reasonable Expenses | Control plan costs |
Who is a Fiduciary?
Under ERISA, fiduciaries include:
- Plan administrators
- Trustees
- Investment managers
- Anyone with discretionary authority over the plan
Fiduciary Liability
Fiduciaries who breach their duties may be personally liable for:
- Restoring losses to the plan
- Returning any profits made through misuse
- Other equitable or remedial relief
Criminal Penalties: Willful ERISA violations can result in fines up to $100,000 and/or imprisonment up to 10 years.
PBGC (Pension Benefit Guaranty Corporation)
The PBGC is a government corporation that insures defined benefit pension plans:
| Feature | Description |
|---|---|
| Purpose | Protect pension benefits if plans terminate |
| Funding | Premiums paid by covered plans |
| Coverage | Defined benefit plans only |
| Limits | Guarantees up to certain monthly amounts |
Not Covered: The PBGC does not insure defined contribution plans (like 401(k)s). These plans hold individual accounts, so there's no pooled promise to protect.
On the Exam
The Series 7 exam frequently tests:
- Distinguishing qualified from non-qualified plans
- Understanding vesting schedules (cliff vs. graded)
- Recognizing ERISA fiduciary duties
- Knowing what the PBGC does and doesn't cover
- Identifying tax advantages of qualified plans
Which of the following is a requirement for a retirement plan to be considered "qualified" under IRS rules?
Under ERISA's graded vesting schedule, an employee with 4 years of service is what percentage vested in employer contributions?
The Pension Benefit Guaranty Corporation (PBGC) insures which type of retirement plan?
A plan fiduciary under ERISA must do all of the following EXCEPT:
10.2 Defined Benefit vs. Defined Contribution
Continue learning