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Defined Benefit Plans
Traditionally, employers provided retirement benefits through defined benefit plans, such as a pension plan, which provides employees with a benefit at retirement based on a defined formula, taking into account years of service and compensation earned. Defined benefit plans sponsored by private employers are subject to special funding rules in the Internal Revenue Code that govern their tax-preferred status and in ERISA that are intended to protect the solvency of the plan and ensure the benefits promised to employees. Thus, in a defined benefit plan, the employer bears the risk of
poor investments and must ensure that the plan is funded to pay the benefit promised at retirement.
Defined Contribution Plans
More recently, employers have shifted from offering defined benefit plans to offering defined contribution plans, such as a 401(k) plan, which permit employees and employers to contribute defined amounts to a participant’s account. The benefit paid out at termination or retirement is based on the investment performance of those contributions. In a defined contribution plan, the employee bears the risk of poor investments and may lose some of his or her retirement savings in a down economy. To protect employees who participate in defined contribution plans, ERISA requires sponsoring employers to meet fiduciary standards in selecting and monitoring investment
funds and also requires employers to disclose information to employees regarding investment performance, fees, and expenses. In addition, the Internal Revenue Code imposes numerous technical requirements on defined contribution plans for them to maintain their tax-preferred status. This taxpreferred status is important because it generally allows contributions to be made on a tax-free basis and grow with earnings until they are distributed at retirement or other distributable events. The tax on the contributions and earnings is generally deferred until the time of distribution.
Executive Compensation Plans
Some employers want to offer additional retirement benefits to their executives. One method is to offer a plan that defers the payment of a portion of the executive’s compensation to a future date. These plans are not subject to the same requirements under the Code and ERISA as defined benefit and defined contribution plans. However, other detailed Code provisions prescribe certain requirements for these plans which, if not met, will result in immediate taxation to the executive and penalty taxes.