Should the Retirement Plan Be Formal or Informal?

Under an informal arrangement, the employer at his own discretion awards pensions to selected employees individually. A formal plan, on the other hand, is a definite, explicit, written agreement or commitment on the part of the employer to provide retirement benefits for either all of his employees or certain categories or classifications of employees.

A formal plan will permit the employer to take advantage of special tax deductions, it will avoid burdening him with a snowballing commitment for retirement payments, and it will let the employees know how much they are going to get —or at least what share.

A formal, funded retirement plan offers the following advantages:

Financial reasons. Funding a pension plan may result in direct savings to the employer. The realization of the costs of adequately funding a plan has resulted in more moderate pension payments and promises. Many employers have started to pay out-of-pocket pensions on a far more generous basis than they could reasonably afford to fund.

The advance funding of pension costs will enable an employer, whose business is subject to fluctuations in profits or cash demands, to be assured of adequate funds to pay pensions when they fall due.

A realistic valuation of the net worth of any business operation includes a reasonable estimate of the liability for pensions for its employees whether a formal plan exists or not. Such liabilities, if not funded, may be considered in arriving at the purchase or sale price of any business unit.

Accounting reasons. It is sound accounting practice to charge a reasonable sum for the annual accrual of each employee's pension to the costs of production during each year of that employee's working lifetime.

The Securities and Exchange Commission and the Financial Accounting Standards Board have taken the position that the value of pensions, when guaranteed to employees, must either be funded or be shown as a liability in the company's annual statement.

ERISA requires all qualified defined benefit plans to be funded. Initial past service costs of new plans must be amortized over a period of 30 years or less. Plans that existed on January 1, 1974 must amortize past service liabilities over a period of 40 years or less. Experience losses and gains must be amortized over a period of 5 years or less. These amortization schedules are for single-employer plans. Multiemployer plans may amortize past service liabilities over 40 years and experience losses and gains over 15 years for plans that began before 1988.

Employee relations reasons. The funding of a pension plan legally establishes the employee's interests and protects him against the hazards of the business, future changes of management, or an unexpected sale or liquidation. Furthermore, defined benefit pension plan benefits are insured under the Pension Benefit Guaranty Corporation's (PBGC) plan termination insurance provisions of ERISA and the contributing plan sponsor or a member of such a contributing sponsor's controlled group is liable (up to certain limits) for underfunding the plan.

A reasonable pension program has become one of the standards of a satisfactory employment relationship.

Tax reasons. In times of high tax rates, pensions may be funded at a relatively small cost to the stockholders.

Since the investment returns of a pension fund are free of income tax, the yield to the employer of an investment in a pension fund is equivalent to a much higher yield on funds kept in the business.

Contributions to a pension fund for the employees are a valuable form of personal income to the employee because they are free of current income tax.

A funded pension plan is a valuable investment for each employee with an interest in it because the investment returns of the fund are free of current personal income taxation.

Reprinted with permission. © CCH