Defined Benefit Plan

Ashgrove Metals sponsors a qualified retirement plan that invests primarily in Ashgrove's own common stock and allocates shares to participant accounts each year. Nolan Reyes participates and watches his account balance rise and fall with Ashgrove's share price. This arrangement is BEST described as:

1. A.A nonqualified deferred compensation arrangement, since it is funded with the employer's own shares.Wrong. Nonqualified deferred compensation is a selective, unfunded promise to a small group. An ESOP is a broad-based qualified plan with real assets held in trust.
2. B.A defined benefit pension plan, because the employer bears responsibility for the retirement outcome.Wrong. In a defined benefit plan the employer promises a stated benefit and bears investment risk. Here Nolan's balance rises and falls with the stock, which is defined contribution behavior.
3. C.An employee stock ownership plan - a qualified defined contribution plan whose assets are invested primarily in employer securities.Correct. An ESOP is a defined contribution plan built to hold employer stock, which is why the participant's balance moves with the share price.
4. D.A money purchase pension plan, because the employer must contribute a fixed percentage of pay each year.Wrong. A money purchase plan is defined by its mandatory fixed contribution formula, not by holding employer stock. The facts here point to the asset held, not the funding formula.

Why: This is an employee stock ownership plan (ESOP). An ESOP is a qualified DEFINED CONTRIBUTION plan designed to hold employer securities as its principal asset. Because it is a defined contribution plan, what goes IN is defined - the annual allocation of shares - and the participant bears the investment risk on what comes out. That is exactly why Nolan's balance tracks Ashgrove's stock price. The obvious downside is concentration: an ESOP participant's retirement savings and his paycheck both depend on the same employer.

Kettleworth Instruments sponsors a plan that credits each participant a hypothetical account with an annual pay credit equal to a percentage of salary plus a stated annual interest credit, and it expresses each participant benefit as an account balance payable as a lump sum at termination. How is that plan properly classified, and who bears the investment risk?

1. A.A defined contribution plan, because each participant has an individual account balance and the participant bears the investment risk.Incorrect. The account is hypothetical bookkeeping only; assets are pooled, and the employer guarantees the interest credit.
2. B.A profit-sharing plan, because the pay credit is expressed as a percentage of salary each year.Incorrect. A profit-sharing allocation carries no promised interest credit and creates no guaranteed benefit the employer must fund.
3. C.A cash balance plan, which is a defined benefit plan expressed as a hypothetical account, so the EMPLOYER bears the investment risk and must fund any shortfall against the promised interest credit.Correct. The promised pay and interest credits make it a defined benefit obligation, subject to DB funding rules and PBGC coverage.
4. D.A nonqualified deferred compensation arrangement, because benefits are expressed as an account and paid as a lump sum.Incorrect. It is a qualified plan covering the workforce broadly, not a selective nonqualified promise to a small group of executives.

Why: This is a cash balance plan, which is a DEFINED BENEFIT plan wearing defined contribution clothing. The hypothetical account is a bookkeeping device only; there is no segregated individual account holding actual securities. The employer maintains a single pooled trust, is subject to defined benefit minimum funding rules and actuarial certification, and pays premiums to the Pension Benefit Guaranty Corporation for benefit insurance. Because the plan promises a stated pay credit and a stated interest credit, the EMPLOYER bears the investment risk: if the trust earns less than the promised interest credit, the employer must contribute the shortfall, and if it earns more, the employer contribution requirement falls. Employees value the design because the benefit is easy to understand and highly portable, typically distributable as a lump sum that can be rolled over, which traditional final-average-pay formulas rarely offer.

Prentiss Manufacturing sponsors two retirement plans. Under Plan One the employer promises each retiree a monthly benefit computed from a formula using years of service and final average pay, and the employer is responsible for funding that promise. Under Plan Two the employer contributes a set percentage of pay to individual accounts that employees direct themselves, and the retirement benefit is simply whatever the account is worth. Which statement is correct?

1. A.Both are defined contribution plans, since the employer funds both of them.Incorrect. Employer funding is common to both types and does not determine the classification.
2. B.Plan One is a defined contribution plan because the benefit is set by a formula, and Plan Two is a defined benefit plan because the contribution is set.Incorrect. This reverses the definitions. The plan is named for what is fixed, and Plan One fixes the benefit.
3. C.Plan One is a defined benefit plan, in which the employer bears investment and longevity risk; Plan Two is a defined contribution plan, in which the employee bears both.Correct. A formula-driven promised benefit is defined benefit; a fixed deposit into a participant-directed account is defined contribution.
4. D.Under Plan One the employee bears the investment risk, because the benefit depends on final average pay.Incorrect. Final average pay is a salary measure, not an investment result. The employer must fund whatever the formula produces.

Why: Plan One defines the BENEFIT, which makes it a defined benefit plan. The employer must contribute whatever the actuaries say is needed to fund the promised payment, so the employer carries both investment risk and the risk that retirees live longer than expected. Plan Two defines the CONTRIBUTION, which makes it a defined contribution plan. The employer obligation ends when the contribution is deposited, and from that point the employee bears the investment results and the risk of outliving the balance.

Vantry Foods is choosing between a profit-sharing plan and a money purchase pension plan for its employees. Which statement correctly distinguishes the two?

1. A.A money purchase plan promises each participant a stated monthly benefit at retirement, while a profit-sharing plan does not.Wrong. That describes a defined BENEFIT plan. A money purchase plan fixes the contribution going in, never the benefit coming out.
2. B.Only the profit-sharing plan is qualified; a money purchase pension plan is a nonqualified arrangement.Wrong. Both are qualified plans eligible for pre-tax employer contributions and tax-deferred growth.
3. C.A profit-sharing plan requires an annual contribution equal to a set percentage of profits, while a money purchase plan is discretionary.Wrong - this reverses the two. Despite the name, a profit-sharing plan's contribution is discretionary and need not be tied to profits at all.
4. D.A money purchase plan commits the employer to a fixed contribution formula every year, while a profit-sharing plan lets the employer set the amount annually - including nothing at all.Correct. Mandatory versus discretionary funding is the distinguishing feature. Both remain defined contribution plans.

Why: Both are qualified DEFINED CONTRIBUTION plans, so both define the employer's input rather than the participant's eventual benefit. The difference is whether that input is mandatory. A money purchase pension plan locks the employer into a fixed contribution formula - a stated percentage of each participant's compensation - which must be funded every year regardless of profits. A profit-sharing plan leaves the amount to the employer's discretion each year, and the employer may contribute nothing in a lean year. The trade-off is predictability for the employee versus flexibility for the employer.