Defined Contribution 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.

Halvorsen Machine Works wants a qualified defined contribution plan deliberately designed to invest primarily in the sponsoring employer's own stock, so that participants build an ownership stake and departing employees receive shares or their value. Which arrangement fits?

1. A.An EMPLOYEE STOCK OWNERSHIP PLAN, a defined contribution plan required to invest primarily in qualifying employer securities.Correct. The ESOP is the qualified plan built to hold employer stock, giving participants an ownership stake and giving a closely held sponsor a ready market for its shares.
2. B.A money purchase pension plan.A money purchase plan commits the employer to a fixed annual contribution stated as a percentage of pay. Its assets are ordinarily diversified and it carries no mandate to hold employer stock.
3. C.A defined benefit pension plan.A defined benefit plan promises a formula benefit at retirement and the employer bears the investment risk. Holdings of employer securities in such a plan are tightly restricted.
4. D.A SIMPLE IRA.A SIMPLE IRA is an IRA-based salary reduction arrangement for small employers. The assets sit in individual IRAs and the plan is not a vehicle for holding the sponsor's stock.

Why: An EMPLOYEE STOCK OWNERSHIP PLAN is a qualified defined contribution plan that is required to invest primarily in qualifying employer securities. It gives employees an equity stake, provides a market for the shares of a closely held business, and lets the sponsor deduct contributions made in stock as well as in cash. Its concentration in one security is the trade-off; ordinary fiduciary diversification duties are relaxed for that reason.

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.