Below are definitions of common employee benefit plans, and a number of terms frequently used in those plans.
401(k) plan. The name of this kind of plan comes from the section number of the Internal Revenue Code that authorizes it. It is a plan that allows an employee to choose what kind of investments the employer will make on the employee's behalf. The employer selects different investments to offer, while the employee chooses which he or she prefers. The investment options may vary in terms of risk and other factors.
Administrator. The person or company who handles day-to-day details of operating a health benefit or pension plan, such as processing claims for benefits, employer and employee contributions, record-keeping, and reports. The administrator is usually identified in the plan creation documents.
Beneficiary. A beneficiary is usually a member of an employee's family who is covered by the employee-benefits plan, and who may receive benefits under the plan.
Cafeteria plan. A plan in which the employer offers a variety of different benefits, and the employees choose those benefits that fit their individual needs. Examples of benefits offered in the cafeteria include group-term life insurance, dental insurance, disability and accident insurance, and reimbursement of healthcare expenses.
COBRA. A federal law that requires employers to offer employees continuing medical insurance after the employee leaves the company. The employee pays the premiums and may continue to participate in the company's medical plan for up to eighteen months. The acronym "COBRA" stands for Consolidated Omnibus Budget Reconciliation Act.
Defined benefit plan. This kind of plan also may be referred to as a unit benefit plan. These terms refer to a plan in which employees are promised that upon retirement they will receive a specific amount of money according to a formula, a calculation that may be based on how long the employee worked for the company, and how much he or she earned. See "Fixed benefit plan."
Defined contribution plan. This kind of plan refers to one in which the employer makes regular contributions of a specified amount of money. In contrast to a defined benefit plan, it does not promise the employees any specific amount of retirement benefits. The employee's retirement benefit will depend on how much was contributed to his or her account, and how the plan's investments performed over the years. Examples of this kind of plan include a profit-sharing plan, a money-purchase plan, a target-benefit plan, stock bonus plans, and employee stock ownership plans.
Eligibility. Different plans have different requirements about who is entitled to participate in a plan. These eligibility requirements can include the employee's age, or how long he or she has been employed by the company. Generally, an employee is eligible when he or she turns twenty-one, or has been employed with the company for one year.
Employee Stock Ownership Plan (ESOP). This plan is primarily funded by the company's own stock, and does not depend on whether the company has made a profit.
ERISA. ERISA is an acronym for the "Employee Retirement Income Security Act," the federal law that regulates and enforces employee benefit and retirement plans.
Employee welfare plan. See "welfare plan."
Fixed benefit plan. In this kind of plan, the amount of retirement benefits is based on a formula that does not include the number of years the employee worked for the company. It could be a particular dollar amount, and it may be based on some percentage of the employee's pay.
Flexible benefit plan. See "cafeteria plan."
Individual Retirement Account (IRA). People who are not covered by any pension plan at work may use an IRA to save for retirement. In a traditional IRA, the contributions are made from the person's taxable income, and grow tax-free in the IRA. A Roth IRA is funded from a person's income, but that income is not taxed in the year it is earned. Instead, the income grows over the years and is taxed when the person withdraws it after he or she retires. Note that an IRA is not considered a "Pension Plan," and the provisions of ERISA do not apply.
IRC. This is an acronym for the Internal Revenue Code.
Keogh Plan. This is a qualified retirement plan for self-employed individuals. Contributions to this plan are tax-deductible. The individual can direct the investment of the funds that are put into a Keogh, e.g., stocks, bonds, or mutual funds.
Money-purchase plan. A defined-benefit plan in which the employer must contribute a specific amount of money each year to each participant's account. The amount of each contribution generally depends on that person's pay.
Multi-employer plan. In this kind of plan, two or more employers pool their contributions for the benefit of their employees. The plan may be established and maintained according to the terms of a collective bargaining agreement between the employers and a labor union. But this kind of plan may also be set up for the employers' non-union employees.
Normal retirement age. By law, an employer cannot dictate when an employee must retire. That can be deemed age discrimination. However, the employer may create a pension plan based on an assumption that employees will decide to retire at some age, and the employer can decide what that age will be. Companies frequently pick age 65; others pick 62 or 59.
Participant. Another way of saying "employee," "participant" refers to an employee who is covered by (or "opts" to participate in) any employee-benefits arrangement.
Plan sponsor. The entity that establishes and maintains a benefits plan The plan sponsor is usually an employer, but may also be an employee organization created for the purpose of offering benefits. If the plan is a "multi-employer plan," the committee or other entity that established the plan is considered the plan sponsor.
Portability. This term refers to an employee's ability to transfer vested benefits to an IRA or some other pension plan, after he or she leaves the company. Without portability, the employee could be subject to large tax bills. These days, the term "portability" also may refer to an employee's ability to transfer eligibility for medical insurance coverage without running into the problem of coverage denials based on a pre-existing medical condition.
Profit-sharing plan. The name of this kind of plan is a little misleading. A profit-sharing plan may be funded from the company's profits, but is not required to be. The terms of a profit-sharing plan will set forth a formula to determine how much should be contributed each year, or the plan may leave the amount to the employer's discretion. Unlike other kinds of plans, a profit-sharing plan may be set up in a manner that makes it tax-exempt. Refer to the entries for "employee stock option plan," above, and "stock bonus plan," below, for a description of two common forms of a profit-sharing plan.
Qualified plan. A qualified plan is one that complies with ERISA. It requires certain standards of vesting and accrual of benefits, and compliance with "nondiscrimination rules." A qualified plan entitles the employer and its employees to the favorable tax treatment provided in the Internal Revenue Code.
Retirement plan. A retirement plan provides retirement income, or it is a savings device in which contributions appreciate over time, with income taxes deferred until withdrawals are made when an employee reaches a certain age (or takes money out before reaching that age).
SIMPLE plan. "SIMPLE" is an acronym for "savings incentive match plans for employees." It describes a plan in which employees can make tax-deferred investments and the employer makes matching contributions. The plan can take the form of an IRA or a 401(k) plan.
Simplified Employee Pension (SEP). In a SEP, the employer directly funds IRAs or annuities that are established by or on behalf of the employees.
Stock bonus plan. This plan is funded by shares of the company's stock.
Summary plan description. This document summarizes the major features of an employee-benefit plan: what kind it is, how it is funded, who is eligible to participate, what steps must be taken to participate, how benefits will be paid out, etc.
Target-benefit plan. In this kind of plan, the employer has some idea of what participants should receive for retirement benefits. The employer then uses an actuarial formula that will meet that target amount by the time the employee is ready to retire. It does not promise a particular amount of benefits, however.
Thrift or savings plan. This kind of plan indicates that the participating employees must make contributions. The employer may make matching contributions, but isn't required to do so.
Top-hat plan. A top-hat plan is one offering unfunded deferred-compensation plans for upper management or highly compensated employees. A top-hat plan is not subject to some provisions of ERISA. See "top-heavy plan."
Top-heavy plan. This plan provides benefits for key employees, such as officers or owners of the company, that are worth more than 60 percent more than the benefits offered to regular employees. A top-heavy plan may require shorter vesting periods for regular employees to balance things out. See "vesting."
Vesting. The process by which contributions to a pension plan for a particular employee may no longer be forfeited. It usually requires that the employee be with the company for a specified period of time before he or she will be eligible for the benefits after retirement. Until then, the employee is "not vested," which means if something happens, like the employee quits or is fired, or if the company has lay-offs, the employee may lose those benefits (the contributions are paid out in a lump-sum, see "Portability" above). Some plans provide for "graded vesting," which means that an employee is vested over time, so that each year a higher percentage of contributions are nonforfeitable, until 100% are nonforfeitable. With graded vesting, the vesting period may be up to seven years. A plan providing that an employee is not vested at all until the specified amount of time elapses is referred to as "cliff vesting." With cliff vesting, the vesting period cannot exceed five years.
Welfare benefit plan. A welfare benefit plan provides medical benefits and other non-pension benefits to employees and their families. The kinds of benefits that may be offered are those that are provided to individual employees as money or services. These benefits include, for example, various kinds of insurance, special arrangements for pre-paid legal services, scholarships, training programs, education, and daycare. In some cases, the employees can choose which benefits they would like to participate in, according to their individual needs. These kinds of plans are described further under "cafeteria plans."
Withdrawal liability. If an employee takes money out of a retirement plan too early, he or she will probably be liable for income taxes and a tax penalty. The idea is to make early withdrawals unattractive so that funds will stay invested for retirement.