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Submitted by: Frank Armstrong
Frank Armstrong, is President and founder of Investor Solutions, Inc. He is a pioneer in integrating academically driven portfolio management techniques with institutional best practices for individual investors around the world. Frank has over 30 years experience in the securities and financial services industry. He holds a B.A. in Economics from the University of Virginia and is a CERTIFIED FINANCIAL PLANNER® practitioner.
Profit Sharing and 401(k) Plans
Chances are, if you have a retirement plan at work, you have or soon will have one of these.
Profit Sharing
Profit sharing plans are a type of Defined Benefit Plan (DB) almost identical to Money Purchase Pension Plans (MPPS), except that the sponsor is not required to make a fixed annual contribution. In a good year they can increase contributions, and in a bad year the plan they can reduce or suspend them. This kind of flexibility is important to many businesses. It encourages companies that otherwise might be reluctant to assume a fixed regular contribution formula to start and maintain plans.
Profit sharing contributions can create and maintain morale by rewarding the entire employee group for productivity gains, cost savings initiatives, or meeting other corporate goals. Properly employed they can be a powerful incentive by giving employees an ownership stake in the success of the enterprise.
From the employee’s side, it’s more difficult to forecast retirement benefits or determine funding needs where the employer has a lower commitment to annual funding, or varies the funding on a year to year basis.
The 401(k) Plan
When 401(k) Plans were first conceived, they were intended to be a supplement to traditional plans, not a replacement. Ted Benna, a benefits consultant, designed a plan to allow some employees of a small bank to tax shelter a bonus if they so desired, while allowing other employees to take the bonus in cash. (The bank president wanted to defer his bonus, but felt that most of the rank and file would prefer cash.) The rest is history. The idea took off grabbing an increasing share of the total retirement plan landscape.
As a supplemental plan, the 401(k) Plan is a truly great idea. As such, they are often offered in combination with other pension plans. A 401(k) Plan gives employees an opportunity to defer income by making voluntary “pre-tax” contributions to a retirement account up to certain limits. The 2004 limits are $13,000 plus and additional $3000 catch up contribution for participants over age 50. Both limits increase $1000 a year until 2006. Employees are always fully vested in their own contributions, but are subject to vesting schedules on the employer’s contributions if any. While contributions are pre tax, or deferrals, they are subject to both Social Security and Medicare withholding.
Under various arcane “non-discrimination” and “top heavy” rules, if not enough of the lower paid employees participate, than the higher paid employees cannot contribute as much as they might like. To encourage sufficient participation most plans offer an employer “match”. Employees that make contributions will have some or all of their contributions matched by the employer. These matching contributions range from exceedingly generous to something even Scrooge would have been ashamed of.
Technically, the 401(k) is a profit sharing plan with voluntary employee deferrals. Like other Defined Contributions Plans, the majority of 401(k) plans are “self directed” in that the employee chooses from a limited menu of investment choices offered under the plan.
Today many firms offer only a 401(k) plan for retirement benefits. As a standalone plan, even with a generous match it falls far short of a perfect retirement solution.
The standalone self directed 401(k) Plan is the last step in a long progression that shifts responsibility for retirement from the employer to the employee:
- The employee funds the plan from his wages through contribution of pay “pre-tax” dollars.
- The employee bears the entire investment risk.
- The employee must determine how much to fund for retirement.
- The employee may (or may not) pay the entire cost of administration and investment management from his/her account balances.
- The employee must design his or her own asset allocation plan from the available choices within the plan.
The trend away from guaranteed secure retirements (Defined Benefit) to a system where nobody cares if the employee sinks or swims (401(k)) is accelerating. If every employee was a disciplined, rational, investment professional, and if every plan offered the best possible investment choices, then the system might work tolerably well. Future installments will deal with those questions. Here’s a hint: The system looks like it’s designed from the ground up for failure.
Coming up:
Plans for Not For Profits, States and Municipalities
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Authored by the
founder of the
PaladinRegistry