PRESENT LAW AND BACKGROUND RELATING TO

EMPLOYER-SPONSORED DEFINED BENEFIT PLANS

 AND THE FINANCIAL POSITION OF THE 

PENSION BENEFIT GUARANTY CORPORATION (“PBGC”)

Scheduled for a Public Hearing

Before the

SENATE COMMITTEE ON FINANCE

on March 11, 2003

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

March 10, 2003

JCX-16-03
CONTENTS

Page

INTRODUCTION .......................................................................................................................... 1

I. OVERVIEW OF PRESENT LAW RELATING TO DEFINED BENEFIT PLANS................. 2

A. Rules Relating to Qualified Retirement Plans Generally.................................................... 2

1. In general....................................................................................................................... 2

2. Types of qualified retirement plans .............................................................................. 4

3. Taxation of qualified retirement plan contributions and distributions.......................... 4

4. Qualified retirement plan reporting and disclosure requirements................................. 5

5. Investment of qualified retirement plan assets.............................................................. 7

B. Rules Relating to Defined Benefit Plans........................................................................... 10

1. Common defined benefit plan designs........................................................................ 10

2. Benefit accrual requirements ...................................................................................... 15

3. Optional forms of benefit............................................................................................ 17

4. Prohibition on reductions in accrued benefits............................................................. 18

5. Spousal protections ..................................................................................................... 18

6. Limits on benefits........................................................................................................ 19

7. Reversions................................................................................................................... 19

II. PRESENT-LAW PENSION FUNDING REQUIREMENTS ................................................. 21

A. Funding Rules for Defined Benefit Plans ......................................................................... 21

1. In general..................................................................................................................... 21

2. General minimum funding rules................................................................................. 22

3. Special rules for multiemployer plans ........................................................................ 25

4. Additional funding requirements for certain plans ..................................................... 26

5. Failure to make required contributions ....................................................................... 30

6. Full funding limit ........................................................................................................ 30

7. Security for plan amendments..................................................................................... 31

B. Deduction Rules for Defined Benefit Plans...................................................................... 32

III. THE PBGC PENSION INSURANCE PROGRAM............................................................... 33

A. Present Law....................................................................................................................... 33

1. In general..................................................................................................................... 33

2. Termination of single-employer defined benefit plans ............................................... 33

3. Multiemployer plans ................................................................................................... 36

4. Guaranteed benefits..................................................................................................... 37

5. Sources of PBGC funding........................................................................................... 38
Page

ii

B. Financial Status of the PBGC........................................................................................... 40

IV. DATA RELATING TO QUALIFIED RETIREMENT PLANS............................................ 44

A. General Data on Qualified Retirement Plan Participation................................................ 44

B. Data on Participation in Defined Benefit Plans and Defined Contribution Plans ............ 46

C. Data on Qualified Retirement Plan Assets........................................................................ 49

V. GENERAL POLICY ISSUES RELATING TO DEFINED BENEFIT PLANS..................... 53
1

INTRODUCTION

The Senate Committee on Finance has scheduled a public hearing on March 11, 2003, on 

issues relating to the funding of defined benefit plans. This document, 1 prepared by the staff of 

the Joint Committee on Taxation, provides a description of present law and background with 

respect to defined benefit plans. Part I of the document discusses the present-law rules relating 

to qualified plans generally and special rules applicable to defined benefit plans. Part II of the 

document describes the present-law funding and deduction rules applicable to defined benefit 

plans. Part III discusses the pension insurance system and the financial status of the PBGC. 

Part IV contains data relating to qualified retirement plans. Part V of the document provides a 

discussion of general issues relating to defined benefit plans and retirement security. 

 

1

 This document may be cited as follows: Joint Committee on Taxation, Present Law 

and Background Relating to Employer-Sponsored Defined Benefit Plans and the Financial 

Position of the Pension Benefit Guaranty Corporation (“PBGC”) (JCX-16-03), March 10, 2003.
2

I. OVERVIEW OF PRESENT LAW RELATING TO DEFINED BENEFIT PLANS2

A. Rules Relating to Qualified Retirement Plans Generally

1. In general

A plan of deferred compensation that meets the qualification standards of the Internal 

Revenue Code (a “qualified retirement plan”) is accorded special tax treatment under present 

law. Employees do not include qualified retirement plan benefits in gross income until the 

benefits are distributed, even though the plan is funded and the benefits are nonforfeitable. An 

employer is entitled to a current deduction (within limits) for contributions to a qualified 

retirement plan even though the contributions are not currently included in an employee’s 

income. Contributions to a qualified retirement plan are held in a tax-exempt trust.

Employees, as well as employers, may make contributions to a qualified retirement plan. 

Employees may, subject to certain restrictions, make both pre-tax and after-tax contributions to a 

qualified retirement plan. Pre-tax employee contributions (e.g., employee elective deferrals to a 

qualified cash or deferred arrangement, i.e., a 401(k) plan) are generally treated the same as 

employer contributions for tax purposes.

Present law imposes a number of requirements on qualified retirement plans that must be 

satisfied in order for the plan to obtain tax-favored status.3 One of these requirements is that a 

qualified retirement plan must be maintained for the exclusive benefit of employees. In 

particular, a qualified retirement plan must prohibit the diversion of assets for purposes other 

than the exclusive benefit of employees and their beneficiaries (the “exclusive benefit rule”).

In addition, minimum participation and coverage rules and nondiscrimination rules are 

designed to ensure that qualified retirement plans benefit an employer’s rank-and-file employees 

as well as highly compensated employees.4 Under the minimum coverage rules, a plan must 

satisfy one of the following requirements: (1) the plan benefits at least 70 percent of employees

who are nonhighly compensated employees;5 (2) the plan benefits a percentage of nonhighly 

 

2

 Except as otherwise indicated, this discussion refers to rules in the Internal Revenue 

Code. The Employee Retirement Income Security Act of 1974 (“ERISA”) also contains rules 

relating to qualified plans, including defined benefit plans. Some, but not all, of the ERISA 

provisions are described here.

3

 See sec. 401(a). In some cases, special provisions apply to qualified retirement plans 

maintained by State and local governments. This document discusses the rules applicable to 

qualified retirement plans without regard to such special provisions, except as specifically 

mentioned.

4

 Sec. 410.

5

 Under present law, an employee is treated as highly compensated if the employee 

(1) was a five-percent owner of the employer at any time during the year or the preceding year, 

or (2) either (a) had compensation for the preceding year in excess of $90,000 (for 2003) or (b) at 

the election of the employer, had compensation for the preceding year in excess of $90,000 (for 
3

compensated employees that is at least 70 percent of the percentage of highly compensated 

employees benefiting under the plan; or (3) the plan satisfies an average benefits test that 

compares the benefits received by highly compensated employees and nonhighly compensated 

employees. Present law also contains a general nondiscrimination requirement which provides 

that a qualified retirement plan may not discriminate in favor of highly compensated employees. 

This requirement generally applies to all benefits, rights, and features under the plan, not just to 

contributions and benefits. Special rules apply to plans that primarily benefit key employees 

(called “top-heavy plans”). 

The plan qualification standards also define the rights of plan participants and 

beneficiaries and provide some limits on the tax benefits for qualified retirement plans. A limit 

of $200,000 (for 2003) applies to the amount of a participant’s compensation that may be taken 

into account for qualified retirement plan purposes.6 Limits apply also to the benefits or 

contributions provided to a participant and to the amount an employer may deduct for 

contributions to a qualified retirement plan, based on the type of plan. 7

Certain rules that apply to qualified retirement plans are designed to ensure that the 

amounts contributed to such plans are used for retirement purposes. Thus, for example, an early 

withdrawal tax applies to premature distributions from qualified retirement plans, and the ability 

to obtain distributions prior to termination of employment from certain types of qualified 

retirement plans, including defined benefit plans, is restricted.

Qualified retirement plans are also subject to regulation under ERISA. The ERISA rules 

generally relate to the rights of plan participants, reporting and disclosure, and the obligations of 

plan fiduciaries. Some of the provisions of the Internal Revenue Code and ERISA applicable to 

qualified retireme nt plans are identical or very similar. For example, both the Internal Revenue 

Code and ERISA impose minimum participation and vesting requirements.

Enforcement of the requirements that apply to qualified retirement plans depends on the 

source of the requirements. The qualification requirements under the Internal Revenue Code are 

enforced by the Internal Revenue Service (“IRS”). If a plan fails to meet the qualification 

requirements, then the favorable tax treatment for such plans may be denied; that is, the 

employer may lose tax deductions and employees may have current income taxation. The IRS 

rarely disqualifies a plan. Instead, the IRS may impose sanctions short of disqualification and 

require the employer to correct any violation of the qualification rules.

 

2003) and was in the top 20 percent of employees by compensation for such year. A nonhighly 

compensated employee is an employee other than a highly compensated employee.

6

 Sec. 401(a)(17).

7

 Secs. 415, 402(g), and 404. See the discussion in Part I.B.6., below. The Economic 

Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) increased many of the limits 

that apply to qualified retirement plans. These limit increases are generally effective for years 

beginning after December 31, 2001. The EGTRRA provisions generally do not apply for years 

beginning after December 31, 2010.
4

Certain of the Internal Revenue Code rules relating to qualified plans are enforced 

through an excise tax rather than through disqualification. For example, a failure to satisfy the 

minimum funding requirements for defined benefit plans, discussed below, does not result in 

disqualification of the plan. Instead, an excise tax is imposed on the employer.

Employees do not have a right to sue to enforce the qualified retirement plan 

requirements under the Internal Revenue Code. ERISA’s requirements generally may be 

enforced through administrative actions by the Department of Labor or by lawsuits brought by 

plan participants, the Department of Labor, or plan fiduciaries.

2. Types of qualified retirement plans

Qualified retirement plans are broadly classified into two categories, defined benefit 

plans and defined contribution plans, based on the nature of the benefits provided.

Under a defined benefit plan, benefits are determined under a plan formula, generally 

based on compensation and years of service. For example, a defined benefit plan might provide 

an annual retirement benefit of two percent of final average compensation multiplied by total 

years of service completed by an employee. Benefits under a defined benefit plan are funded by 

the general assets of the trust established under the plan; individual accounts are not maintained 

for employees participating in the plan.

Employer contributions to a defined benefit plan are subject to minimum funding 

requirements under the Internal Revenue Code and ERISA to ensure that plan assets are 

sufficient to pay the benefits under the plan. An employer is generally subject to an excise tax 

for a failure to make required contributions. Benefits under a defined benefit plan are guaranteed 

(within limits) by the PBGC.

Benefits under defined contribution plans are based solely on the contributions (and 

earnings thereon) allocated to separate accounts maintained for each plan participant. 

Profit-sharing plans and qualified cash or deferred arrangements (commonly called “401(k) 

plans” after the section of the Internal Revenue Code regulating such plans) are examples of 

defined contribution plans. 

Certain types of qualified retirement plans are referred to as hybrid plans because they 

have features of both a defined benefit plan and a defined contribution plan. For example, a cash 

balance plan is a hybrid plan. Legally, a cash balance plan is a defined benefit plan; however, 

plan benefits are defined by reference to a hypothetical account balance.

3. Taxation of qualified retirement plan contributions and distributions 8

Employer contributions and employee pre-tax contributions to a qualified retirement plan 

are not includible in an employee’s income at the time of contribution. 

 

8

 Secs. 72, 402.
5

A distribution of benefits from a qualified retirement plan generally is includible in gross 

income in the year it is paid or distributed, except to the extent the amount distributed represents 

a return of the employee’s after-tax contributions (i.e., basis). Special rules apply in certain 

cases, e.g., in the case of distributions rolled over to another employer-sponsored retirement plan 

or IRA, and distributions of employer securities.

Early distributions from qualified retirement plans generally are subject to an additional 

10-percent early withdrawal tax. 9 That is, includible amounts distributed prior to attainment of 

age 59-1/2 are subject to an additional 10-percent tax, unless the distribution is due to death or 

disability, is made in the form of certain periodic payments, is made to an employee after 

separation from service after attainment of age 55, or is used to pay medical expenses in excess 

of 7.5 percent of adjusted gross income.

Distributions from a qualified retirement plan are required to begin no later than the 

participant’s required beginning date.10 The required beginning date is April 1 of the calendar 

year following the later of (1) the calendar year in which the employee attains age 70-1/2, or 

(2) the calendar year in which the employee retires. In the case of an employee who is a 

five-percent owner, the required beginning date is April 1 of the calendar year following the 

calendar year the employee attains age 70-1/2. Distributions after the participant’s death also 

must meet certain minimum distribution requirements.

The sanction for failure to make a minimum required distribution to an employee (or 

other payee) under a qualified retirement plan is a 50-percent nondeductible excise tax on the 

excess in any taxable year of the amount required to have been distributed under the minimum 

distribution rules, over the amount that actually was distributed.11 The tax is imposed on the 

individual required to take the distribution. However, the qualification requirements also require 

that a plan must expressly provide that, in all events, distributions under the plan are to satisfy 

the minimum distribution requirements.

4. Qualified retirement plan reporting and disclosure requirements

Annual report

A qualified retirement plan is subject to annual reporting requirements under both the 

Internal Revenue Code and ERISA. The plan administrator of a qualified retirement plan 

generally must submit an annual report of certain information with respect to the qualification, 

financial condition, and operation of the plan. This report is made as a single submission to the 

Department of Labor on the Form5500, which forwards copies of the report to the IRS and the 

PBGC. The plan administrator must automatically provide participants with a summary of the 

annual report described above. In addition, on written request, a participant must be provided 

with a copy of the full annual report.

 

9

 Sec. 72(t).

10 Sec. 401(a)(9).

11 Sec. 4974.
6

Annual registration statement

A plan administrator is required to file an annual registration statement with the IRS with 

respect to any participant who (1) separates from service during the year, (2) is entitled to a 

deferred vested benefit under the plan as of the end of the plan year, and (3) whose benefits were 

not paid during the year. The annual registration statement is filed by means of Schedule SSA of 

the Form 5500 for the year following the year in which the employee separates from service. 

The plan administrator must also furnish an individual statement to each participant who 

separates from service and is listed in the annual registration statement described above. The 

individual statement must set forth the nature, amount and form of the deferred vested benefit to 

which the participant is entitled.

Summary plan description

ERISA requires that a plan administrator furnish participants with a summary plan 

description that includes certain information, including administrative information about the 

plan, the plan’s requirements as to eligibility for participation and benefits, the plan’s vesting 

provisions, and the procedures for claiming benefits under the plan. 12 The summary plan 

description must be furnished within 90 days after the participant first becomes a participant in 

the plan. In addition, if plan amendments are made, the plan administrator must furnish each 

participant every fifth year with an updated summary plan description that includes all the plan 

amendments made within the five-year period (or, if there have been no amendments, a new 

summary plan description every tenth year). A participant may also obtain a copy of the 

summary plan description on request.

The plan administrator must also furnish participants with a summary of any material 

modification in the terms of the plan and any change in the information required in the summary 

plan description within 210 days after the end of the plan year in which the modification or 

change occurs. 

These documents must be written in a manner calculated to be understood by the average 

plan participant and must reasonably apprise participants of their rights and obligations under the 

plan.

Benefit statements

ERISA provides that a plan administrator must furnish a benefit statement to any 

participant or beneficiary who makes a written request for such a statement. This requirement 

applies in the case of any plan that is subject to ERISA, including defined contribution and 

defined benefit plans. The benefit statement must indicate, on the basis of the latest available 

information, (1) the participant’s or beneficiary’s total accrued benefit, and (2) the participant’s 

or beneficiary’s vested accrued benefit or the earliest date on which the accrued benefit will 

become vested. A participant or beneficiary is not entitled to receive more than one benefit 

statement during any 12-month period.

 

12 The summary plan description must also be furnished to the Department of Labor on 

request.
7

Special requirements for defined benefit plans

Defined benefit plans must provide certain reports or notices if the plan is underfunded, if 

a plan amendment significantly reduces the rate of future benefit accrual, or if plan assets are 

transferred to health benefit accounts. 

5. Investment of qualified retirement plan assets

Risk of investment loss

The person who bears the risk of investment loss with respect to qualified retirement plan 

assets depends on whether the plan is a defined benefit plan or a defined contribution plan.

In a defined benefit plan, plan benefits are funded with the general assets of the plan, 

which are invested by plan fiduciaries in accordance with plan terms. Investment risk is 

generally on the employer as a result of the minimum funding requirements, under which the 

employer must make contributions in the amount necessary to fund promised benefits. The 

minimum funding rules also require periodic valuation of defined benefit plan assets. If the plan 

suffers investment losses, the employer may be required to increase plan contributions to 

maintain the funded status of the plan. 13

Benefits under defined benefit plans are guaranteed (within limits) by the PBGC. In the 

event a plan terminates with assets insufficient to pay promised benefits, the PBGC pays benefits 

up to the maximum guaranteed amount. For 2003, the maximum guaranteed benefit for an 

individual retiring at age 65 is $3,664.77 per month, or $43,977.24 per year.14

In a defined contribution plan, the benefit the participant is entitled to is the account 

balance. Thus, the plan participant bears the risk of investment losses, regardless of whether 

investment decisions are made by the participant or a plan fiduciary. Because the benefits due to 

participants in the event of a termination of a defined contribution plan are based on the assets 

held by the plan, defined contribution plans are not insured by the PBGC.

Fiduciary rules

ERISA contains general fiduciary standards that apply to all fiduciary actions, including 

the investment of plan assets held by a defined benefit plan. ERISA requires that a plan 

fiduciary must discharge its duties solely in the interests of participants and beneficiaries and:

• for the exclusive purpose of providing benefits to plan participants and beneficiaries 

and defraying reasonable expenses of plan administration;

• with the care, prudence, and diligence under the circumstances then prevailing that a 

prudent man acting in a like capacity and familiar with such matters would use in the 

conduct of an enterprise of a like character and with like aims;

 

13 The funding rules are discussed further in Part II.A., below.

14 The PBGC insurance program is discussed further in Part III, below.
8

• by diversifying the investments of the plan so as to minimize the risk of large losses, 

unless under the circumstances it is clearly prudent not to do so; and

• in accordance with plan documents insofar as they are consistent with ERISA.15

Violations of the fiduciary rules under ERISA are subject to enforcement through 

administrative actions by the Department of Labor or by lawsuits brought by plan participants, 

the Department of Labor, or plan fiduciaries.

ERISA generally provides that a person is a plan fiduciary to the extent the fiduciary 

exercises any discretionary authority or control over management of the plan or exercises 

authority or control over management or disposition of its assets, renders investment advice for a 

fee or other compensation, or has any discretionary authority or responsibility in the 

administration of the plan. As a result, a person who makes investment decisions with respect to 

a qualified retirement plan is generally a plan fiduciary and investment decisions are fiduciary 

actions.16

Generally, the plan trustee has exclusive authority and responsibility for managing and 

controlling plan assets and is thus responsible for investing plan assets. However, the plan may 

make the trustee subject to the direction of a named fiduciary, or the authority for managing plan 

assets may be delegated to an investment manager. An investment manager is a registered 

investment advisor, bank, trust company, or insurance company that is appointed by a named 

fiduciary of the plan with the power to manage, acquire, or dispose of plan assets. The 

investment manager must acknowledge in writing its status as a fiduciary.

Plan investment decisions that violate the fiduciary requirements of ERISA may in some 

cases violate the exclusive benefit rule under the Internal Revenue Code. However, not all 

fiduciary violations relating to plan investments are violations of the exclusive benefit rule.

Limits on investments in employer securities and real property

ERISA imposes restrictions on the investment of qualified retirement plan assets in 

employer securities or employer real property. A qualified retirement plan may hold only a 

“qualifying” employer security and only “qualifying” employer real property. In addition, 

ERISA prohibits defined benefit plans from acquiring qualifying employer securities or real 

property if, after the acquisition, more than 10 percent of the assets of the plan would be invested 

in employer securities and real property. Most defined contribution plans, other than a type of 

defined contribution plan known as money purchase pension plans, are not subject to these 

limits.

 

15 ERISA sec. 404.

16 Under a special ERISA provision, if a participant in a defined contribution plan 

exercises control over the assets in his or her account (as determined under regulations), the 

participant is not deemed to be a fiduciary by reason of such exercise and no person who is 

otherwise a fiduciary is liable for any loss, or by reason of any breach, that results from the 

participant’s exercise of control.
9

Any stock issued by the employer or an affiliate of the employer is a qualifying employer 

security. In the case of a defined benefit plan (and money purchase pension plans other than 

certain pre-ERISA plans), in order for stock to be a qualifying employer security, the plan cannot 

hold more than 25 percent of the aggregate amount of the issued and outstanding stock of the 

same class, and at least 50 percent of the aggregate amount of that stock must be held by persons 

independent of the issuer. Qualifying employer securities also include certain publicly traded 

partnership interests and certain marketable obligations (i.e., a bond, debenture, note, certificate 

or other evidence of indebtedness).

Qualifying employer real property means parcels of employer real property (1) if a 

substantial number of the parcels are dispersed geographically, (2) if each parcel of real property 

and the improvements thereon are suitable (or adaptable without excessive cost) for more than 

one use, (3) even if all of the real property is leased to one lessee (which may be an employer, or 

an affiliate of an employer), and (4) if the acquisition and retention of such property generally 

comply with the fiduciary rules of ERISA (with certain specified exceptions).

Prohibited transactions

Both the Internal Revenue Code and ERISA contain prohibited transaction rules that 

prohibit the employer, plan fiduciaries, and other persons with a close relationship to a qualified 

retirement plan from engaging in transactions with the plan. 17 These rules are not targeted toward 

particular types of investments, but rather seek to prevent self-dealing transactions. 

Prohibited transactions include (1) the sale, exchange or leasing of property, (2) the 

lending of money or other extension of credit, (3) the furnishing of goods, services or facilities, 

(4) the transfer to, or use by or for the benefit of, the income or assets of the plan, (5) in the case 

of a fiduciary, any act that deals with the plan’s income or assets for the fiduciary’s own interest 

or account, and (6) the receipt by a fiduciary of any consideration for the fiduciary’s own 

personal account from any party dealing with the plan in connection with a transaction involving 

the income or assets of the plan.

Certain transactions are exempt from prohibited transaction treatment. In addition, the 

Department of Labor may grant administrative exemptions in particular circumstances.

If a prohibited transaction occurs, the disqualified person who participates in the 

transaction is subject to a two-tier excise tax. The first level tax is 15 percent of the amount 

involved in the transaction. The second level tax is imposed if the prohibited transaction is not 

corrected within a certain period and is 100 percent of the amount involved.

 

17 Code sec. 4975; ERISA secs. 406-408.
10

B. Rules Relating to Defined Benefit Plans

1. Common defined benefit plan designs

In general

Subject to the applicable qualification rules, the employer (and, in the case of collectively 

bargained plans, employee representatives) determines the benefit formula under a defined 

benefit plan, as well as other plan features. Thus the benefits under such plans vary from 

employer to employer. Some common types of plan design are discussed below.

Final average pay plans

Under a final average pay plan, an employee’s benefit is based on the average of the 

employee’s compensation for a certain number of years (e.g., three or five years). Generally, the 

years taken into account are the most recent years (e.g., the three or five most recent years) or, if 

applicable, an earlier period of years in which the employee’s average compensation is the 

highest (sometimes referred to as “average annual compensation”).

The formula used to determine an employee’s normal retirement benefit under a final 

average pay plan may be a unit credit formula or a flat benefit formula.18 A unit credit formula 

provides a specified rate of benefit for each year of service, often with a limit on the years of 

service taken into account. For example, a plan may provide a normal retirement benefit of 

1.5 percent of final average pay for each year of service up to 30 years.19 A flat benefit formula 

provides a normal retirement benefit of a specified percentage without regard to years of service, 

for example, 50 percent of final average pay.

Because the normal retirement benefit under a final average pay plan is based on an 

employee’s most recent or highest pay, increases in an employee’s pay are reflected in the 

employee’s entire benefit. As a result, under a unit credit benefit formula, for an employee with 

a long period of service, compensation increases generally result in significant benefit increases 

because the compensation increase is reflected in the benefit attributable to all years of service. 

In addition, in the case of an employee who works for the employer until retirement, the 

retirement benefit is based on the employee’s most recent or highest pay at the time of 

retirement.

 

18 The benefit formula describes the benefit payable under the plan at normal retirement 

age. However, the benefit payable to an employee in the case of termination of employment (or 

termination of the plan) before normal retirement age depends on the portion of the normal 

retirement benefit that has accrued, which is determined under the plan’s accrual method, as 

discussed below. In addition, the amount of the accrued benefit payable to the employee 

depends on the extent to which the employee’s right to the accrued benefit is vested.

19 A unit credit formula may provide different benefit rates for different years of service 

(e.g., 1 percent of final average pay for each year of service up to 15 years and 1.25 percent of 

final average pay for each year of service from 16 to 30 years), subject to the accrual rules 

discussed below.
11

Career average plans

Under a career average pay plan, an employee’s normal retirement benefit consists of the 

sum of separate benefits determined for each year of service, based on compensation for the year 

of service. For example, a career average plan may provide a benefit of 1.5 percent of 

compensation for each year of service, with the total normal retirement benefit consisting of the 

sum of the separate benefits determined for each year of service. This plan design is also 

referred to sometimes as an “accumulation” plan. Under a career average plan, an increase in an 

employee’s compensation does not affect the portion of the employee’s normal retirement 

benefit attributable to previous years of service.20

Permitted disparity

The permitted disparity rules allow a defined benefit plan to provide a higher rate of 

benefit with respect to compensation above a certain amount without violating the prohibition on 

discrimination in favor of highly compensated employees. 21

The rationale for permitted disparity lies in the design of the Social Security system, 

under which an employer pays Social Security taxes on an employee’s compensation and, as a 

result, is considered to provide a portion of the employee’s Social Security benefits.22 Because 

Social Security benefits are based on an employee’s compensation only up to the wage base, 

permitted disparity allows the employer to provide higher (that is, disparate) benefits with 

respect to the portion of an employee’s compensation that is not taken into account under the 

Social Security system. 23 The amount of disparity that is permitted under a defined benefit plan 

is based roughly on the rate at which Social Security benefits replace earnings.

 

20 An employer maintaining a career average plan may periodically amend the plan to 

provide a one-time benefit adjustment under which the employee’s benefit is the greater of 

(1) the benefit determined under the career average formula for the employee’s completed years 

of service, and (2) the benefit determined under a final average pay formula, based on final 

average compensation as of the year in which the amendment applies and the employee’s 

completed years of service. For subsequent years (i.e., years after the year in which the 

amendment applies), the employee’s benefit consists of the sum of (1) the benefit determined 

under the amendment and (2) the benefit determined under the career average formula for years 

of service in subsequent years.

21 Secs. 401(a)(5)(C) and 401(l). The permitted disparity rules also allow a defined 

contribution plan to provide a higher rate of contribution with respect to compensation above a 

certain amount.

22 The employee also pays Social Security taxes on his or her compensation, at the same 

rate as the employer.

23 Before 1989, the methods by which contributions or benefits under a qualified 

retirement plan were integrated with the Social Security system were provided in Rev. 

Rul. 71-446, 1971-2 C.B. 187. Permitted disparity is sometimes referred to as “Social Security 

integration,” and a plan that uses permitted disparity is referred to as an “integrated” plan.
12

Two methods may be used for applying permitted disparity under a defined benefit plan: 

the excess benefit method and the offset method. Under the excess benefit method, the plan 

provides one rate of benefit with respect to compensation up to a specified amount (i.e., the 

“integration level”) and a higher rate of benefit with respect to compensation in excess of the 

integration level. Under the offset method, the plan provides the same rate of benefit with 

respect to all compensation (the “gross benefit”) and offsets the gross benefit by a specified 

percentage of compensation up to the integration level or by a portion of the employee’s 

estimated benefits under the Social Security program. 24

Cash balance plans

A cash balance plan is a defined benefit plan under which benefits are defined by 

reference to a hypothetical account balance. An employee’s hypothetical account is determined 

by reference to hypothetical annual allocations to the account (e.g., a certain percentage of the 

employee’s compensation for the year) and hypothetical earnings on the account. Depending on 

the design of the cash balance plan, an employee who receives a hypothetical allocation to his or 

her account for a year may be automatically entitled to future hypothetical earnings on that 

allocation, or the right to future hypothetical earnings on the allocation (or the amount of the 

earnings) may depend on whether the employee continues employment with the employer 

maintaining the plan.

Hypothetical earnings on the account may be determined in the form of hypothetical 

interest on the account at a rate specified in the plan or based on a specified market index, such 

as the rate of interest on certain Treasury securities. Alternatively, hypothetical earnings on the 

account may be based on hypothetical assets held in the account, similar to earnings on an 

account under a defined contribution plan, which are based on the assets held in the account. In 

that case, the plan may permit the employee to designate the hypothetical assets on which 

hypothetical earnings are based or permit the employee to choose from hypothetical investment 

options.25

Under defined benefit plans generally, normal retirement benefits are payable in the form 

of an annual benefit commencing at normal retirement age. Under a cash balance plan, the 

annual benefit payable to an employee at normal retirement age is generally determined as the 

actuarial equivalent of the amount of the employee’s hypothetical account balance at normal 

retirement age, using actuarial factors specified in the plan. In addition, cash balance plans 

generally provide for lump sum distributions based on the employee’s hypothetical account 

balance at the time the distribution is made.

 

24 The term for the Social Security benefit payable to an individual at Social Security 

retirement age is the individual’s primary insurance amount or “PIA.” A defined benefit plan 

that bases the offset on estimated Social Security benefits is referred to as a “PIA offset” plan.

25 The assets of the cash balance plan may or may not include the assets or investments 

on which hypothetical earnings are based. As in the case of other defined benefit plans, a plan 

fiduciary would be responsible for making investment decisions with respect to cash balance 

plan assets.
13

Contributory defined benefit plans

In general

Some defined benefit plans provide for employee contributions. Such a plan is referred 

to as a “contributory” defined benefit plan. Contributory defined benefit plans are fairly 

common among governmental defined benefit plans, but not among plans maintained by private 

employers.

Generally, employee contributions to a defined benefit plan are made on an after-tax 

basis.26 However, under a special rule, employee contributions to a plan maintained by a State or 

local government employer may be “picked up” by the employer and made on a pre-tax basis. 

Pre-tax treatment applies even if the employee’s salary is reduced by the amount of the 

contributions picked up by the employer. 

Types of employee contributions

A defined benefit plan may be designed to provide for mandatory or voluntary employee 

contributions.

In the case of mandatory contributions, an employee must make the contributions in order 

to be covered by the defined benefit plan and receive employer-provided benefits under the plan. 

Depending on the plan design chosen by the employer, an employee may be given the choice 

(generally at the start of employment or after completing a year of service) of whether to make 

mandatory contributions and participate in the plan, so that employee contributions are a 

condition of participation in the plan. Alternatively, employee contributions may be required as 

a condition of employment, i.e., all employees must make contributions and participate in the 

plan.27 

In the case of voluntary employee contributions to a defined benefit plan, an employee 

has the option of making contributions and receiving additional benefits based on those 

contributions. A plan may be designed so that a separate account is maintained for voluntary 

employee contributions, to which income, expenses, gains, and losses are allocated, and benefits 

attributable to the employee contributions are based on the balance of the separate account. In 

that case, the separate account is treated as a defined contribution plan for certain purposes.

 

26 Employee elective deferrals under a qualified cash or deferred arrangement (i.e., a 

401(k) plan) are made on a pre-tax basis. Under a qualified cash or deferred arrangement, 

benefits (other than employer matching contributions) must not be contingent on the employee’s 

election to make deferrals. This rule prevents employee contributions to a defined benefit plan, 

even if voluntary, from being treated as pre-tax elective deferrals because benefits under a 

contributory defined benefit plan depend in part on employee contributions. 

27 Employee contributions required as a condition of employment are a common feature 

in governmental defined benefit plans.
14

Vesting rules for employee contributions 28

Under a qualified retirement plan, an employee must be fully vested in the benefits under 

the plan that are attributable to employee contributions. The method for determining the amount 

of benefits attributable to employee contributions depends on whether the employee 

contributions are mandatory or voluntary and, in the case of voluntary employee contributions, 

whether the contributions are maintained in a separate account.

The amount of benefits attributable to mandatory employee contributions under a defined 

benefit plan is determined as the amount of the employee’s “accumulated contributions,” 

converted to an actuarially equivalent annuity payable at normal retirement age, using a statutory 

interest rate (i.e., the interest rate on 30-year Treasury securities). “Accumulated contributions” 

means the total of all mandatory contributions made by the employee plus interest thereon, 

projected to the employee’s normal retirement age using a specified rate and annual 

compounding. 29 The fact that the amount of mandatory employee contributions must be 

accounted for and credited with interest does not cause the employee contributions to be 

maintained in a separate account that is treated as a defined contribution plan, as described 

above.

If voluntary employee contributions are maintained in a separate account that is treated as 

a defined contribution plan, as described above, the amount of benefits attributable to employee 

contributions is the account balance. If voluntary employee contributions are not maintained in 

a separate account, the amount of benefits attributable to employee contributions is determined 

by multiplying the amount of the employee’s total benefits under the plan by the ratio of (1) the 

total of the employee’s contributions to the plan to (2) the sum of the employee’s contributions 

and the employer contributions made to the plan on behalf of the employee. 

Cost-of-living adjustments

Generally the amount of an employee’s annual retirement benefit from a defined 

contribution plan is determined at retirement and does not change. However, some defined 

benefit plans provide for post-retirement benefit increases based on cost-of-living adjustments 

(“COLAs”). A COLA may be provided automatically as part of the normal retirement benefit 

under the plan (an “automatic” COLA) or may be provided by a plan amendment made at the 

time (or times) the employer deems a COLA to be appropriate (an “ad hoc” COLA).

Insurance contract plans

An insurance contract plan is a defined benefit plan that meets the following 

requirements: (1) the plan is funded exclusively by the purchase of individual insurance 

 

28 Governmental plans are not subject to the vesting requirements.

29 The specified rate is (1) 120 percent of the Federal midterm rate for the period from 

the time the contribution is made to the time the determination is made, and (2) the statutory 

interest rate (i.e., the interest rate on 30-year Treasury securities) for the period from the time the 

determination is made to the time the employee would reach normal retirement age.
15

contracts,30 (2) the contracts are paid for by level annual premiums over the period of the 

individual’s participation in the plan, (3) benefits under the plan equal the benefits provided 

under the contracts at normal retirement age under the plan and are guaranteed by the insurance 

carrier, (4) premiums payable for the plan year, and all prior plan years, have been paid, (5) no 

rights under the contracts have been subject to a security interest at any time during the plan 

year, and (6) no policy loans are outstanding at any time during the plan year. Special accrual 

and funding rules apply to insurance contract plans. 

2. Benefit accrual requirements31

In general

Several of the requirements that apply to a qualified retirement plan relate to a 

participant’s accrued benefit. For example, the vesting requirements apply with respect to a 

participant’s accrued benefit. In addition, as discussed below, a plan amendment may not have 

the effect of reducing a participant’s accrued benefit.

In the case of a defined contribution plan, a participant’s accrued benefit is the balance of 

his or her account under the plan. In the case of a defined benefit plan, a participant’s accrued 

benefit is the portion of the normal retirement benefit (i.e., the annuity payable at normal 

retirement age under the plan’s benefit formula, based on the participant’s compensation and 

years of service) that has accrued under the accrual method provided under the plan. For 

example, if a participant terminates employment before reaching normal retirement age, the 

benefit to which the participant is entitled is the accrued benefit. The accrual method under a 

defined benefit plan must satisfy one of three accrual methods provided under the Code.

Permissible accrual methods

The three permissible accrual methods are (1) the 133-1/3 percent method, (2) the 

fractional method, and (3) the three-percent method. Most defined benefit plans use the 133-1/3 

percent method or the fractional method.

Under the 133-1/3 percent method, (1) the accrued benefit payable at normal retirement 

age must equal the normal retirement benefit under the plan, and (2) the annual rate at which any 

individual who is or could be a participant can accrue the retirement benefits payable at normal 

retirement age for any plan year cannot be more than 133-1/3 percent of the annual rate at which 

he or she can accrue benefits for any earlier plan year. For example, if the plan provides that a 

participant accrues a benefit of 1.5 percent of compensation for each year of service up to 20 and 

2 percent of compensation for each year of service in excess of 20, the plan satisfies the 

requirements of the 133-1/3 percent method. However, a benefit that accrues at the rate of 

one percent of compensation for each year of service up to 20 and 1.5 percent of compensation 

for each year of service in excess of 20 does not satisfy the requirements of the 133-1/3 percent 

method.

 

30 Group insurance contracts may be used if certain requirements are met. 

31 Sec. 411. Governmental plans are not subject to the accrual requirements.
16

Under the fractional method, the accrued benefit to which a participant is entitled at any 

time must equal or exceed the participant’s “fractional rule benefit,” multiplied by a fraction (not 

exceeding one), the numerator of which is the participant’s total years of participation in the 

plan, and the denominator of which is the total number of years of plan participation the 

participant would have if he or she separated from service at normal retirement age. A 

participant’s “fractional rule benefit” is the normal retirement benefit to which the participant 

would be entitled under the plan if the participant attained normal retirement age on the date the 

benefit is being determined (i.e., based on the participant’s current amount of compensation and 

years of service).

The fractional method is illustrated by the following example. Suppose a plan provides a 

normal retirement benefit at age 65 of two percent of compensation for each year of service up to 

30 years, so that a participant with 15 years of service has a fractional rule benefit of 30 percent 

of compensation (determined as if the participant attained normal retirement age on the date the 

benefit is being determined). For a participant who began participation in the plan at age 21 and 

is now age 36, the participant’s accrued benefit under the fractional method is the participant’s 

fractional rule benefit (30 percent of compensation), multiplied by the fraction 15/44 (i.e., the 

participant’s 15 years of participation over the participant’s projected years of plan participation 

at normal retirement age of 65) or 10.23 percent of compensation. For a participant who began 

participation in the plan at age 35 and is now age 50, the participant’s accrued benefit under the 

fractional method is the participant’s fractional rule benefit (30 percent of compensation), 

multiplied by the fraction 15/30 (i.e., the participant’s 15 years of participation over the 

participant’s projected years of plan participation at normal retirement age of 65) or 15 percent 

of compensation. 

Under the three-percent method, the accrued benefit to which each participant is entitled 

(computed as if the participant separated from the service as of the end of the plan year) must be 

at least three percent of the “three-percent method benefit,” multiplied by the participant’s years 

of plan participation as of the end of the year (but not more than 33-1/3 years). A participant’s 

“three-percent method benefit” is the normal retirement benefit to which the participant would be 

entitled if he or she began participation at the earliest age possible under the plan and 

participated in the plan continuously until the earlier of age 65 or the normal retirement age 

under the plan.

The fractional method and the three-percent method provide the minimum rate at which a 

participant’s benefit must accrue. Therefore, a plan may use an accrual method under which 

participants’ accrued benefits exceed the minimum, provided that no participant’s accrued 

benefit can be less than the minimum.

Notice of reduction in future rate of accrual32

If an amendment to a defined benefit plan provides for a significant reduction in the rate 

of future benefit accrual, including any elimination or reduction of an early retirement benefit or 

retirement-type subsidy, the plan administrator must furnish a written notice concerning the 

 

32 Sec. 4980F.
17

amendment. The plan administrator is required to provide in this notice, in a manner calculated 

to be understood by the average plan participant, sufficient information (as defined in Treasury 

regulations) to allow participants to understand the effect of the amendment.

The plan administrator is required to provide this notice to each affected participant, each 

affected alternate payee, and each employee organization representing affected participants. An 

affected participant or alternate payee is a participant or alternate payee whose rate of future 

benefit accrual may reasonably be expected to be significantly reduced by the plan amendment. 

The plan administrator is generally required to provide the notice at least 45 days before the 

effective date of the plan amendment.

3. Optional forms of benefit

Accrued benefits under a defined benefit plan generally must be paid in the form of an 

annuity for the life of the participant unless the participant consents to a distribution in another 

form. 33 Under an exception, if a participant ceases to be employed by the employer that 

maintains the plan, the plan may distribute the participant’s vested accrued benefit without the 

consent of the participant, if the present value of the benefit does not exceed $5,000.34

Defined benefit plans generally provide that a participant may choose among other forms 

of benefit offered under the plan, such as a lump sum distribution. These optional forms of 

benefit generally must be actuarially equivalent to the life annuity benefit payable to the 

participant.35

A defined benefit plan must specify the actuarial assumptions that will be used in 

determining optional forms of benefit under the plan in a manner that precludes employer 

discretion in the assumptions to be used. For example, a plan may specify that a variable interest 

rate will be used in determining actuarial equivalent forms of benefit, but may not give the 

employer discretion to choose the interest rate.

In addition, statutory actuarial assumptions must be used in determining the minimum 

value of certain optional forms of benefit, such as a lump sum. 36 That is, the lump sum payable 

under the plan may not be less than the amount of the lump sum that is actuarially equivalent to 

 

33 Governmental plans are not subject to this requirement. See below for a discussion of 

the spousal protection rules (including spousal consent) for distributions in the case of a married 

participant.

34 The portion of a participant’s benefit that is attributable to amounts rolled over from 

another plan may be disregarded in determining the present value of the participant’s vested 

accrued benefit.

35 In some cases, an optional form of benefit may be “subsidized,” i.e., more valuable on 

an actuarial basis than the life annuity payable to the participant.

36 The statutory actuarial assumptions must be used also in determining whether the 

present value of the benefit exceeds $5,000.
18

the life annuity payable to the participant, determined using the statutory assumptions. The 

statutory assumptions consist of an applicable mortality table (as published by the Internal 

Revenue Service) and an applicable interest rate.

The applicable interest rate is the annual interest rate on 30-year Treasury securities, 

determined as of a time that is permitted under regulations. The regulations provide various 

options for determining the interest rate to be used under the plan, such as the period for which 

the interest rate will remain constant (“stability period”) and the use of averaging. 

4. Prohibition on reductions in accrued benefits37

An amendment of a qualified retirement plan may not decrease the accrued benefit of a 

plan participant. 38 This prohibition applies to benefits that have already accrued. An amendment 

may reduce the amount of future benefit accruals, provided that, in the case of a significant 

reduction in the rate of future benefit accrual, notice is provided as discussed above.

For purposes of the prohibition on reductions in accrued benefits, an amendment is also 

treated as reducing an accrued benefit if, with respect to benefits accrued before the amendment 

is adopted, the amendment has the effect of either (1) eliminating or reducing an early retirement 

benefit or a retirement-type subsidy, or (2) except as provided by Treasury regulations, 

eliminating an optional form of benefit.

5. Spousal protections39

Defined benefit plans are required to provide benefits in the form of a qualified joint and 

survivor annuity (“QJSA”) unless the participant and his or her spouse consent to another form 

of benefit. A QJSA is an annuity for the life of the participant, with a survivor annuity for the 

life of the spouse which is not less than 50 percent (and not more than 100 percent) of the 

amount of the annuity payable during the joint lives of the participant and his or her spouse. In 

the case of a married participant who dies before the commencement of retirement benefits, the 

surviving spouse must be provided with a qualified preretirement survivor annuity (“QPSA”), 

which must provide the surviving spouse with a benefit that is not less than the benefit that 

would have been provided under the survivor portion of a QJSA.

The participant and his or her spouse may waive the right to a QJSA and QPSA provided 

certain requirements are satisfied. In general, these requirements include providing the 

 

37 Sec. 411(d)(6).

38 This restriction is sometimes referred to as the “anticutback” rule.

39 Secs. 401(a)(11) and 417. These requirements also apply to money purchase pension 

plans, but not to other defined contribution plans if the participant does not elect an annuity as 

the form of payment, the surviving spouse is the participant’s beneficiary (unless the spouse 

consents to the designation of another beneficiary), and, with respect to the participant, the plan 

has not received a transfer from a plan to which the QJSA and QPSA requirements applied (or 

separately accounts for the transferred assets).
19

participant with a written explanation of the terms and conditions of the survivor annuity, the 

right to make, and the effect of, a waiver of the annuity, the rights of the spouse to waive the 

survivor annuity, and the right of the participant to revoke the waiver. In addition, the spouse 

must provide a written consent to the waiver, witnessed by a plan representative or a notary 

public, which acknowledges the effect of the waiver.

6. Limits on benefits40

Annual benefits payable under a defined benefit plan generally may not exceed the lesser 

of (1) 100 percent of average compensation, or (2) $160,000 (for 2003). All defined benefit 

plans of the employer are aggregated for purposes of this limit. The dollar limit is adjusted 

annually for cost-of-living increases. The dollar limit is reduced proportionately for individuals 

with less than 10 years of participation in the plan. The compensation limit is reduced 

proportionately for individuals with less than 10 years of service.

The dollar limit on annual benefits is reduced if benefits under the plan begin before 

age 62. If benefits under a defined benefit plan begin after age 65, the dollar limit is increased so 

that it is the actuarial equivalent of a benefit beginning at age 65 in the amount of the dollar limit.

The dollar limit generally applies to a benefit payable in the form of a straight life annuity 

beginning at age 65. If a benefit is payable in another form, the benefit must be adjusted to be 

actuarially equivalent to a straight life annuity that does not exceed the dollar limit. If the other 

form of benefit must be determined using the 30-year Treasury interest rate discussed above 

(e.g., a lump sum benefit), that interest rate must be used also in making the adjustment.

Under a special rule, a minimum benefit can be paid even if the benefit exceeds the 

normally applicable benefit limitations. Thus, the overall limits on benefits are deemed to be 

satisfied if the retirement benefit of a participant under all defined benefit pension plans of the 

employer does not exceed $10,000 for a year or any prior year, and the participant has not 

participated in a defined contribution plan of the employer. The $10,000 limit is reduced for 

participants with less than 10 years of service with the employer.

7. Reversions

In general

Defined benefit plan assets generally may not revert to an employer before termination of 

the plan and the satisfaction of all plan liabilities. In addition, the plan must provide for the 

reversion. A reversion prior to plan termination may constitute a prohibited transaction and may 

result in disqualification of the plan. Certain limitations and procedural requirements apply to a 

reversion upon plan termination. Any assets that revert to the employer upon plan termination 

are includible in the gross income of the employer and subject to an excise tax. 41 The excise tax 

rate is generally 20 percent, but increases to 50 percent if the employer does not maintain a 

 

40 Sec. 415(b).

41 Sec. 4980.
20

replacement plan or make certain benefit increases. Upon plan termination, the accrued benefits 

of all plan participants are required to be fully vested.

Use of excess plan assets for retiree health benefits42

A qualified transfer of excess assets of a defined benefit plan may be made to a separate 

account within the plan in order to fund retiree health benefits. Excess assets generally means 

the excess, if any, of the value of the plan’s assets43 over the greater of (1) the lesser of (a) the 

accrued liability under the plan (including normal cost) or (b) 170 percent of the plan’s current

liability (for 2003),44 or (2) 125 percent of the plan’s current liability.

Excess assets transferred in a qualified transfer may not exceed the amount reasonably 

estimated to be the amount that the employer will pay out of such account during the taxable 

year of the transfer for qualified current retiree health liabilities. Amounts transferred in a 

qualified transfer are not includible in the gross income of the employer and are not subject to 

the excise tax on reversions of assets in a defined benefit plan. No deduction is allowed to the 

employer for (1) a qualified transfer or (2) the payment of qualified current retiree health 

liabilities out of transferred funds (and any income thereon).

In order for the transfer to be qualified, accrued retirement benefits under the pension 

plan generally must be 100-percent vested as if the plan terminated immediately before the 

transfer (or in the case of a participant who separated in the one-year period ending on the date of 

the transfer, immediately before the separation). In addition, at least 60 days before the date of a 

qualified transfer, the plan administrator must notify each participant and beneficiary under the 

plan of such transfer.45 The notice must include information with respect to the amount of excess 

pension assets, the portion to be transferred, the amount of health benefits liabilities expected to 

be provided with the assets transferred, and the amount of pension benefits of the participant that 

will be vested immediately after the transfer. The employer maintaining the plan must also 

provide advance notice of the transfer to the Department of Labor and the Department of 

Treasury, and any employee organization representing participants in the plan. A copy of this 

notice must be available for inspection in the principal office of the administrator.

No qualified transfer may be made after December 31, 2005.

 

42 Sec. 420.

43 The value of plan assets is the lesser of fair market value or actuarial value.

44 The current liability full funding limit is repealed for years beginning after 2003. 

Under the general sunset provision of EGTRRA, the limit is reinstated for years after 2010.

45 ERISA sec. 101(e).
21

II. PRESENT-LAW PENSION FUNDING REQUIREMENTS

A. Funding Rules for Defined Benefit Plans

1. In general

Defined benefit plans are subject to minimum funding requirements.46 The minimum 

funding requirements are designed to ensure that plan assets are sufficient to pay plan benefits 

when due. The amount of contributions required for a plan year under the minimum funding 

rules is generally the amount needed to fund benefits earned during that year plus that year’s 

portion of other liabilities that are amortized over a period of years, such as benefits resulting 

from a grant of past service credit. The amount of required annual contributions is determined 

under one of a number of acceptable actuarial cost methods. Additional contributions are 

required in the case of certain plans.

In general, plan contributions required to satisfy the funding rules must be made within 

8-1/2 months after the end of the plan year. If the contribution is made by such date, the 

contribution is treated as if it were made on the last day of the plan year. However, a plan 

subject to the additional contributions requirements (described below) may be required to make 

quarterly contributions.

An employer sponsoring a defined benefit plan generally may deduct amounts 

contributed to satisfy the minimum funding requirements for a plan year. No contribution is 

required under the minimum funding rules in excess of the full funding limit (described below). 

In addition, contributions in excess of the full funding limit generally are not deductible. Special 

deduction limits apply in the event an employer maintains both a defined contribution plan and 

defined benefit plan. Nondeductible contributions are subject to a 10-percent excise tax, unless 

an exception applies.47

The minimum required or maximum permitted contribution that can be made to a defined 

benefit plan depends on the funding method used by the plan and the actuarial assumptions used 

by the plan actuary. As a result, subject to the minimum funding requirements and the limits on 

deductible contributions, plan sponsors have flexibility to determine the amount of a contribution 

to make with respect to any plan year. Thus, for example, plan sponsors may vary the amount of 

the contributions based on the business cycle of the employer.

 

46 Sec. 412.

47 Sec. 4972.
22

2. General minimum funding rules48

Funding standard account

As an administrative aid in the application of the funding requirements, a defined benefit 

plan is required to maintain a special account called a “funding standard account” to which 

specified charges and credits (as described below), including credits for contributions to the plan, 

are to be made for each plan year. If, as of the close of a plan year, the account reflects credits 

equal to or in excess of charges, the plan is generally treated as meeting the minimum funding 

standard for the year. Thus, as a general rule, the minimum contribution for a plan year is 

determined as the amount by which the charges to the account would exceed credits to the 

account if no contribution were made to the plan. If, as of the close of the plan year, charges to 

the funding standard account exceed credits to the account, then the excess is referred to as an 

“accumulated funding deficiency.” For example, if the balance of charges to the funding 

standard account of a plan for a year would be $200,000 without any contributions, then a 

minimum contribution equal to that amount would be required to meet the minimum funding

standard for the year to prevent an accumulated funding deficiency.

Funding methods

In general

A defined benefit plan is required to use an acceptable actuarial cost method to determine 

the elements included in its funding standard account for a year. Generally, an actuarial cost 

method breaks up the cost of benefits under the plan into annual charges consisting of two 

elements for each plan year. These elements are referred to as (1) normal cost, and 

(2) supplemental cost.

Normal cost

The normal cost for a plan for a year generally represents the cost of future benefits 

allocated to the year by the funding method used by the plan for current employees and, under 

some funding methods, for separated employees. Specifically, it is the amount actuarially 

determined that would be required as a contribution by the employer to maintain the plan if the 

plan had been in effect from the beginning of service of the included employees and if the costs 

for prior years had been paid, and all assumptions as to interest, mortality, time of payment, etc., 

had been fulfilled. The normal cost will be funded by future contributions to the plan (1) in level 

dollar amounts, (2) as a uniform percentage of payroll, (3) as a uniform amount per unit of 

service (e.g., $1 per hour), or (4) on the basis of the actuarial present values of benefits 

considered accruing in particular plan years.

Supplemental cost

The supplemental cost for a plan year is the cost of future benefits that would not be met 

by future normal costs, future employee contributions, or plan assets. The most common 

 

48 Governmental plans are not subject to the minimum funding rules.
23

supplemental cost is that attributable to past service liability, which represents the cost of future 

benefits under the plan (1) on the date the plan is first effective, or (2) on the date a plan 

amendment increasing plan benefits is first effective. Under some funding methods, there is no 

past service liability component.

Other supplemental costs may be attributable to net experience losses, changes in 

actuarial assumptions, and amounts necessary to make up funding deficiencies for which a 

waiver was obtained. Supplemental costs must be amortized over a specified number of years.

Acceptable methods

Normal cost and supplemental cost are key elements in computations under the minimum 

funding standard. Although these costs may differ substantially, depending upon the actuarial 

cost method used to value a plan’s assets and liabilities, they must be determined under one of a 

number of permissible actuarial cost methods. Normal costs and supplemental costs under a plan 

are computed on the basis of an actuarial valuation of the assets and liabilities of a plan. An 

actuarial valuation is generally required annually.

Charges and credits to the funding standard account

In general

Under the minimum funding standard, the portion of the cost of a plan that is required to 

be paid for a particular year depends upon the nature of the cost. For example, the normal cost 

for a year is generally required to be funded currently. On the other hand, costs with respect to 

past service (for example, the cost of retroactive benefit increases), experience losses, and 

changes in actuarial assumptions, are spread over a period of years.

Normal cost

Each plan year, a plan’s funding standard account is charged with the normal cost 

assigned to that year under the particular acceptable actuarial cost method adopted by the plan. 

The charge for normal cost will require an offsetting credit in the funding standard account. 

Usually, an employer contribution is required to create the credit. For example, if the normal 

cost for a plan year is $150,000, the funding standard account would be charged with that 

amount for the year. Assuming that there are no other credits in the account to offset the charge 

for normal cost, an employer contribution of $150,000 will be required for the year to avoid an 

accumulated funding deficiency.

Past service liability

There are three separate charges to the funding standard account, one or more of which 

may apply as the result of past service liabilities. The first applies to a plan under which past 

service liability has increased due to a plan amendment made after January 1, 1974; the second 

applies only to a plan that came into existence after January 1, 1974; and the third applies only to 

a plan in existence on January 1, 1974. Past service liabilities result in annual charges to the 

funding standard account over a specified period of years, generally 30 years for the first two 
24

types of past service liabilities and 40 years for the third type of past service liability. 49 

Assuming that there are no other credits in the account to offset a charge for past service liability, 

an employer contribution will be required for the year to avoid an accumulated funding 

deficiency.

For example, assume that a plan uses the calendar year as the plan year. Further assume 

that during 1987 the plan was amended to increase benefits and that the net result of plan 

amendments for 1987 was an increase in the past service liability under the plan of $500,000. In 

addition, the plan’s actuary uses an interest rate of eight percent in determining plan costs. The 

30-year schedule requires that $44,414 be charged to the funding standard account each year to 

amortize the past service liability.50 Accordingly, for each year in the 30-year period beginning 

with 1987, the plan’s funding standard account is charged with the amount of $44,414. If there 

are no other credits in the account to offset the charge for past service liability, an employer 

contribution of $44,414 would be required for each of the 30 years to avoid an accumulated 

funding deficiency unless the plan becomes fully funded.

Gains and losses from changes in assumptions

If the actuarial assumptions used for funding a plan are revised and, under the new 

assumptions, the accrued liability of a plan is less than the accrued liability computed under the 

previous assumptions, the decrease is a gain from changes in actuarial assumptions. If the new 

assumptions result in an increase in the accrued liability, the plan has a loss from changes in 

actuarial assumptions. The accrued liability of a plan is the actuarial present value of projected 

pension benefits under the plan that will not be funded by future contributions to meet normal 

cost or future employee contributions. Under the funding standard, the gain or loss for a year 

from changes in actuarial assumptions is amortized over a period of ten years, resulting in credits 

or charges to the funding standard account.

Experience gains and losses

In determining plan funding under an actuarial cost method, a plan’s actuary generally 

makes certain assumptions regarding the future experience of a plan. These assumptions 

typically involve rates of interest, mortality, disability, salary increases, and other factors 

affecting the value of assets and liabilities. The actuarial assumptions are required to be 

reasonable, as discussed below. If, on the basis of these assumptions, the contributions made to 

the plan result in actual unfunded liabilities that are less than those anticipated by the actuary, 

then the excess is an experience gain. If the actual unfunded liabilities are greater than those 

 

49 In the case of certain multiemployer plans, special amortization periods may apply to 

credits and charges related to certain past service liabilities. Sec. 412(b)(6).

50 This amount, $44,414, when paid annually over a 30-year period, has a present value 

of $500,000 when discounted using an eight percent interest rate.
25

anticipated, then the difference is an experience loss. Experience gains and losses for a year are 

generally amortized over a five-year period.51

Waived funding deficiencies

Under the funding standard, the amount of a waived funding deficiency is amortized over 

a period of five years, beginning with the year following the year in which the waiver is granted. 

Each year, the funding standard account is charged with the amount amortized for that year 

unless the plan becomes fully funded. The interest rate used for purposes of determining the 

amortization on the waived amount is the greater of (1) the rate used in computing costs under 

the plan, or (2) 150 percent of the mid-term applicable Federal interest rate (AFR) in effect for 

the first month of the plan year.

Reasonableness of actuarial assumptions

All costs, liabilities, interest rates, and other factors are required to be determined on the 

basis of actuarial assumptions and methods (1) each of which is reasonable individually or 

(2) which result, in the aggregate, in a total plan contribution equivalent to a contribution that 

would be obtained if each assumption were reasonable. In addition, the assumptions are required 

to reflect the actuary’s best estimate of experience under the plan.

3. Special rules for multiemployer plans 52

Certain modifications to the funding rules apply to multiemployer plans that experience 

financial difficulties, referred to as “reorganization status.” A plan is in reorganization status for 

a year if the contribution needed to balance the charges and credits to its funding standard 

account exceeds its “vested benefits charge.” The plan’s vested benefits charge is generally the 

amount needed to amortize, in equal annual installments, unfunded vested benefits under the 

plan, over (1) 10 years in the case of obligations attributable to participants in pay status, and 

(2) 25 years in the case of obligations attributable to other participants. A plan in reorganization 

status is eligible for a special funding credit. In addition, a cap on year-to-year contribution 

increases and other relief is available to employers that continue to contribute to the plan.

Subject to certain requirements, a multiemployer plan in reorganization status may also 

be amended to reduce or eliminate accrued benefits in excess of the amount of benefits 

guaranteed by the PBGC.53 In order for accrued benefits to be reduced, at least six months 

 

51 In the case of certain multiemployer plans, special amortization periods may apply to 

credits and charges related to certain experience gains or losses. Sec. 412(b)(6).

52 Secs. 418-418D. A multiemployer plan is a plan (1) maintained pursuant to one or 

more collective bargaining agreements between one or more employee organizations and more 

than one employer, (2) to which more than one employer is required to contribute, and (3) that 

satisfies other requirements prescribed by the Secretary of Labor. 

53 The rules applicable to qualified retirement plans generally prohibit a plan amendment 

that reduces participants’ accrued benefits.
26

before the beginning of the plan year in which the amendment is adopted, notice must be given 

that the plan is in reorganization status and that, if contributions to the plan are not increased, 

accrued benefits will be reduced or an excise tax will be imposed on employers obligated to 

contribute to the plan. The notice must be provided to plan participants and beneficiaries, any 

employer who has an obligation to contribute to the plan, and any employee organization 

representing employees in the plan.

Multiemployer plans are also exempt from the additional funding requirements 

(described below) and the statutory interest and mortality assumptions required to be used for 

that purpose.

4. Additional funding requirements for certain plans 54

In general

Additional contributions may be required under a special funding rule for certain singleemployer defined benefit pension plans.55 These additional funding requirements were enacted 

in 1987 and amended in 1994 to address demands on the PBGC insurance system as a result of 

terminations of underfunded plans.

Under the special funding rule, additional contributions are generally required if the value 

of the plan assets is less than 90 percent of the plan’s current liability.56 The value of plan assets 

as a percentage of current liability is the plan’s “funded current liability percentage.” In general, 

a plan’s current liability means all liabilities to employees and their beneficiaries under the plan, 

determined on a present value basis.

The minimum required contribution under the special rule is, in general, the greater of 

(1) the amount determined under the normal funding rules, or (2) the deficit reduction 

contribution, plus the amount required with respect to benefits that are contingent on 

unpredictable events. The deficit reduction contribution is the sum of (1) the unfunded old 

liability amount, (2) the unfunded new liability amount, (3) the expected increase in current 

liability due to benefits accruing during the plan year, and (4) the amount needed to amortize 

increases in current liability due to certain future changes in the mortality table required to be 

used in determining current liability. The amount of additional contributions required under the 

 

54 Sec. 412(l).

55 Single-employer plans with no more than 100 participants on any day in the preceding 

plan year are not subject to the special funding rule. Single-employer plans with more than 100 

but not more than 150 participants are generally subject to lower contribution requirements under 

the special funding rule.

56 Under an alternative test, a plan is not subject to the special rule if (1) the value of the 

plan assets is at least 80 percent of current liability and (2) the value of the plan assets was at 

least 90 percent of current liability for each of the two immediately preceding years or each of 

the second and third immediately preceding years.
27

special funding rule cannot exceed the amount needed to increase the plan’s funded current 

liability percentage to 100 percent.

Unfunded old liability amount

The unfunded old liability amount is the sum of two amounts. The first amount is, in 

general, the amount necessary to amortize the unfunded old liability under the plan in equal 

annual installments (until fully amortized) over a fixed period of 18 plan years, beginning with 

the first plan year beginning after December 31, 1988. The “unfunded old liability” with respect 

to a plan is generally the unfunded current liability of the plan as of the beginning of the first 

plan year beginning after December 31, 1987, determined without regard to any plan amendment 

adopted after October 16, 1987, that increases plan liabilities (other than amendments adopted 

pursuant to certain collective bargaining agreements). The second amount is, in general, the 

amount needed to amortize the additional old unfunded liability over a period of 12 years, 

beginning with the first plan year beginning after December 31, 1994. The “additional old 

unfunded liability” is the increase in the unfunded old liability resulting from statutory changes 

made in the interest rate and mortality assumptions used to determine current liability for plan 

years beginning after December 31, 1994.

Unfunded new liability amount

The unfunded new liability amount for a plan year is the applicable percentage of the 

plan’s unfunded new liability. “Unfunded new liability” means the unfunded current liability of 

the plan for the plan year, determined without regard to (1) the unamortized portion of the 

unfunded old liability amount, any unfunded mortality increases, and certain unfunded liabilities 

under a collectively bargained plan, and (2) the liability with respect to any unpredictable 

contingent event benefits, without regard to whether or not the event has occurred. Thus, in 

calculating the unfunded new liability, all unpredictable contingent event benefits are 

disregarded, even if the event on which that benefit is contingent has occurred.

If the funded current liability percentage is less than 60 percent, then the applicable 

percentage is 30 percent. The applicable percentage decreases by .40 of one percentage point for 

each percentage point by which the plan’s funded current liability percentage exceeds 60 percent. 

Unpredictable contingent event benefits

The value of any unpredictable contingent event benefit is not considered until the event 

has occurred. In the case of a plan that is subject to the additional funding requirements, if the 

event on which an unpredictable contingent event benefit is contingent occurs during the plan 

year and the assets of the plan are less than current liability (calculated after the event has 

occurred), then an additional contribution (over and above the minimum funding contribution 

otherwise due) is required.

Unpredictable contingent event benefits include benefits that depend on contingencies 

that, like facility shutdowns or reductions or contractions in workforce, are not reliably and 

reasonably predictable. The event on which an unpredictable contingent event benefit is 

contingent is generally not considered to have occurred until all events on which the benefit is 

contingent have occurred.
28

The amount of the additional contribution is generally equal to the greatest of the 

following three amounts: (1) the unfunded portion of the unpredictable contingent event benefits 

paid during the plan year, including (except as provided by the Secretary) any payment for the 

purchase of an annuity contract for a participant with respect to unpredictable contingent event 

benefits; (2) the amount that would be determined for the year if the unpredictable contingent 

event benefit liabilities were amortized in equal annual installments over seven years, beginning 

with the plan year in which the event occurs; and (3) the additional contribution that would be 

required if the unpredictable contingent event benefit liabilities were included in the calculation 

of the plan’s unfunded new liability for the plan year. In addition, the present value of the

additional funding contribution with respect to one event is limited to the unpredictable 

contingent event benefit liabilities attributable to that event.

Required interest rate

Specific interest rate and mortality assumptions must be used in determining a plan’s 

current liability for purposes of the special funding rule. The interest rate used to determine a 

plan’s current liability must be within a permissible range of the weighted average57 of the 

interest rates on 30-year Treasury securities for the four-year period ending on the last day before 

the plan year begins.58 The permissible range is generally from 90 percent to 105 percent. 59 The 

IRS publishes the applicable rate on a monthly basis. The Department of the Treasury does not 

currently issue 30-year Treasury securities.60 As of March 2002, the IRS publishes the average 

yield on the 30-year Treasury bond maturing in February 2031 as a substitute.

Section 405 of the Job Creation and Worker Assistance Act of 2002,61 provides a special 

interest rate rule applicable in determining the amount of additional contributions for plan years 

beginning after December 31, 2001, and before January 1, 2004 (the “applicable plan years”). 

The special rule expands the permissible range of the statutory interest rate used in calculating a 

plan’s current liability for purposes of applying the additional contribution requirements for the 

 

57 The weighting used for this purpose is 40 percent, 30 percent, 20 percent and 10 

percent, starting with the most recent year in the four-year period.

58 The interest rate used under the plan must be consistent with the assumptions which 

reflect the purchase rates which would be used by insurance companies to satisfy the liabilities 

under the plan. Sec. 412(b)(5)(B)(iii)(II).

59 If the Secretary of the Treasury determines that the lowest permissible interest rate in 

this range is unreasonably high, the Secretary may prescribe a lower rate, but not less than 80 

percent of the weighted average of the 30-year Treasury rate.

60 As discussed elsewhere in this document, the interest rate on 30-year Treasury 

securities is used for other purposes also, including determination of certain optional forms of 

benefits (e.g., a lump sum), application of the dollar limit on benefits to certain forms of benefit, 

determination of benefits attributable to mandatory employee contributions, and determination of 

additional PBGC premiums.

61 Pub. L. No. 107-147.
29

applicable plan years. The permissible range is from 90 percent to 120 percent for these years. 

Use of a higher interest rate under the expanded range will affect the plan’s current liability, 

which may in turn affect the need to make additional contributions and the amount of any 

additional contributions.

Quarterly contributions requirement

In the case of a plan with a funded current liability percentage of less than 100 percent for 

the preceding plan year, estimated contributions for the current plan year must be made in 

quarterly installments during the current plan year. The amount of each required installment is 

generally 25 percent of the lesser of (1) 90 percent of the amount required to be contributed for 

the current plan year or (2) 100 percent of the amount required to be contributed for the 

preceding plan year.62 Quarterly installments for a plan year are generally due on April 15, 

July 15, October 15 of the plan year and January 15 of the following year.

The amount of a quarterly installment must also be sufficient to cover any shortfall in the 

plan’s liquid assets (a “liquidity shortfall”). In general, a plan has a liquidity shortfall for a 

quarter if the plan’s liquid assets are less than the base amount for the quarter. For this purpose 

liquid assets include cash, marketable securities, and other assets specified by the Secretary of 

the Treasury. The base amount for a quarter is generally three times the adjusted disbursements 

from the plan for the 12-month period ending on the last day of the month preceding the 

quarterly installment due date. A plan’s adjusted disbursements means the amount of all 

disbursements from the plan’s trust and administrative expenses, reduced by the product of the 

plan’s funded current liability percentage and the sum of certain disbursements. The amount of 

the liquidity shortfall for a quarter must be paid in liquid assets. The amount of any liquidity 

shortfall payment, when added to prior installments for the plan year, cannot exceed the amount 

necessary to increase the funded current liability percentage of the plan to 100 percent, taking 

into account the expected increase in the plan’s current liability due to benefits accruing in the 

plan year.

 

62 In connection with the expanded interest rate range available for 2002 and 2003, 

special rules apply in determining current liability for the preceding plan year for plans years 

beginning in 2002 (when the expanded range first applies) and 2004 (when the expanded range 

no longer applies). In each of those years (“present year”), current liability for the preceding 

year is redetermined, using the permissible range applicable to the present year. This 

redetermined current liability will be used for purposes of the plan’s funded current liability 

percentage for the preceding year, which may affect the need to make quarterly contributions, 

and for purposes of determining the amount of any quarterly contributions in the present year, 

which is based in part on the preceding year.
30

5. Failure to make required contributions

Funding waivers

Within limits, the IRS is permitted to waive all or a portion of the contributions required 

under the minimum funding standard for a plan year.63 A waiver may be granted if the employer 

(or employers) responsible for the contribution could not make the required contribution without 

temporary substantial business hardship and if requiring the contribution would be adverse to the 

interests of plan participants in the aggregate. A waiver may be granted only if the business 

hardship is temporary and if the entire controlled group of which the employer is a member, as 

well as the employer itself, is experiencing the hardship. No more than three waivers may be 

granted within any period of 15 consecutive plan years (five of any 15 years in the case of 

multiemployer plan consecutive plan years).

The IRS is authorized to require security to be granted as a condition of granting a waiver 

of the minimum funding standard if the sum of the plan’s accumulated funding deficiency and 

the balance of any outstanding waived funding deficiencies exceeds $1 million.

Excise tax and notice to employees 

An employer is generally subject to an excise tax if it fails to make minimum required 

contributions and fails to obtain a waiver from the IRS.64 The excise tax is 10 percent of the 

amount of the funding deficiency (five percent in the case of a multiemployer plan). In addition, 

a tax of 100 percent may be imposed if the funding deficiency is not corrected within a certain 

period. If an employer maintaining a plan (other than a multiemployer plan) fails to make 

minimum required contributions and fails to obtain a waiver, the employer must notify 

participants of the failure.65

6. Full funding limit

No contributions are required under the minimum funding rules in excess of the full 

funding limit and such contributions, if made, generally are not deductible.66 The full funding 

limit is generally defined as the excess, if any, of (1) the lesser of (a) the accrued liability under 

the plan (including normal cost) or (b) 170 percent (for 2003) of the plan’s current liability 

(including the current liability normal cost), over (2) the lesser of (a) the market value of plan 

assets or (b) the actuarial value of plan assets (i.e., the average fair market value over a period of 

 

63 Sec. 412(d).

64 Sec. 4971.

65 ERISA sec. 101(d).

66 Sec. 412(c)(6) and (c)(7). The 10-percent excise tax on nondeductible contributions 

generally applies only to contributions in excess of the accrued liability full funding limit.
31

years).67 However, the full funding limit may not be less than the excess, if any, of 90 percent of 

the plan’s current liability (including the current liability normal cost) over the actuarial value of 

plan assets. In general, current liability is all liabilities to plan participants and beneficiaries 

accrued to date, whereas the accrued liability under the full funding limit may be based on 

projected future benefits, including future salary increases. 

The full funding limit based on 170 percent of current liability is repealed for plan years 

beginning in 2004 and thereafter. Thus, in 2004 and thereafter, the full funding limit is the 

excess, if any, of (1) the accrued liability under the plan (including normal cost), over (2) the 

value of the plan’s assets, but in no case less than the excess, if any, of 90 percent of the plan’s 

current liability over the actuarial value of plan assets, as described above.68

7. Security for plan amendments

Under the Code and ERISA, if a plan amendment increasing current liability is adopted, 

the contributing sponsor and members of the controlled group of the contributing sponsor must 

provide security in favor of the plan equal to the excess of (1) the lesser of (a) the amount by 

which the plan’s assets are less than 60 percent of current liability, taking into account the 

benefit increase, or (b) the amount of the benefit increase and prior benefit increases after 

December 22, 1987, over (2) $10 million.69 The amendment is not effective until the security is 

provided.

The security must be in the form of a bond, cash, certain U.S. government obligations, or 

such other form as is satisfactory to the Secretary of the Treasury and the parties involved. The 

security is released after the funded liability of the plan reaches 60 percent.

 

67 In determining current liability for this purpose, the permissible range interest rate 

range is from 90 percent to 110 percent of the weighted average of the interest rates on 30-year 

Treasury securities for the preceding four-year period. In addition, certain service that is 

generally disregarded in determining current liability is taken into account for purposes of the 

full funding limit.

68 The full funding limit based on 170 percent of current liability is reinstated pursuant to 

the general sunset provision of EGTRRA for years beginning after 2010.

69 Sec. 401(a)(29).
32

B. Deduction Rules for Defined Benefit Plans

In general

Employer contributions to qualified retirement plans are deductible subject to certain 

limits.70 In general, the deduction limit depends on the kind of plan.

In the case of a defined benefit plan, the employer generally may deduct the amount 

necessary to satisfy the minimum funding cost of the plan for the year. In order to encourage 

plan sponsors to fully fund defined benefit plans, the maximum amount otherwise deductible 

generally is not less than the plan’s unfunded current liability. In the case of a plan that 

terminates during the year, the maximum deductible amount is generally not less than the 

amount needed to make the plan assets sufficient to fund benefit liabilities as defined for 

purposes of the PBGC termination insurance program. Contributions in excess of the full 

funding limit71 are generally not deductible.

If an employer sponsors both a defined benefit plan and a defined contribution plan that 

covers some of the same employees, the total deduction for all plans for a plan year generally is 

limited to the greater of (1) 25 percent of compensation or (2) the contribution necessary to meet 

the minimum funding requirements of the defined benefit plan for the year (or the amount of the 

plan’s unfunded current liabilities, in the case of a plan with more than 100 participants).

Excise tax on nondeductible contributions

Subject to certain exceptions, an employer that makes nondeductible contributions to a 

plan is subject to an excise tax equal to 10 percent of the amount of the nondeductible 

contributions for the year.72 In determining the amount of nondeductible contributions for this 

purpose, the employer is permitted to elect not to take into account contributions to a defined 

benefit pension plan except to the extent they exceed the accrued liability full funding limit. 

Thus, if an employer elects, contributions in excess of the current liability full funding limit are 

not subject to the excise tax on nondeductible contributions.

 

70 Sec. 404.

71 The full funding limit is described above in Part II.A.

72 Sec. 4972.
33

III. THE PBGC PENSION INSURANCE PROGRAM

A. Present Law

1. In general

As enacted in ERISA, as well as under present law, the minimum funding requirements 

permit an employer to fund defined benefit plan benefits over a period of time. Thus, it is 

possible that a plan may be terminated at a time when plan assets are not sufficient to provide all 

benefits accrued by employees under the plan. In order to protect plan participants from losing 

retirement benefits in such circumstances, the Pension Benefit Guaranty Corporation (“PBGC”), 

a corporation within the Department of Labor, was created in 1974 under ERISA to provide an 

insurance program for benefits under most defined benefit plans maintained by private 

employers.73 According to the PBGC’s latest annual report (for fiscal year 2002), the PBGC 

currently insures about 44 million participants in more than 32,700 defined benefit plans. Of 

these, about 34.4 million participants are covered by approximately 31,050 single-employer 

pension plans, and about 9.5 million are covered by approximately 1,650 multiemployer plans.

2. Termination of single-employer defined benefit plans

In general

An employer may voluntarily terminate a single-employer plan only in a standard 

termination or a distress termination. 74 The participants and the PBGC must be notified of the 

termination. The PBGC may also involuntarily terminate a plan.

Standard terminations

A standard termination is permitted only if plan assets are sufficient to cover benefit 

liabilities.75 Generally, benefit liabilities equal all benefits earned to date by plan participants, 

including vested and nonvested benefits (which automatically become vested at the time of 

termination), and including certain early retirement supplements and subsidies.76 Benefit 

liabilities may also include certain contingent benefits (for example, plant shutdown benefits). If 

assets are sufficient to cover benefit liabilities (and other termination requirements, such as 

notice to employees, have not been violated), the plan distributes benefits to participants. The 

plan provides for the benefit payments it owes by purchasing annuity contracts from an insurance 

company, or otherwise providing for the payment of benefits, for example, by providing the 

benefits in lump sum distributions.

 

73 The PBGC termination insurance program does not cover plans of professional service 

employers that have fewer than 25 participants.

74 ERISA sec. 4041.

75

 Id.

76 ERISA sec. 4001(a)(16).
34

If certain requirements are satisfied, and the plan so provides, assets in excess of the 

amounts necessary to cover benefit liabilities may be recovered by the employer in an asset 

reversion. Reversions are subject to an excise tax, described in Part I.B.7., above.

Distress terminations and involuntary terminations by the PBGC

Distress terminations

If assets in a defined benefit plan are not sufficient to cover benefit liabilities, the 

employer may not terminate the plan unless the employer meets one of four criteria necessary for 

a ‘‘distress’’ termination:

• The contributing sponsor, and every member of the controlled group of which the 

sponsor is a member, is being liquidated in bankruptcy or any similar Federal law or 

other similar State insolvency proceedings;

• The contributing sponsor and every member of the sponsor’s controlled group is 

being reorganized in bankruptcy or similar State proceeding;

• The PBGC determines that termination is necessary to allow the employer to pay its 

debts when due; or 

• The PBGC determines that termination is necessary to avoid unreasonably 

burdensome pension costs caused solely by a decline in the employer’s work force.77

These requirements, added by the Single Employer Pension Plan Amendments Act of 

198678 and modified by the Pension Protection Act of 198779 and the Retirement Protection Act 

of 1994,80 are designed to ensure that the liabilities of an underfunded plan remain the 

responsibility of the employer, rather than of the PBGC, unless the employer meets strict 

standards of financial need indicating genuine inability to continue funding the plan.

Involuntary terminations by the PBGC

In order to terminate a plan involuntarily, the PBGC must obtain a court order.81 The 

PBGC may institute court proceedings only if the plan in question has not met the minimum 

funding standards, will be unable to pay benefits when due, has a substantial owner who has 

received a distribution greater than $10,000 (other than by reason of death) while the plan has 

unfunded nonforfeitable benefits, or may reasonably be expected to increase PBGC’s long-run 

loss unreasonably. The PBGC must terminate a plan if the plan is unable to pay benefits that are 

currently due. A court may order termination of the plan in order to protect the interests of 

 

77 ERISA sec. 4041.

78 Pub. L. No. 99-272.

79 Pub. L. No. 100-203.

80 Pub. L. No. 103-465.

81 ERISA sec. 4042.
35

participants, to avoid unreasonable deterioration of the plan’s financial condition, or to avoid an 

unreasonable increase in the PBGC’s long-run loss.

Asset allocation

ERISA contains rules for allocating the assets of a single-employer plan when the plan 

terminates.82 Plan assets available to pay for benefits under a terminating plan include all plan 

assets remaining after subtracting all liabilities, other than liabilities for future benefit payments, 

paid or payable from plan assets under the provisions of the plan. On termination, the plan 

administrator must allocate plan assets available to pay for benefits under the plan in the manner 

prescribed by ERISA. In general, plan assets available to pay for benefits under the plan are 

allocated to six priority categories.83 If the plan has sufficient assets to pay for all benefits in a 

particular priority category, the remaining assets are allocated to the next lower priority category. 

This process is repeated until all benefits in the priority category are provided or until all 

available plan assets have been allocated.84 

Payment of benefits

When a plan terminates in a distress termination and assets are sufficient to pay 

guaranteed benefits, the plan pays out benefits. When an underfunded plan terminates in a 

distress or involuntary termination and benefits are insufficient to pay guaranteed benefits, the 

plan effectively goes into PBGC receivership.85 The PBGC becomes the trustee of the plan, 

takes control of any plan assets, and assumes responsibility for liabilities under the plan. The 

PBGC makes payments for benefit liabilities promised under the plan with assets received from 

two sources: assets in the plan before termination, and assets recovered from the employer. The 

balance, if any, of guaranteed benefits owed to beneficiaries is paid from the PBGC’s revolving 

funds.

Employer liability to the PBGC

Additionally, following a distress or involuntary termination, the plan’s contributing 

sponsor and every member of that sponsor’s controlled group is liable to the PBGC for the 

excess of the value of the plan’s liabilities as of the date of plan termination over the fair market 

value of the plan’s assets on the date of termination. 86 The liability is joint and several, meaning 

that each member of the controlled group can be held responsible for the entire liability. 

Generally, the obligation is payable in cash or negotiable securities to the PBGC on the date of 

termination. Failure to pay this amount upon demand by the PBGC may trigger a lien on the 

 

82 ERISA sec. 4044(a).

83

 Id.

84 The asset allocation rules also apply in standard terminations.

85 ERISA sec. 4042(b).

86 ERISA sec. 4062.
36

property of the contributing employer’s controlled group for up to 30 percent of its net worth. 

Obligations in excess of this amount are to be paid on commercially reasonable terms acceptable 

to the PBGC.

Restoration of a terminated plan

ERISA authorizes the PBGC to restore a terminated pension plan to its sponsoring 

employer if the PBGC determines that restoration is appropriate and consistent with its duties 

under ERISA.87 The PBGC has restored pension plans only once, in the case of an employer that 

set up new plans (called “follow-on plans”) to provide employees with the benefits under the 

original plans that were not guaranteed by the PBGC.88 After the restoration of those plans, 

Treasury regulations were issued to establish a special funding method (the “restoration 

method”) to apply to restored plans.89

Under the restoration method, a special amortization base (the “initial restoration 

amortization base”) is established, consisting of the unfunded liability of the plan (i.e., the 

amount by which liabilities exceed assets) as of the first valuation date after the restoration, 

based upon the assets and liabilities restored by the PBGC. The PBGC establishes a schedule of 

restoration payments to be made by the employer, over a period of no more than 30 years, to 

amortize the initial restoration amortization base. The restoration method generally applies only 

to the initial restoration amortization base, i.e., the usual funding rules generally apply to plan 

costs, gains and losses for periods after the plan is restored.

Subject to limitations, the PBGC may grant a deferral of the required restoration 

payments for a year in order to avoid temporary substantial business hardship of the plan 

sponsor. The PBGC may also modify the restoration payment schedule; however, any 

modification must comply with the requirements of the restoration method, including the 

requirement that the 30-year period not be extended.

3. Multiemployer plans

In the case of multiemployer plans, the PBGC insures plan insolvency, rather than plan 

termination. Accordingly, a multiemployer plan need not be terminated to qualify for PBGC 

financial assistance, but must be found to be insolvent. A plan is insolvent when its available 

resources are not sufficient to pay the plan benefits for the plan year in question, or when the 

sponsor of a plan in reorganization reasonably determines, taking into account the plan’s recent 

and anticipated financial experience, that the plan’s available resources will not be sufficient to 

 

87 ERISA sec. 4047.

88

 See Pension Benefit Guaranty Corporation v. LTV Corporation, 496 U.S. 633 (1990). 

The opinion notes that the PBGC views follow-on plans as an abuse of the PBGC insurance 

program, under which the PBGC is responsible for benefits under a terminated plan. The 

establishment of a follow-up plan for benefits not covered by the terminated plan means that, in 

effect, the insurance program is being used to subsidize an ongoing retirement program.

89 Treas. Reg. sec. 1.412(c)(1)-3.
37

pay benefits that come due in the next plan year. If it appears that available resources will not 

support the payment of benefits at the guaranteed level, the PBGC will provide the additional 

resources needed as a loan. The PBGC may provide loans to the plan year after year. If the plan 

recovers from insolvency, it must begin repaying loans on reasonable terms in accordance with 

regulations.

Under ERISA, an employer which withdraws from a multiemployer plan in a complete or 

partial withdrawal is liable to the plan in the amount determined to be the withdrawal liability. 90 

In general, “complete withdrawal” means the employer has permanently ceased operations under 

the plan, has permanently ceased to have an obligation to contribute.91 A “partial withdrawal” 

generally occurs if, on the last day of a plan year, there is a 70-percent contribution decline for 

such plan year or there is a partial cessation of the employer’s contribution obligation. 92 When 

an employer withdraws from a multiemployer plan, the plan sponsor is required to determine the 

amount of the employer’s withdrawal liability, notify the employer of the amount of the 

withdrawal liability, and collect the amount of the withdrawal liability from the employer.93 The 

employer’s withdrawal liability generally is based on the extent of the plan’s unfunded vested 

benefits for the plan years preceding the withdrawal.94 

4. Guaranteed benefits

In general

Single-employer plans

When an underfunded plan terminates, the amount of benefits that the PBGC will pay 

depend on legal limits, asset allocation, and recovery on the PBGC’s employer liability claim. 

Within certain limits, the PBGC guarantees any retirement benefit that was vested on the date of 

plan termination (other than benefits that vest solely on account of the termination), and any 

death, survivor or disability benefit that was owed or was in payment status at the date of plan 

termination. Generally only that part of the retirement benefit that is payable in monthly 

installments (rather than, for example, lump sum benefits payable to encourage early retirement) 

is guaranteed.95

Retirement benefits that begin before normal retirement age are guaranteed, provided 

they meet the other conditions of guarantee such as that before the date the plan terminates, the 

 

90 ERISA sec. 4201.

91 ERISA sec. 4203.

92 ERISA sec. 4205.

93 ERISA sec. 4202.

94 ERISA secs. 4209, 4211.

95

 ERISA sec. 4022(b) and (c).
38

participant had satisfied the conditions of the plan necessary to establish the right to receive the 

benefit other than application for the benefit). Contingent benefits (for example, early retirement 

benefits provided only if a plant shuts down) are guaranteed only if the triggering event occurs 

before plan termination.

For 2003, the maximum guaranteed benefit for an individual retiring at age 65 is 

$3,664.77 per month, or $43,977.24 per year.96 The dollar limit is indexed annually for inflation. 

The guaranteed amount is reduced for benefits starting before age 65, and does not apply to 

certain types of ancillary benefits. In the case of a plan or a plan amendment that has been in 

effect for less than five years before a plan termination, the amount guaranteed is phased in by 20 

percent a year.

Multiemployer plans

The PBGC guarantees benefits under a multiemployer plan of the same type as those 

guaranteed under a single-employer plan, but a different guarantee ceiling applies. The limit for 

multiemployer plans is the sum of 100 percent of the first $11 of monthly benefits and 75 percent 

of the next $33 of monthly benefits for each year of service.97 

5. Sources of PBGC funding

The PBGC is funded by assets in terminated plans, amounts recovered from employers 

who terminate underfunded plans, premiums paid with respect to covered plans, and investment 

earnings. 

Single-employer plans

All covered single-employer plans are required to pay a flat per-participant premium and 

underfunded plans are subject to an additional variable premium based on the level of 

underfunding.

As initially enacted in ERISA, covered plans were required to pay a flat premium to the 

PBGC of $1 per plan participant. The flat-rate per-participant premium has been increased 

several times since the enactment of ERISA and is $19 per participant.98 

 

96 Special rules limit the guaranteed benefits of individuals who are substantial owners 

covered by a plans whose benefits have not been increased by reason of any plan amendment. A 

substantial owner generally is an individual who (1) owns the entire interest in an unincorporated 

trade or business, (2) in the case of a partnership, is a partner who owns, directly or indirectly, 

more than 10 percent of either the capital interest or the profits interest in the partnership, (3) in 

the case of a corporation, owns, directly or indirectly, more than 10 percent in value of either the 

voting stock of the corporation or all the stock of the corporation, or (4) at any time within the 

preceding 60 months was a substantial owner under the plan. ERISA sec. 4022(b)(5).

97 ERISA sec. 4022A(c).

98 ERISA sec. 4006(a).
39

In the case of an underfunded plan, additional PBGC premiums are required in the 

amount of $9 per $1,000 of unfunded vested benefits (the amount which would be the unfunded 

current liability if only vested benefits were taken into account and if benefits were valued at the 

variable premium interest rate). These premiums are referred to as “variable rate premiums.”99 

No variable-rate premium is imposed for a year if contributions to the plan for the prior year 

were at least equal to the full funding limit for that year. In determining the amount of unfunded 

vested benefits, the interest rate used is generally 85 percent of the interest rate on 30-year 

Treasury securities for the month preceding the month in which the plan year begins. Under 

section 405 of the Job Creation and Worker Assistance Act of 2002, the interest rate used in 

determining the amount of unfunded vested benefits for PBGC variable rate premium purposes 

for 2002 and 2003 is increased to 100 percent of the interest rate on 30-year Treasury securities 

for the month preceding the month in which the applicable plan year begins. 

Multiemployer plans 

The rules under ERISA governing terminations of multiemployer defined benefit plans 

also require employers to pay plan termination insurance premiums to the PBGC. The PBGC 

premium rate for multiemployer plans is $2.60 per participant per plan year.100 This flat-rate 

per-participants premium is the only premium paid to the PBGC for multiemployer plans.

 

99 If variable rate premiums are required to be paid, the plan administrator generally must 

provide notice to plan participants of the plan’s funding status and the limits on the PBGC 

benefit guarantee if the plan terminates while underfunded.

100 ERISA sec. 4006(a)(3).
40

B. Financial Status of the PBGC

In general

As of September 30, 2002, the PBGC reported a total deficit of $3.48 billion.101 At the 

end of the prior fiscal year, a $7.85 billion surplus was reported. The single-employer program 

reported a loss of $11.37 billion for fiscal year 2002, which, according to the PBGC, was the 

largest loss in its 28-year history. The multiemployer program reported net income of $42 

million for fiscal year 2002. 

The single-employer program loss resulted in the PBGC’s first deficit position since 

fiscal year 1995. The PBGC was in a deficit for the first 21 years of its existence. From 1996 

though 2001, a surplus was reported. According to the PBGC, the record terminations of 

underfunded pension plans and financial weakness among many plan sponsors contributed to the 

decline in its financial position and increased exposure to future claims. In addition, poor returns 

and interest rate drop worsened its financial position.

As of September 30, 2002, the value of the PBGC’s assets in the single-employer and 

multiemployer programs was approximately $26 billion. This is an increase from approximately 

$23 billion as of September 30, 2001. The PBGC had an overall rate of return on investment for 

fiscal year 2002 of 2.1 percent compared with a negative 3.3 percent in 2001.

Table 1 and Table 2, below, summarize the PBGC’s financial position and net income for 

fiscal year 2001 and fiscal year 2002.

Table 1.– Summary of PBGC Financial Position

(millions)

Fiscal year 2001 Fiscal year 2002

Single-employer program 

surplus/(deficit)102 $7,732 ($3,638)

Multiemployer program 

surplus/(deficit) $116 $158

Combined surplus/(deficit) $7,848 ($3,480)

 

101 Information on the financial status of the PBGC was obtained from the Pension 

Benefit Guaranty Corporation 2002 Annual Report, released January 30, 2003.

102 The program’s surplus is its assets less liabilities. 
41

Table 2.–PBGC Net Income/(Loss)

(millions)

Fiscal year 2001 Fiscal year 2002

Single-employer program 

income/(loss) ($1,972) ($11,370)

Multiemployer program 

income/(loss) ($151) $42

Combined income/(loss) ($2,123) ($11,328)

Single-employer program

The single-employer program reported a $3.64 billion deficit at the end of fiscal year 

2002 and a $7.73 billion surplus at the end of fiscal year 2001. The single-employer program 

loss of $11.37 billion for fiscal year 2002 was an increase from the loss of $1.97 billion in fiscal 

year 2001. According to the PBGC, the single-employer program loss in fiscal year 2002 

principally resulted from completed and probable terminations of underfunded pension plans. In 

fiscal year 2002, the PBGC experienced the largest plan termination in its history with the 

termination and trusteeship of the four LTV Steel pension plans, which resulted in a loss of $1.9 

billion. According to the PBGC, another $396 million in losses was absorbed from the pension 

plans of other steel companies. The PBGC’s losses from completed and probable plan 

terminations increased from a loss of $705 million in fiscal year 2001 to a loss of $9.31 billion in 

fiscal year 2002. The PBGC states that future losses remain unpredictable as the PBGC’s loss 

experience is highly sensitive to losses from large claims. According to the PBGC, the decline in 

interest rates increased the PBGC’s liabilities by $1.65 billion. The single-employer program 

reported an investment gain of $170 million for fiscal year 2002. 

According to the PBGC, premium revenues for 2002 fell to their lowest level in 11 years, 

while the benefit payments exceeded $1.5 billion for the first time in the PBGC’s history. 

Under generally accepted accounting principles, the PBGC recognizes both actual and 

probable pension plan terminations as losses. The PBGC reports that during fiscal year 2002, 

$5.91 billion of the $9.31 billion in losses were probable. Since the close of the 2002 fiscal year, 

the PBGC has assumed responsibility for the pension plans of two steel companies, Bethlehem 

Steel and National Steel, that together accounted for $5.16 billion of the probable loss. The steel 

industry accounted for $7.57 billion of the $9.31 billion in losses from completed and probable 

pension plan terminations in fiscal year 2002. 

As of September 30, 2002, the single-employer program reported $25.43 billion in assets 

to cover $29.07 billion in liabilities. As of September 30, 2001, the program reported $21.77 

billion in assets to cover $14.04 billion in liabilities. According to the PBGC, despite the loss 

and resulting deficit, the program’s total assets assure that PBGC will be able to continue 

meeting its benefit and other obligations while it examines ways to restore a positive net position 

for the single-employer program. Table 3, below, summarizes the financial position of the 

single-employer program.
42

Table 3.–Summary of Financial Position of Single-Employer Program

(millions)

Fiscal year 2001 Fiscal year 2002

Single-employer program 

assets $21,768 $25,430

Single-employer program 

liabilities $14,036 $29,068

Single-employer program 

surplus/(deficit) $7,732 ($3,638)

Multiemployer program

The PBGC reported that the multiemployer program recorded a financial gain of $42 

million for fiscal year 2002, compared with a net loss of $151 million in 2001. The PBGC 

attributed the gain to reduced losses from financial assistance to plans and increased investment 

income. For the fiscal year 2002, the multiemployer program reported a surplus of $158 million, 

with total assets of $944 million and liabilities totaling $786 million. According to the PBGC, 

investment income totaled $118 million and premium income totaled $25 million for fiscal year 

2002. Table 4, below, summarizes the financial position of the multiemployer program.

Table 4.–Summary of Financial Position of Multiemployer Program

(millions)

Fiscal year 2001 Fiscal year 2002

Multiemployer program assets $807 $944

Multiemployer program 

liabilities $691 $786

Multiemployer program 

surplus/(deficit) $116 $158

Forecasts

The PBGC’s expected claims are dependent on the amount of underfunding in the 

pension plans that the PBGC insures and the likelihood that corporate sponsors of the 

underfunded plans will encounter financial distress that results in bankruptcy and plan 

termination. The PBGC evaluates its exposure and expected claims. The PBGC classifies the 

underfunding of financially weak companies as “reasonable possible” exposure, as required 

under accounting principles. The reasonable possible exposure as of September 30, 2002, was 

calculated at $35 billion compared to $11 billion for fiscal year 2001. Under the PBGC’s model, 

median claims 103 over the next 10 years are projected to be approximately $1.85 billion per year 

(expressed in today’s dollars). According to the PBGC, the average level of claims is projected 

to be approximately $2.25 billion per year. 

 

103 Half of the simulations show claims above this amount and half show claims below 

this amount.
43

The PBGC also projected its financial position for 2012. The projected median financial 

position for 2012 is a $9.6 billion deficit. The average financial position for 2012 is predicted to 

be a $12.6 billion deficit. According to the PBGC, the probability of a surplus of any amount in 

2012 is 30 percent. 
44

IV. DATA RELATING TO QUALIFIED RETIREMENT PLANS

A. General Data on Qualified Retirement Plan Participation

The recent U.S. Department of Labor National Compensation Survey found that 48 

percent of private sector employees participated in employer-sponsored qualified retirement 

plans in 2000. The survey found that, among full-time employees, participation was 55 

percent. 104 Participation rates were higher among public sector employees. The Bureau of 

Census’s Current Population Survey found that 87 percent of State and local government 

employees and 88 percent of Federal government employees participated in an employersponsored retirement plan in 1997.

The National Compensation Survey also found that, in 2000, among full-time employees 

in the private sector, 42 percent participated in an employer-sponsored defined contribution plan 

and 22 percent participated in an employer-sponsored defined benefit plan. Some employees 

participated in both.

Participation in employer-sponsored qualified retirement plans varies with firm size and 

industry. Figure 1 and Figure 2, below, present some of the findings of the more detailed 1999 

National Compensation Survey. Figure 1 and Figure 2 document some of the variability of 

employee participation in employer-sponsored qualified retirement plans by industry and firm 

size.

 

104 Bureau of Labor Statistics, National Compensation Survey, “Employee Benefits in 

Private Industry, 2000.”
45

Figure 1

0

10

20

30

40

50

60

70

Percentage

manufacturing finance, insurance, real

estate

retail trade services

Industry

Percentage of Employees Participating in Employer-Sponsored Qualified Retirement 

Plans in Select Industries, 1999

68

62

30

45

Source: Bureau of Labor Statistics, National Compensation Survey, “Employee Benefits in Private Industry, 1999.”

Figure 2

0

10

20

30

40

50

60

70

80

90

Percent

1-49 employees 50-99 employees 100-499 employees 500-999 employees 1,000-2,499

employees

2,500 or more

employees

Firm Size

Percentage of Employees Participating in an Employer-Provided Pension Plan by Firm Size, 1999

30

49

57

70 70

81

Source: Bureau of Labor Statistics, National Compensation Survey, “Employee Benefits in Private Industry, 1999.”
46

B. Data on Participation in Defined Benefit Plans and Defined Contribution Plans 

In 1998, about 56 percent of workers in the private sector who participated in a qualified 

retirement plan were covered only by a defined contribution plan, 30 percent were covered by 

both a defined benefit plan and a defined contribution plan, and 14 percent were covered only by 

a defined benefit plan. Figure 3, Figure 4, and Figure 5, below, document the growth of private 

sector defined contribution plans relative to defined benefit plans. The data presented in these 

figures are based on Form 5500 filings. As illustrated in the figures below, the number of 

defined contribution plans and active participants in those plans have increased over time, while 

the number of defined benefit plans and the number of active participants in those plans have 

decreased. As Figure 5 indicates, the number of plan participants only in defined contribution 

plans grew steadily over the period 1979 to 1998. The number of participants in both defined 

contribution and defined benefit plans grew from 1979 through 1985 and then stagnated for a 

decade. The number of participants only in defined benefit plans fell in almost every year. The 

growth in defined contribution plans and active participants has occurred almost wholly in 

401(k) plans.105

 

105 Joint Committee on Taxation, Present Law and Background Relating to EmployerSponsored Defined Contribution Plans and Other Retirement Arrangements (JCX-9-02), 

February 25, 2002, documents the growth of 401(k) plans and the concurrent decline in defined 

benefit plans and other defined contribution plans.
47

Figure 3

Figure 4

Qualified Retirement Plan Active Participants

1979-1998

0

10

20

30

40

50

60

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Year

Millions

Total Participants

Defined Contribution

Defined Benefit

Number of Qualified Retirement Plans

1978-1998

0

50

100

150

200

250

300

350

400

450

500

550

600

650

700

750

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Plan Year

Thousands

Defined Benefit

DefinedContribution
48

Figure 5

The data for Figure 3, Figure 4, and Figure 5 were compiled by the staff of the Joint Committee on Taxation from 

Form 5500 Annual Reports filed with the Internal Revenue Service. 

Qualified Retirement Plan Active Participants

By Type of Plan,

1979-1998

0

10

20

30

40

50

60

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Year

Millions

Total Participants

Participants in a DC plan only

DC and DB plan

Participants in a DB plan only
49

C. Data on Qualified Retirement Plan Assets

Figure 3 and Figure 4, above, document the increase in the number of defined 

contribution plans and the number of participants in defined contribution plans, as well as the 

concomitant decline in the number of defined benefit plans and the number of participants in 

defined benefit plans. However, the assets held in both types of plans increased substantially 

from 1988 through 2001. As of December 31, 1988, data from the Federal Reserve Board of 

Governors showed that defined benefit plans held assets valued at $812.8 billion and defined 

contribution plans held assets valued at $594.7 billion. As of December 31, 2002, data showed 

that defined benefit plans held assets valued at $1.6 trillion and defined contribution plans held 

assets valued at $2.1 trillion.

Despite the declining number of plans and participants, the market value of assets held in 

defined benefit plans increased every year throughout the period 1988 through 1999 except in 

1990. The value of assets in defined benefit plans has declined in each of 2000, 2001, and 2002. 

The market value of assets held in defined contribution plans increased in every year throughout 

the period 1988 through 1999. As with defined benefit plans, the value of assets in defined 

contribution plans declined in each of 2000, 2001, and 2002. Figure 6, below, shows the 

increase in market value of assets held in defined benefit plans. Figure 7, below, shows the more 

rapid increase in the market value of assets held in defined contribution plans that would be 

expected with the growth in number of participants in such plans.106 In addition to retirement 

assets held in defined benefit and defined contribution plans, between 1988 and 2002 the market 

value of assets held by individuals in IRAs and Keogh accounts (i.e., qualified retirement plans 

for self-employed individuals), increased from $452 billion at the end of 1988 to $2.5 trillion at 

the end of 2001.107

As noted above, a high percentage of employees of State and local governments 

participate in employer-sponsored pension plans. These plans have significant holdings of 

financial assets. As of the end of 2002, State and local government pension plans held $1.97 

trillion in financial assets. Figure 8, below, documents that the value of assets in State and local 

 

106 Data for Figure 6 and Figure 7 are from the Board of Governors, United States 

Federal Reserve System, Flow of Funds, March 6, 2003. The data reported on defined 

contribution plans include balances in the Federal Retirement System Thrift Savings Plan. The 

data reported in Figure 6 and Figure 7 do not include the value of direct holdings of real estate by 

private pension plans and thereby understate the total value of private pension fund assets. The 

Federal Reserve reported this understatement to be less than $100 billion as of the end of 2001.

107 Board of Governors, United States Federal Reserve System, Flow of Funds, March 6, 

2003. Estimates of IRA balances as of the close of 2002 are not yet available. Like the value of 

assets in defined contribution plans, the value of assets in IRAs increased every year from 1988 

through 1999, and declined in 2000 and 2001.
50

plans has increased by one half since 1995. As was the experience for private plans, the value of 

assets in State and local government pension plans declined in 2001 and 2002. 108

Figure 6

Source: Board of Governors, Federal Reserve, Flow of Funds.

 

108 As with the data reported above for private pension plans, the data in Figure 8 do not 

include direct holding of real estate. The Federal Reserve estimates that direct holdings of real 

estate by State and local pension plans are less than $50 billion in value. Board of Governors, 

United States Federal Reserve System, Flow of Funds, March 6, 2003.

Market Value of Assets Held In Defined Benefit Plans,

1988-2002

0

500

1,000

1,500

2,000

2,500

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Billions of dollars
51

Figure 7

Source: Board of Governors, Federal Reserve, Flow of Funds.

Market Value of Assets Held in Defined Contribution Plans,

1988-2002

0

500

1,000

1,500

2,000

2,500

3,000

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Billions of dollars
52

Figure 8

Source: Board of Governors, Federal Reserve; Flow of Funds.

Market Value of Assets Held in State and Local

Government Employees Retirement Fund

1995-2002

0

500

1,000

1,500

2,000

2,500

1995 1996 1997 1998 1999 2000 2001 2002

Year

Billions of dollars
53

V. GENERAL POLICY ISSUES RELATING TO DEFINED BENEFIT PLANS

In general

Almost all changes to pension laws require the balancing of competing policy objectives, 

including concerns regarding retirement income security, simplification, reduction of 

administrative burdens, and fiscal and tax policy. In some cases, a single policy concern may 

result in competing issues. For example, concerns regarding retirement income security may 

lead to the enactment of provisions giving employees greater rights under pension plans; 

however, if the new provisions are too severe, plan sponsors may modify plans or reduce 

benefits, thereby potentially reducing retirement security. 

Any legislative changes to the rules relating to defined benefit plans are likely to involve 

such balancing. General policy issues that may arise in connection with legislative proposals 

relating to defined benefit plan are discussed below.

Retirement income security

Helping to ensure that individuals have retirement income security is the major objective

of the U.S. private pension system. Defined benefit plans are considered by many to provide 

greater retirement income security than defined contribution plans. Factors that contribute to this 

view include the fact that such plans offer a specified benefit, the employer bears the risk of 

investment loss, and benefits are guaranteed (within limits) by the PBGC in the event the plan 

terminates and plan assets are not sufficient to pay promised benefits. In addition, defined 

benefit plans are required to provide certain benefits to the spouse of the employee, unless both 

the spouse and employee elect otherwise, thus providing some degree of income security for 

spouses.

In contrast, defined contribution plans do not promise a specific benefit, but instead pay

the value of the participant’s account. Under defined contribution plans, the plan participant, 

rather than the employer, bears the risk of investment loss. Benefits provided by defined 

contribution plans are not guaranteed by the PBGC. The spousal rules applicable to defined 

contribution plans vary based on the specifics of the plan; however, in most cases, the spouse has 

only the right to be named the beneficiary of the amount (if any) remaining upon death. Thus, 

spousal rights are not as great as under defined benefit plans.

The relative decline in defined benefit plan coverage has caused some to be concerned 

about a possible decline in retirement income security. This concern has focused attention on 

both defined contribution plans and defined benefit plans.

The reasons for the decline in defined benefit plan coverage are not entirely clear. A 

number of possible reasons have been cited, including changing worker demographics, 

administrative burdens on employers, applicable legal restrictions, worker preferences, and 

employer cost. The need for and design of any legislative changes relating to the defined benefit 

plan system depend in part on what is viewed as the source of the decline in coverage. For 

example, EGTRRA made a variety of changes with respect to the rules relating to employersponsored retirement plans with a stated goal of expanding coverage. The changes relating to 
54

defined benefit plans include increases in the amount of benefits that can be provided, provisions 

designed to reduce administrative burdens, and greater flexibility in funding rules. The 

EGTRRA changes may make defined benefit plans more attractive to employers, owneremployees, and highly compensated employees, thus leading to the establishment of new plans 

or the expansion of existing arrangements.109 

Some view the decline in defined benefit plan coverage as part of a natural shift toward 

defined contribution plans. Some argue that many employees prefer defined contribution plans 

to defined benefit plans and are better off under such plans. For example, traditional defined 

benefit plans provide the greatest level of benefits to longer-service employees; employees who 

terminate employment after only a few years of service may have a very low accrued benefit 

under a traditional defined benefit plan. Workers who change jobs relatively frequently may 

prefer the portability typically offered by a defined contribution plan; their account balance can 

be rolled over and continue to accumulate earnings. While some defined benefit plans may offer 

lump-sum benefits that would provide the same portability opportunities, not all do. Thus, in 

some cases, defined contribution plans may enable employees to accrue greater benefits under a 

defined contribution plan than under a defined benefit plan, thereby increasing retirement 

security. 110 Employees often find defined contribution plans easier to understand than defined 

benefit plans, and also often like the opportunity provided by some defined contribution plans to 

make their own investment decisions. Some argue that legislative changes addressing retirement 

income security should adapt to the shift toward defined contribution plans, and focus on ways in 

which to enhance security with respect to such plans.

In some cases, particular plan features may give rise to concerns regarding retirement 

benefit security. For example, conversions of more traditional defined benefit plans to cash 

balance plans have raised issues with respect to whether employees in general and in specific 

cases are better off under the new plan design or the old plan design and whether employees 

have sufficient information to understand the plan changes. Concerns regarding conversions to 

cash balance plans led to the enactment in EGTRRA of new notification requirements regarding 

a significant reduction in future benefit accruals. 

Issues relating to funding and the solvency of the PBGC insurance program

As discussed above, present law imposes minimum funding requirements with respect to 

defined benefit plans and a limit on the maximum amount of deductible contributions. In 

addition, nondeductible contributions are discouraged through the imposition of an excise tax. 

Contributions in excess of the amount needed to provide plan benefits are also discouraged 

through the restrictions on reversions of plan assets. These funding rules are a cornerstone of the 

 

109 On the other hand, some have raised concerns that some of EGTRRA’s changes may 

serve merely to increase benefits for highly compensated employees without any change in 

benefits for rank and file workers.

110 On the other hand, some argue that this increased retirement security may not 

materialize if the individual incurs investment losses or low investment earnings on his or her 

account balance.
55

defined benefit plan system and, over time, have been a frequent source of discussion and 

change.

Like many of the qualified retirement plan rules, the funding rules for defined benefit 

plans involve balancing competing policy interests. The minimum funding rules are designed to 

promote benefit security by helping to ensure that plan assets will be sufficient to pay promised 

benefits when due. The minimum funding rules also address moral hazard concerns relating to 

the PBGC insurance program by preventing employers from purposely underfunding plans. 

Such underfunding can increase costs to the Federal government as well as PBGC premium 

payors. 

On the other hand, the minimum funding rules recognize that pension benefits are often 

long-term liabilities that can be funded over a period of time. Some argue that if minimum 

funding requirements are too stringent, funds may be unnecessarily diverted from the employer’s 

other business needs and may cause financial problems for the business, thus jeopardizing the 

future of not just the employees’ retirement benefits, but also their jobs. This suggestion tends to 

arise during a period of economic downturn, either generally or in a particular industry. Some 

also argue that overly stringent funding requirements may discourage the establishment of 

defined benefit plans.

The limits on deductible contributions, the excise tax on nondeductible contributions, and 

the rules relating to reversions of defined benefit plan assets have as a major objective preventing 

the use of defined benefit plans as a tax-favored funding mechanism for the business needs of the 

employer. They also serve to limit the tax expenditure associated with defined benefit plans. 

Some argue that if the maximum limits on plan funding are too low, then benefit security will be 

jeopardized. They argue that employers need flexibility to make greater contributions when 

possible, in order to ensure adequate funding in years in which the business may not be as 

profitable. In addition, some argue that if restrictions on reversions are too strict, employers 

may be discouraged from making contributions in excess of the required minimums.

The desire to achieve the proper balance between these competing policy objectives has 

resulted in a variety of legislative changes to address the concerns arising at particular times. For 

example, the Omnibus Budget Reconciliation Act of 1987 made comprehensive changes to the 

minimum funding rules promoted by concerns regarding the solvency of the defined benefit plan 

system. That Act also added the current liability full funding limit. Legislation enacted in 1990 

allowed employers access to excess assets in defined benefit plans in order to pay retiree health 

liabilities. The Retirement Protection Act of 199r again made comprehensive changes to the 

funding rules. Recent changes to the funding rules have focused on increasing the maximum 

deductible contribution, and on the interest rate that must be used to calculate required 

contributions. For example, EGTRRA increased the current liability full funding limit and then 

repeals the current liability full funding limit in 2004.
56

Issues related to the interest rate used to value benefits under a plan

In general

One issue relating to defined benefit plans that has received attention is the rate of 

interest used to determine the present value of benefits under such plans for purposes of the 

plan’s current liability (and hence the amount of contributions required under the funding rules) 

and the amount of minimum and maximum lump sum benefits under the plan. The theoretical 

basis for the interest rate to be used to determine the present value of pension plan benefits is an 

interest rate that would be used in setting the price for private annuity contracts that provide 

similar benefits. However, in practice, the price of an annuity contact encompasses not only an 

interest rate factor but also other factors, such as the costs of servicing the contract and 

recordkeeping. Under present law, the interest rate used for determining current liability is 

intended to embody all of these factors.111

Under present law, the interest rates used for these purposes are based on the interest rate 

on 30-year Treasury obligations. The interest rate issue has received attention because the 

Treasury Department stopped issuing 30-year obligations. As a result, there is no longer a 30-

year Treasury interest rate, and statutory changes are necessary to reflect this. In addition, 

concerns had been raised by some, particularly employers, that the 30-year Treasury rate was too 

low compared to annuity purchase rates and therefore, as described below, resulted in 

inappropriate results, both on funding obligations and lump-sum benefits.

For plan funding purposes, the use of a lower interest rate in determining current liability 

results in a higher present value of the benefits and larger contributions required to fund those 

benefits. Alternatively, the use of a higher interest rate results in a lower present value of future 

liabilities and therefore lower required contributions. Thus, determining the appropriate rate of 

interest involves a balancing of the same competing interests as the minimum funding rules 

generally, i.e., retirement income security, potential costs to the Federal government and PBGC 

premium payors, the appropriate level of tax subsidy, and the financial needs of the business 

maintaining the plan. 112 Employers have argued that the 30-year Treasury rate resulted in 

inappropriately high levels of minimum funding contributions and that such level of 

contributions was not necessary to achieve an appropriate level of benefit security.

Because minimum lump sum distributions are calculated as the present value of future 

benefits, the interest rate used to calculate this present value will affect the value of the lump sum 

benefit. Specifically, the use of a lower interest rate results in larger lump sum benefits; the use 

of a higher interest rate results in lower lump sum benefits. The appropriate rate of interest to be 

 

111 See H.R. Rpt. No. 100-495, at 868 (1987).

112 The tax subsidy results from the prefunding of the retirement benefit, which produces 

tax-free inside buildup on the earnings from the pension assets. A given employer may prefer a 

low rate that enables the employer to make larger deductible contributions and hence maximize 

the tax subsidy. Alternatively, another employer may wish a higher rate that would reduce 

required contributions, thus freeing up funds for other business uses.
57

used for this purpose also involves several policy considerations, including coordination of the 

value of benefits as determined for funding purposes with the value of the benefits provided 

under the plan and ensuring that different forms of benefit offered under a plan are generally 

equivalent in value. Those who thought the 30-year Treasury rate was too low compared to 

annuity rates raised concerns that using this rate in determining lump sums makes the lump sum 

benefit disproportionately large in comparison with a life annuity benefit payable under the plan, 

thus providing an incentive for employees to take benefits in a lump sum rather than in the form 

of a life annuity.

Possible interest rates

The theoretically correct interest rate to be used to determine the present value of pension 

plan benefits is an interest rate that would be used in setting the price for private annuity 

contracts that provide similar benefits.113 Some studies have shown that it is not practicable to 

identify such a rate accurately because of variation in the manner in which prices of private 

annuity contracts are determined.114 As a result, the interest rate used to value pension benefits is 

intended to approximate the rate used in pricing annuity contracts. Some have described this 

standard as a rate comparable to the rate earned on a conservatively invested portfolio of assets. 

Various interest rate indexes have been suggested as possible interest rates to be used in 

place of the 30-year Treasury rate to value pension benefits and for other purposes.115 Possible 

interest rate indexes include rates on Treasury or other Federal agency obligations (e.g., Federal 

National Mortgage Association notes), rates determined by the PBGC for use in valuing benefit 

liabilities, rates based on high-quality corporate bonds, or rates used in interest rate swaps. Some 

have suggested the use of an interest rate determined as a blend or composite of different interest 

rate indexes. Others have suggested that use of any single interest rate is inappropriate, and 

rather that different interest rates should be used to reflect the varying times when benefits 

become payable under a plan, e.g., different expected retirement dates of employees.116

 

113 As discussed above, in practice the price of an annuity contract may reflect factors 

other than the interest rate, and present-law rules relating to interest rates are intended to 

encompass such other factors.

114

 See, e.g., Victor Modugno, 30-Year Treasury Rates and Defined Benefit Pension 

Plans (2001), Commissioned for Society of Actuaries, <http://www.soa.org/sections/dbpp.pdf>.

115 Because the interest rate used for various plan purposes is not the 30-year Treasury 

rate per se but is based on that rate, the decision regarding a substitute for the 30-year Treasury 

rate should include a reevaluation of the present-law rules relating to use of a weighted average 

Treasury rate and those permitting use of a rate that falls within a specified range about the 

Treasury rate. For example, to the extent that these rules are intended to give plans greater 

flexibility in their required contributions, or to prevent sudden spikes in required contributions, 

there may be alternative ways to achieve this result.

116 This approach would mirror the manner in which financial institutions value a series 

of future liabilities. See, e.g., Ryan Labs, Inc., Pension Financial Management and Valuation 
58

Some favor use of an interest rate index based on Treasury or other Federal agency 

obligations out of concern that a privately determined index could be improperly manipulated 

because the elements on which the index is based, such as the bonds on which a corporate bond 

index is based, may not be known (i.e., the rate is not “transparent”) or because those elements 

are subject to change by the organization determining the index. 117 On the other hand, some 

argue that, compared with interest rates on government obligations, private interest rate indexes 

are more consistent with the interest rates used in pricing annuity contracts.

With respect to the use of a private interest rate index, some have raised the concern that 

information on some private indexes is available to the public only by subscription. However, 

whatever interest rate applies for pension purposes can be published by the IRS, consistent with 

current practice.

Other issues may also arise in connection with the interest rate used to determine the 

present value of pension plan benefits. For example, one issue that may arise is whether it is 

appropriate to grant the Treasury Department authority to prescribe limited interest rate 

adjustments if the statutory rate is unreasonably low (similar to its current authority to prescribe 

a lower rate if the statutory rate is unreasonably high), thereby permitting changes in the rate to 

be made administratively. Another issue that may arise is whether transition rules are 

appropriate, e.g., because employers or employees have relied on present-law rules.

 

Discount Rates (2001), Commissioned for Society of Actuaries, 

<http://www.soa.org/sections/dbpp.pdf>.

117 This concern has been raised also in connection with rates determined by the PBGC.