PRESENT LAW AND BACKGROUND RELATING TO

EMPLOYER-SPONSORED DEFINED BENEFIT PLANS

Scheduled for a Public Hearing

Before the

SUBCOMMITTEE ON OVERSIGHT

of the

HOUSE COMMITTEE ON WAYS AND MEANS

on June 20, 2002

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

June 18, 2002

JCX-71-02
i

CONTENTS

Page

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

I. PRESENT LAW.......................................................................................................................... 2

A. Overview of Rules Relating to Qualified Retirement Plans............................................... 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. Special Rules for 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. Funding and deduction rules............................................................................................. 19

8. Reversions......................................................................................................................... 26

9. PBGC insurance................................................................................................................ 27

II. DATA RELATING TO QUALIFIED RETIREMENT PLANS............................................. 28

A. General Data on Qualified Retirement Plan Participation................................................ 28

B. Data on Participation in Defined Benefit Plans and Defined Contribution Plans ............ 30

C. Data on Qualified Retirement Plan Assets........................................................................ 33

III. GENERAL POLICY ISSUES RELATING TO DEFINED BENEFIT PLANS.................... 36
1

INTRODUCTION

The Subcommittee on Oversight of the House Committee on Ways and Means has 

scheduled a public hearing on June 20, 2002, on retirement security and defined benefit pension 

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 contains data relating to qualified 

retirement plans. Part III 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 (JCX-71-02), 

June 18, 2002.
2

I. PRESENT LAW2

A. Overview of Rules Relating to Qualified Retirement Plans

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. The 

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. 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;4 (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

 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

 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 2002) 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 which 

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 2002) applies to the amount of a participant’s compensation that may be taken 

into account for qualified retirement plan purposes. 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.5

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 the Employee Retirement 

Income Security Act of 1974 (“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 retirement 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 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. As a practical matter, 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.

 

2002) 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.

5

 The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Act”) 

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 provisions of the 2001 Act 

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 contributions 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

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

are not includible in an employee’s income. The tax treatment of such contributions is 

essentially the same as that of deductible contributions to an individual retirement arrangement 

(“IRA”). However, the limits on contributions to qualified retirement plans are much higher than 

the IRA contribution limits, so that qualified retirement plans provide for a greater accumulation 
5

of funds on a tax-favored basis. The policy rationale for permitting greater accumulation under 

qualified retirement plans than IRAs is that the tax benefits for qualified retirement plans 

encourage employers to provide benefits for a broad group of their employees. This reduces the 

need for public assistance and may reduce pressure on the social security system. For example, 

if pension benefits are inadequate, then more people will have to rely more on social security 

alone (with any personal savings) for retirement income. If this happens, it may raise more 

questions about the continued adequacy of social security benefits.

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 to lump-sum 

distributions, 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. 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. 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 5-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. The tax is imposed on the 

individual required to take the distribution. However, in order to satisfy the qualification 

requirements, 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 Form 5500, which forwards copies of the report to the Internal 

Revenue Service and the PBGC. The plan administrator must automatically provide participants 
6

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.

Annual registration statement

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

Revenue Service 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

A plan administrator is required to 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.6 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 

 

6

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

request.
7

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.

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. These notice requirements are discussed in part I.B., 

below.

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, as 

discussed above. 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.

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 2002, the maximum guaranteed benefit for an 

individual retiring at age 65 is $3,579.55 per month, or $42,954.60 per year.

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;
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.

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.7

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 money 

purchase pension plans, are not subject to these limits.

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 

 

7

 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

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. 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.
10

B. Special Rules for 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, employer 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.8 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.9 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.

 

8

 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.

9

 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 1.5 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.10

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. 11

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.12 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.13 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.

 

10 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.

11 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.

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

rate as the employer.

13 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.14

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.15

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.

 

14 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.

15 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.16 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.17 

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.

 

16 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. 

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

in governmental defined benefit plans.
14

Vesting rules for employee contributions18

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.19 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 

 

18 Governmental plans are not subject to the vesting requirements.

19 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,20 (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 requirements21

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.

 

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

21 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 10.22 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 accrual

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 

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.
17

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.22 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 $5,000.23

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.24

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.25 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 

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.

 

22 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.

23 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.

24 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.

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

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

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 benefits

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

plan participant.26 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 protections27

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 

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.

 

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

27 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

6. Limits on benefits

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 2002). 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. Funding and deduction rules

In general

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

contributions are required in the case of underfunded plans.

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.
20

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.

Minimum funding rules28

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 (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. 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. 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.”

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.

 

28 Governmental plans are not subject to the minimum funding rules. In addition, a 

number of special minimum funding rules apply in the case of a multiemployer plan.
21

Supplemental cost.--The supplemental cost for a plan year is the cost of future benefits 

allocated to the year that would not be met by normal costs and employee contributions. The 

most common 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 

that may arise 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 

types of past service liabilities and 40 years for the third type of past service liability. 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.
22

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 8 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. 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. 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 anticipated by the actuary, then the excess is an experience gain. If the actual unfunded 

liabilities are greater than those anticipated, then the difference is an experience loss. Experience 

gains and losses for a year are generally amortized over a five-year period.

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.

Switchback liability.--Certain plans may elect to use an alternative minimum funding 

standard account for any year in lieu of the funding standard account. Specified annual charges 

and credits apply to the alternative account. No accumulated funding deficiency is considered to 

exist for the year if a contribution meeting the requirements of the alternative account is made, 

even if a smaller contribution is required to balance charges and credits in the alternative account 

than would be required to balance the funding standard account for a plan year. During years for 

which contributions are made under the alternative account, an employer must also maintain a 

record of the charges and credits to the funding standard account. If the plan later switches back 
23

from the alternative account to the funding standard account, the excess, if any, of charges over 

credits at the time of the change (“the switchback liability”) must be amortized over a period of 

five years.

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.

Additional contributions for underfunded plans

Additional contributions are required under a special funding rule if a single-employer 

defined benefit plan is underfunded.29 Under the special rule, a plan is considered underfunded 

for a plan year if the value of the plan assets is less than 90 percent of the plan’s current 

liability.30 The value of plan assets as a percentage of current liability is the plan’s “funded 

current liability percentage.”

If a plan is underfunded, the amount of additional required contributions is based on 

certain elements, including whether the plan has an unfunded liability related to benefits accrued 

before 1988 or 1995 or to changes in the mortality table used to determine contributions, and 

whether the plan provides for unpredictable contingent event benefits (that is, benefits that 

depend on contingencies that are not reliably and reasonably predictable, such as facility 

shutdowns or reductions in workforce). However, the amount of additional contributions cannot 

exceed the amount needed to increase the plan’s funded current liability percentage to 

100 percent.

In general, a plan’s current liability means all liabilities to employees and their 

beneficiaries under the plan. The interest rate used to determine a plan’s current liability must be 

within a permissible range of the weighted average of the interest rates on 30-year Treasury 

securities for the four-year period ending on the last day before the plan year begins.31 The 

 

29 Plans with no more than 100 participants on any day in the preceding plan year are not 

subject to the special funding rule. Plans with more than 100 but not more than 150 participants 

are generally subject to lower contribution requirements under the special funding rule.

30 Under an alternative test, a plan is not considered underfunded 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.

31 The interest rate used under the plan for funding purposes must also be consistent with 

the assumptions which reflect the purchase rates which would be used by insurance companies to 

satisfy the liabilities under the plan.
24

permissible range is generally from 90 percent to 105 percent. As a result of debt reduction, the 

Department of the Treasury does not currently issue 30-year Treasury securities.32

Section 405 of the Job Creation and Worker Assistance Act of 2002,33 enacted March 9, 

2002, 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 applicable plan years. The permissible range is from 

90 percent to 120 percent for these years.

Timing of plan contributions

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

81⁄2 months after the end of the plan year. If the contribution is made by such due date, the 

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

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 

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.34

Failure to make required contributions

An employer may request a waiver from the Internal Revenue Service of the employer’s 

minimum required contributions for a year if the employer is unable to make the contribution 

without substantial business hardship and if requiring the contribution would be adverse to the 

interests of plan participants in the aggregate. 

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 Internal Revenue Service. The excise tax is 

10 percent of the amount of the funding deficiency. In addition, a tax of 100 percent may be 

imposed if the funding deficiency is not corrected within a certain period. An employer that fails 

 

32 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.

33 Pub. L. No. 107-147.

34 No additional quarterly contributions are due once the plan’s funded current liability 

percentage for the plan year reaches 100 percent.
25

to make minimum required contributions and fails to obtain a waiver must also notify 

participants.

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.35 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) 165 percent of the plan’s current liability (for 2002), over 

(2) the value of the plan’s assets.36 In general, current liability is all liabilities to plan 

participants and beneficiaries accrued to date, whereas the accrued liability under the full funding 

limit is based on projected benefits. The current liability full funding limit is scheduled to 

increase to 170 percent for plan years beginning in 2003 and 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.

Deduction rules

Employer contributions to qualified retirement plans are deductible subject to certain 

limits. 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 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.

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).

 

35 The 10-percent excise tax on nondeductible contributions generally applies only to 

contributions in excess of the accrued liability full funding limit.

36 Special rules apply for purposes of determining the full funding limit of an 

underfunded plan.
26

8. 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. The excise tax 

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

replacement plan or makes 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 benefits 

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 fair market value of the plan’s assets over the greater of (1) the lesser of 

(a) the accrued liability under the plan (including normal cost) or (b) 165 percent of the plan’s 

current liability (for 2002), 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. 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 transfer after December 31, 2005, is a qualified transfer.
27

9. PBGC insurance

The PBGC provides insurance protection for participants and beneficiaries under certain 

defined benefit pension plans by guaranteeing certain basic benefits under the plan in the event 

the plan is terminated with insufficient assets to pay benefits promised under the plan.37 The

guaranteed benefits are funded in part by premium payments from employers who sponsor 

defined benefit plans. The amount of the required annual PBGC premium for a single-employer 

plan is generally a flat rate premium of $19 per participant.

In the case of an underfunded plan, additional PBGC premiums are required in the 

amount of $9 per $1,000 of unfunded vested benefits. These premiums are referred to as 

“variable rate premiums.” No variable-rate premium is imposed for a year if contributions to the 

plan were at least equal to the full funding limit. 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.

In general, the PBGC guarantees all basic benefits which are payable in periodic 

installments for the life (or lives) of the participant and his or her beneficiaries and are nonforfeitable at the time of plan termination. For 2002, the maximum guaranteed benefit for an 

individual retiring at age 65 is $3,579.55 per month, or $42,954.60 per year. The PBGC 

guarantee is phased in ratably in the case of plans that have been in effect for less than five years, 

and with respect to benefit increases from a plan amendment that was in effect for less than five 

years before termination of the plan. Certain limitations also apply in the case of a substantial 

owner of the employer maintaining the plan. A substantial owner is one who owns, directly or 

indirectly, more than 10 percent of the voting stock of a corporation or all the stock of a 

corporation.

 

37 The PBGC termination insurance program does not cover plans of professional service 

employers that have fewer than 25 participants.
28

II. 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 in 1999, 

48 percent of private sector employees participated in employer-sponsored qualified retirement 

plans. The survey found that, among full-time employees, participation was 56 percent. 

Participation rates were higher among public sector employees. The Bureau of Census’s Current 

Population Survey found that, in 1997, 87 percent of State and local government employees and 

88 percent of Federal government employees participated in an employer-sponsored retirement 

plan.

The National Compensation Survey also found that, in 1999, among full-time employees 

in the private sector, 42 percent participated in an employer-sponsored defined contribution plan 

and 25 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 1999 National 

Compensation Survey and some of the variability of employee participation in employersponsored qualified retirement plans by industry and firm size.

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.”
29

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.”
30

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.38

 

38 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.
31

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
32

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
33

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, 2001, data showed 

that defined benefit plans held assets valued at $1.81 trillion and defined contribution plans held 

assets valued at $2.34 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 and 2001. 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 and 2001. 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.39 In addition to retirement assets held in 

defined benefit and defined contribution plans, between 1988 and 2001 the market value of 

assets held by individuals in IRAs and Keogh accounts (i.e., qualified retirement plans for selfemployed individuals), increased from $452 billion at the end of 1988 to $2.40 trillion at the end 

of 2001.40

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 2001, State and local government pension plans held $2.18 

trillion in financial assets. Figure 8, below, documents that the value of assets in State and local 

plans has increased by two thirds since 1995.41

 

39 Data for Figure 6 and Figure 7 are from the Board of Governors, United States Federal 

Reserve System, Flow of Funds, December 7, 2001 and June 6, 2002. 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 

reports this understatement to be less than $100 billion as of the end of 2001.

40 Board of Governors, United States Federal Reserve System, Flow of Funds, December 

7, 2001 and June 6, 2002. 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.

41 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 
34

Figure 6

Source: Board of Governors, Federal Reserve, Flow of Funds.

 

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, June 6, 2002.

Market Value of Assets Held In Private Defined Benefit Plans,

1988-2001

0

500

1,000

1,500

2,000

2,500

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Billions of dollars
35

Figure 7

Source: Board of Governors, Federal Reserve, Flow of Funds.

Figure 8

Source: Board of Governors, Federal Reserve; Flow of Funds.

Market Value of Assets Held in Defined Contribution Plans,

1988-2001

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

Year

Billions of dollars

Market Value of Assets Held in State and Local

Government Employees Retirement Funds

1995-2001

0

500

1,000

1,500

2,000

2,500

1995 1996 1997 1998 1999 2000 2001

Year

Billions of dollars
36

III. 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 

our 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 Pension Benefit Guaranty 

Corporation 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 Pension Benefit Guaranty Corporation. 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.42

 

42 The House Committee on Ways and Means held a hearing on issues relating to defined 

contribution plans on February 26, 2002. For a discussion of such plans, see, Joint Committee 

on Taxation, Present Law and Background Relating to Employer-Sponsored Defined 

Contribution Plans and Other Retirement Arrangements (JCX-9-02), February 25, 2002.
37

The reasons for the decline in defined benefit plan coverage are not 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, the Economic 

Growth and Tax Relief Reconciliation Act of 2001 made a variety of changes with respect to the

rules relating to employer-sponsored retirement plans with a stated goal of expanding coverage. 

The changes relating to 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, owner-employees, and highly compensated employees, thus leading to the 

establishment of new plans or the expansion of existing arrangements.43 

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. 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 

 

43 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.
38

through the restrictions on reversions of plan assets. These funding rules are a cornerstone of the 

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 Pension Protection Act of 1993 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.