Q: What is ERISA?

The Employee Retirement Income Security Act of 1974, or ERISA, protects the assets of millions of Americans so that funds placed in retirement plans during their working lives will be there when they retire.

ERISA is a federal law that sets minimum standards for pension plans in private industry.  For example, if an employer maintains a pension plan, ERISA specifies when employees must be allowed to become a participant, how long an employee must work before having a non-forfeitable interest in their pension, how long they can be away from the job before it might affect the benefit, and whether the employee's spouse has a right to part of the pension in the event of the employee's death.  Most of the provisions of ERISA are effective for plan years beginning on or after January 1, 1975.

ERISA does not require any employer to establish a pension plan.  It only requires that those who establish plans must meet certain minimum standards.  The law generally does not specify how much money a participant must be paid as a benefit.

ERISA does the following:

• Requires plans to provide participants with information about the plan including important information about plan features and funding.  The plan must furnish some information regularly and automatically.  Some is available free of charge, some is not.

• Sets minimum standards for participation, vesting, benefit accrual and funding.  The law defines how long a person may be required to work before becoming eligible to participate in a plan, to accumulate benefits, and to have a non-forfeitable right to those benefits.  The law also establishes detailed funding rules that require plan sponsors to provide adequate funding for the plan.

• Requires accountability of plan fiduciaries.  ERISA generally defines a fiduciary as anyone who exercises discretionary authority or control over a plan's management or assets, including anyone who provides investment advice to the plan.  Fiduciaries who do not follow the principles of conduct may be held responsible for restoring losses to the plan.

• Gives participants the right to sue for benefits and breaches of fiduciary duty.

• Guarantees payment of certain benefits if a defined plan is terminated, through a federally chartered corporation, known as the Pension Benefit Guaranty Corporation.

Q: What are defined benefit and defined contribution pension plans?

Generally speaking, there are two types of pension plans: defined benefit plans and defined contribution plans.  A defined benefit plan promises you a specified monthly benefit at retirement.  The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement.  Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service - for example, 1 percent of an employee's average salary for the last 5 years of employment for every year of service with the employer.

A defined contribution plan, on the other hand, does not promise an employee a specific amount of benefits at retirement.  In these plans, the employee and employer (or both) contribute to the individual account under the plan, sometimes at a set rate, such as 5 percent of the employee's earnings annually.  These contributions generally are invested on the employee's behalf.  The employee will ultimately receive the balance in his or her account, which is based on contributions plus or minus investment gains or losses.  The value of the employee's account will fluctuate due to changes in the value of his or her investments.  Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.  The general rules of ERISA apply to each of these types of plans, but some special rules also apply. 

A money purchase pension plan is a plan that requires fixed annual contributions from the employer to the employee's individual account.  Because a money purchase pension plan requires these regular contributions, the plan is subject to certain funding and other rules.

Q: What are simplified employee pension plans (SEPs)?

SEPs are relatively uncomplicated retirement savings vehicles that allow employers to make contributions on a tax-favored basis to individual retirement accounts (IRAs) owned by the employees.  SEPs are subject to minimal reporting and disclosure requirements.

Under a SEP, the employee must set up an IRA to accept the employer's contributions.  As a general rule, the employer can contribute up to 25 percent of the employee's pay into a SEP each year, up to a maximum of $40,000.

Starting January 1, 1997, employers may no longer set up Salary Reduction SEPs.  However, the Small Business Job Protection Act of 1996 (Public Law 104-188) permitted employers to establish SIMPLE IRA plans beginning in 1997.  A SIMPLE IRA plan allows salary reduction contributions up to $6,000 in 2001 ($7,000 in 2002).