Types of Employee Benefit Plans (Defined Contribution, Defined Benefit)

19.1 Types of Employee Benefit Plans (Defined Contribution, Defined Benefit)

Employee Benefit Plans (EBPs) are vital for providing retirement and other benefits to employees. Under the Employee Retirement Income Security Act (ERISA) and related regulations, employers must meet certain reporting and disclosure obligations, including comprehensive audits for certain plans to safeguard participant interests.

This section focuses on two major plan categories: (1) Defined Contribution Plans and (2) Defined Benefit Plans. Each category has unique operational, funding, and audit considerations.

Understanding Employee Benefit Plan Structures

Before diving into the specifics of Defined Contribution (DC) and Defined Benefit (DB) plans, it helps to visualize how contributions, investments, and distributions generally flow in an EBP context.

    flowchart LR
	    A((Employer/Employee Contributions)) --> B((Plan Fiduciary))
	    B --> C((Investments))
	    C --> D((Distribution of Benefits))

In this flowchart: • Contributions (A) from both employer and employees are directed to the plan fiduciary (B).
• These amounts are invested (C) according to the plan’s guidelines, risk tolerance, and regulatory constraints.
• Once a participant retires or meets other distributable events, benefits are paid out (D).

Defined Contribution (DC) Plans

A Defined Contribution (DC) plan establishes how much the sponsor (employer) and/or employees will contribute, but the ultimate retirement benefit depends on the investment performance of the accumulated contributions. Participants typically select from multiple investment options. Common types of DC plans include 401(k), 403(b), profit-sharing, and money purchase pension plans.

Key Characteristics

1. Contributions are specified:

   • Employers may match employee contributions up to a certain percentage, or commit to a fixed annual amount.
   • Employees often voluntarily defer a portion of their salary.

2. Investment risk falls on the plan participant:

   • Each participant’s account balance reflects contributions plus any investment gains or losses.
   • Market fluctuations directly affect the eventual benefit.

3. Vesting schedules vary:

   • Employee contributions typically vest immediately.
   • Employer contributions may vest over time (e.g., three- to five-year schedules), providing a retention incentive.

Audit Considerations for Defined Contribution Plans

Audits of DC plans typically center on participant account balances, contributions, and investment transactions. Key areas include:

1. Timeliness of Contributions:

   • Auditors verify employer and employee deferrals are remitted to the plan promptly, in compliance with Department of Labor (DOL) guidelines. Late remittances can trigger penalties or require corrective actions (e.g., lost earnings to participants).

2. Participant Data and Eligibility:

   • Auditors test the accuracy of employee eligibility determinations and contribution amounts to ensure they align with the plan document.

3. Investment Transactions:

   • Since participants have individual accounts, the auditor verifies that all purchases, sales, and related expenses or gains are correctly allocated.

4. Participant Disclosures and Statements:

   • Benefit statements must accurately reflect each participant’s account balance, investment performance, and vesting status.

5. Controls Over Participant Directions:

   • When participants make changes to contribution rates or investment elections, auditors consider whether these changes are properly authorized and accurately recorded.

Practical Example – 401(k) Plan

• Imagine an employer that matches 50% of the first 6% of the salary an employee contributes. Each participant independently selects their investment options from a menu (e.g., shares of mutual funds, bonds, or company stock).
• The plan’s fiduciaries must ensure contributions are transmitted on time and that investments are tracked accurately to participant accounts. During an audit, examining payroll records, participant forms, and investment statements helps validate that the plan is operating as intended.

Defined Benefit (DB) Plans

In a Defined Benefit (DB) plan, participants receive a predetermined retirement benefit calculated based on factors such as years of service, compensation history, and age at retirement. The plan sponsor (employer) assumes the investment and actuarial risks, ensuring sufficient funding to meet future benefit obligations.

Key Characteristics

1. Fixed Formula for Benefits:

   • The retirement benefit might be stated as a percentage of the participant’s average salary over the final years of employment multiplied by years of service.

2. Sponsor Bears Funding Risk:

   • If investments underperform or demographic assumptions change (e.g., life expectancy increases), the sponsor must make additional contributions to fund future benefits.

3. Actuarial Assumptions and Valuation:

   • Actuaries project plan obligations using discount rates, mortality tables, and turnover rates.
   • These estimates are key to determining the plan’s funded status.

Audit Considerations for Defined Benefit Plans

DB plan audits must review both the plan’s financial statements and the actuarial valuation. Key areas include:

1. Actuarial Assumptions and Liabilities:

   • Auditors evaluate whether the actuarial methodologies and assumptions (mortality, discount rate, expected returns on plan assets) align with accounting standards and realistic expectations.
   • Small changes in assumptions can significantly affect the plan’s projected benefit obligation.

2. Valuation of Plan Assets:

   • DB plans may invest in a broad range of assets, including stocks, bonds, and alternative investments.
   • Auditors verify the fair market value of these assets at the reporting date and ensure appropriate disclosures (e.g., fair value hierarchy).

3. Minimum Funding and Funding Status:

   • Sponsors are subject to minimum funding requirements under ERISA and the Internal Revenue Code.
   • Auditors confirm whether contributions meet these mandates and that any funding shortfalls are adequately addressed.

4. Benefit Payments:

   • Because benefits can be paid in lump sums or periodic annuities, testing ensures that disbursements are only made to eligible participants and that payments align with plan terms.

5. Regulatory Compliance:

   • DB plans face stringent rules regarding plan amendments, plan terminations, or funding waivers.
   • The audit typically involves scrutiny of compliance with disclosure and reporting requirements (e.g., Form 5500 and related schedules).

Practical Example – Pension Plan

• A traditional pension formula might promise a monthly benefit equal to 1.5% of the participant’s final five-year average salary multiplied by years of credited service.
• If the plan’s assets perform poorly, the sponsor may be required to contribute additional funds to maintain the minimum required funding status, which is verified by the plan’s actuary and audited financials.

Comparing DC and DB Plans at a Glance

Below is a simplified table summarizing key differences:

Common Pitfalls and Best Practices

1. Pitfall: Late contribution remittances in DC plans can result in penalties and lost earnings.
   • Best Practice: Establish robust payroll processes and timelines for remittances that comply with DOL guidelines.

2. Pitfall: Inaccurate actuarial assumptions in DB plans can understate liabilities, exposing sponsors to future cash flow issues.
   • Best Practice: Use reputable actuaries and periodically review assumptions (e.g., mortality tables, discount rate) against market conditions.

3. Pitfall: Lack of proper documentation for participant data and investment elections.
   • Best Practice: Maintain clear records, updating them promptly when employees change their contribution levels or investment choices.

4. Pitfall: Overlooking changes in regulations (e.g., new IRS or DOL rules) or ignoring plan amendments that alter funding or benefits.
   • Best Practice: Engage qualified counsel or plan specialists to review plan documents regularly and update them in compliance with the law.

References and Resources

• Official References

• ERISA, specifically Titles I and IV for pension standards.
• FASB ASC 960, 962, 965 for plan accounting guidance.

• Additional Resources

• AICPA “Audit and Accounting Guide: Employee Benefit Plans.”
• DOL website for yearly updates on reporting requirements (Form 5500 instructions, plan audit checklists).

Employee Benefit Plans Quiz: Mastering DC & DB Plans

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