Chapter 1 (9).docx. VERIFIED

Chapter 1 (9).docx. VERIFIED 1. [LO 1, 2] How are defined benefit plans different from defined contribution plans? How are they similar? As the name suggests, defined benefit plans spell out the specific benefit the employee will receive on retirement. In contrast, defined contribution plans specify the maximum annual contributions that employers and employees may contribute to the plan. Defined benefit plans are funded by the employer while defined contribution plans are funded by the employee. Both plans are generally classified as employer-provided qualified retirement plans and have similar rules for vesting (although the vesting rules are slightly more favorable for defined contribution plans than defined benefit plans) and required distributions. 2. [LO 1] Describe how an employee’s benefit under a defined benefit plan is computed. Defined benefit plans provide standard retirement benefits to employees based on a fixed formula. The formula to determine the standard retirement benefit is usually a function of years of service and employees’ compensation as they near retirement. Employees usually receive a fixed benefit for each full year of service for the employer. For example, the formula may provide a benefit of 2% for each year of service, up to a maximum of 50% (25 years of service), of the average of the employee’s three highest years of salary. The maximum annual benefit an employee can receive is the lesser of 100% of the average of three highest years of compensation or $200,000 for employees who separate from service (retire) in 2012. 3. [LO 1, 2] What does it mean to vest in a defined benefit or defined contribution plan? Vesting means that one obtains the legal right to something. An employee vests in (legally obtains the right to receive) her benefits of a defined benefit or contribution plan by meeting certain requirements set forth by her employer—usually the requirement is based on years of service. 4. [LO 1, 2] Compare and contrast the minimum vesting requirements for defined benefit plans and defined contribution plans? The minimum vesting requirements for a defined benefit plan are a five-year cliff or a seven-year graded schedule. These enable the employee to fully vest in her benefits after five years or over the course of seven years, respectively. The minimum vesting requirements for a defined contribution plan are a three-year cliff or a six-year graded schedule. Under these schedules, an employee fully vests after three years of service or over the course of six years, respectively.