Helping Americans To Help Themselves

Helping Americans to Help Themselves:
The role of profit-sharing/ 401(k) plans in the retirement-income security framework

Profit Sharing/ 401(k) Council of America
April 1998

About this paper

Executive summary

A framework for retirement-income security

Retirement-income security: the profit-sharing/401(k) solution

The role of profit-sharing/401(k) plans in the retirement-income security framework

Conclusion

Endnotes

Appendices

Defined-contribution plan types
Plan sponsorship and participation
Calculation of lump-sum and annuity benefits
Research relating to profit-sharing/401(k) plans

Acknowledgments

About this paper

The Profit Sharing/401(k) Council of America (PSCA) is a national, non-profit association of 1,200 companies that sponsor profit-sharing/401(k) plans for more than 2 million employees. Member companies range in size from Fortune 100 firms to small, entrepreneurial businesses.

For over 50 years, PSCA has worked to promote defined-contribution plan sponsorship and participation because of its member companies' common belief that profit-sharing/401(k) and related savings and incentive programs:

provide a vital source of retirement income;
empower and motivate the workforce;
strengthen the free-enterprise system; and
improve domestic and international competitiveness.

Based on its member companies' collective experience in sponsoring retirement benefits and saving and investment programs for millions of Americans, PSCA has prepared this paper, which explains how profit-sharing/401(k) plans can help Americans to ensure their financial security in retirement.

Executive summary

Employer-provided profit-sharing and 401(k) plans are the most popular and successful methods by which individuals, employers and government cooperate to provide retirement income to millions of Americans. Over 50 million Americans are currently accumulating retirement savings through employer-sponsored defined contribution plans, most of which are profit sharing and 401(k) plans. There are many advantages to saving in these plans and consequently over twenty-five million employees currently make personal contributions to their accounts. As a result of profit sharing and 401(k) plan growth, the retirement outlook for many Americans is improving. There is over 1.5 trillion dollars in these accounts and, as plan sponsorship and participation increase, we can look forward to Americans saving even more.

As account balances in profit-sharing/401(k) plans grow, participants become more receptive to cultural messages about saving and investing because the plan gives them a personal and highly visible economic interest in learning more about their financial needs in retirement. They begin to seek out more information about basic investment concepts and about specific investment options from a variety of sources, including government and their employers.

Government already supports saving and investing for retirement through profit-sharing/401(k) plans in a number of ways, including permitting the deferral of current taxes on plan contributions and investment earnings. However, there is much it could do to further encourage profit-sharing/401(k) plan sponsorship and participation. By setting reasonable contribution and benefit limits, easing the administrative burden on plan sponsors and providing a reasonable and coherent tax policy, government could increase the number of companies that sponsor plans and the number of individuals who participate in them.

Employers sponsor retirement plans for a variety of reasons, including to attract, retain and motivate a qualified workforce. The variety of profit-sharing/401(k) plan arrangements that are available provide the flexibility that employers require to meet their unique business needs while assisting individual employees to meet their retirement goals. In particular, profit-sharing/401(k) plans are attractive to small, mid-size and start-up companies because of the difficulties these companies face in budgeting fixed benefit contributions each year.

Finally, profit-sharing/401(k) plans create benefits beyond those produced for individuals, government and employers. The economic impact of the hundreds of billions of dollars that already have been accumulated through profit-sharing/401(k) plans and of the billions of dollars in new contributions made each year should not be underestimated. This ever-increasing pool of capital is invested in the stocks of new and established companies and in corporate- and government-debt issues. These investments contribute to the economy's growth and, in turn, create jobs for American workers.

However, increasing numbers of Americans will be unable to maintain their current standard of living in retirement unless the United States establishes a new framework for retirement-income security. To meet the challenges of changes in demographics, lifestyles, the business environment and national savings patterns and concerns over the long-term viability of the Social Security system, the Profit Sharing/401(k) Council of America recommends a new approach to retirement-income security.

This approach recognizes that individuals are primarily responsible for ensuring their own financial security in retirement, although government and employers will continue to play significant roles. For this approach to succeed, individuals, American social and political culture, government and employers all must participate in a system that emphasizes individual savings and investment. This system already exists through profit-sharing/401(k) plans, but it must be improved.

The Profit Sharing/401(k) Council of America encourages individuals, employers, government and other interested parties to participate in open dialogue to identify the most effective ways to expand profit-sharing/401(k) plan sponsorship and participation in order to ensure that all Americans may achieve retirement-income security.

A framework for retirement-income security

If Americans are to achieve financial security in retirement, the United States must establish a new framework for retirement-income security. That framework must recognize the impact that changes in demographics, lifestyles, government regulation, the business environment and national savings patterns are having on individuals' ability to save and invest for retirement, as well as employers' and government's ability to provide retirement benefits.

In response to these changes, the Profit Sharing/401(k) Council of America in its paper, Helping Americans to Help Themselves: A framework for financial security in retirement, recommended a new approach to retirement-income security that is based upon four principles:

Individuals must be primarily responsible for their own financial security in retirement.
American social and political culture must educate and stimulate individuals to save and invest for the long term, particularly for retirement.
Government must provide an environment that encourages individuals and employers to contribute and invest assets for retirement.
Employers must have the flexibility to design retirement programs that both assist individuals in meeting their retirement goals and address employers' unique business needs.

Individuals, employers and government currently cooperate to provide retirement income through profit-sharing/401(k) plans. These plans offer government a tax-efficient method to help individuals accumulate substantial assets for retirement through the combination of their own and their employer's contributions. Profit-sharing/401(k) plans also allow companies to help their employees to save and invest for retirement while providing a benefit that helps the company to attract, retain and motivate a qualified workforce. However, further efforts by the government to enhance opportunities for employers to sponsor and individuals to participate in profit-sharing/401(k) plans are necessary to ensure that Americans will achieve their retirement-income goals.

Retirement-income security: the profit-sharing/401(k) solution

The Internal Revenue Code defines a defined-contribution plan as one that "provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant's account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant's account."¹ In other words, defined-contribution plans are individual asset-accumulation vehicles from which an individual can make withdrawals in retirement.

Although there are a variety of defined-contribution plan types (see Appendix A), the most frequently sponsored defined-contribution plan type is the profit-sharing/401(k) plan. In 1993 (the most recent year for which complete U.S. Department of Labor data is available), approximately three-quarters of the over 600,000 private-employer defined-contribution plans were profit-sharing/401(k) plans. In addition, as of 1993 (the most recent year for which Department of Labor data is available) more than 23 million Americans were saving for retirement through 401(k) plans.² (Additional profit-sharing/401(k) plan data may be found in Appendix B.)

Profit-sharing/401(k) plans already have demonstrated that individuals, government and employers can cooperate to facilitate retirement-income security for American workers. Profit-sharing/401(k) plans can provide individuals with substantial assets for retirement, government with a tax-efficient way to encourage private savings and investment for retirement, and employers with opportunities to provide retirement income to individuals while realizing the benefits of a more productive and focused workforce. Further, many employers sponsor both profit-sharing/401(k) plans and defined-benefit pension plans, thereby providing employees with an especially broad- based retirement program.

Providing assets for retirement
Through the combination of employee and employer contributions and the compounded earnings on those contributions, individuals can accumulate substantial assets for retirement through profit-sharing/401(k) plans. For example, a profit-sharing/401(k) plan participant who retires with a final salary of $35,000 after 40 years of employment and plan participation can expect to have an account balance at retirement of $240,589. If he uses that amount to purchase a lifetime annuity, his annual payments would be $27,824. (See Appendix C.) Because profit-sharing/401(k) plan assets are portable (meaning that individuals may take their accumulated plan assets with them when they change jobs or leave the workforce), profit-sharing/401(k) plan participants do not have to work for the same employer for their entire career to be able to save and invest sufficient assets for retirement.

Profit-sharing/401(k) plans also give individuals control over the flow of their distributions at retirement. For example, terminating employees can elect to leave their assets in their former employer's plan and make withdrawals as needed, can use the accumulated assets to purchase an annuity, or can transfer the entire amount directly into another employer's qualified plan or an individual retirement account (IRA) and continue to defer taxes on the distribution while investing the assets to outpace inflation.

Tax-efficient method of encouraging private savings and investment
Individuals can defer paying federal--and in most cases state and municipal--income taxes on their personal and employer contributions to profit-sharing/401(k) plans, as well as on investment earnings that accrue on those contributions, until they withdraw money from the plan. Although the General Accounting Office "scores" these tax deferrals as an expenditure when calculating the federal government's annual budgets, the government's only retirement plan-related expenditure is the cost of the temporary loss of the tax revenue during the deferral period.

Defined-contribution plans offer an efficient means of providing retirement income because the benefits are pre-funded-in other words, less money needs to be set aside today to pay for benefits 20, 30 or 40 years from now because assets multiply dramatically over time through the tax-deferred compounding of investment earnings.

Profit-sharing and 401(k) plans benefit plan sponsors and the U.S. economy
Public and private research conducted over the past six decades has shown that profit-sharing/401(k) plans provide numerous benefits to employers and the economy, as well as to employees.

The first extensive study of profit sharing, published in 1939 by a subcommittee of the Senate Committee on Finance, concluded that, in addition to contributing substantially to financial security in retirement, profit sharing helps to build a strong economy because it:

improves an employee's energy and efficiency by stimulating hope and ambition;
improves company workforce efficiency by sustaining group interest and instilling a feeling of responsibility for profits;
improves relations between employers and employees;
reduces employee turnover by providing attractive rewards for continued, faithful service and by penalizing separation from service;
prevents waste and losses usually due to carelessness and discontent;
promotes efficient management and encourages self-imposed supervision in the employee group; and
creates and builds a market for company securities.³

Academic and private research supports the subcommittee's conclusions. Most recently, Douglas Kruse of Rutgers University for his 1993 book, Profit Sharing: Does It Make a Difference?, analyzed survey data on the corporate performance of 500 U.S. companies-half with profit-sharing plans, half without-between 1970 and 1991. Kruse found that companies that established profit-sharing plans during that period experienced first-year productivity increases that were 3.5 percent to 5 percent higher than the companies that did not establish plans. Further, the companies that established profit-sharing plans were able to sustain productivity increases over time.⁴ (Refer to Appendix D for a discussion of research relating to profit-sharing/401(k) plans.)

Profit-sharing, 401(k) and other types of defined-contribution plans create benefits beyond those produced for the sponsoring employer, however. The economic impact of the more than $1 trillion in assets already accumulated in defined-contribution plans and of the billions of dollars in new contributions each year ($100 billion in 1993, the most recent year for which D.O.L. data is available) should not be underestimated.⁵ The result is an ever-increasing pool of capital that is invested in the stocks of new and established companies and in corporate- and government-debt issues.

The role of profit-sharing/401(k) plans in the retirement-income security framework

The framework for retirement-income security recommended by the Profit Sharing/401(k) Council of America (PSCA) rests on the principle that individuals are primarily responsible for their financial security in retirement. However, if their efforts to save and invest for retirement are to be successful, individuals must be assisted and encouraged by American social and political culture, government and their employers. PSCA believes that profit-sharing/401(k) plans offer unique opportunities for all parties to work together within the retirement-income security framework by sponsoring, participating in and promoting the use of these plans.

How profit-sharing/401(k) plans help individuals take responsibility for their financial security in retirement
Employer-sponsored retirement plans provide advantages that other savings and investment vehicles do not. For example, profit-sharing/401(k) plans offer:

Secure benefits. By definition, profit-sharing/401(k) plans cannot be under-funded. Assets accumulate in individual employee accounts, which are held in trust solely for the future benefit of those individuals. In addition, strict fiduciary guidelines, set down under the Employee Retirement Income Security Act of 1974 (ERISA), ensure prudent money-management practices.
Easy to understand. Because profit-sharing/401(k) plans provide individuals with a personal account, it is easy for the individual to understand the value of his or her own contributions, the employer's contributions and the increase or decrease in the account balance due to investment results. Further, because the employer usually pre-selects a few investment alternatives for the plan from the thousands that are available, the individual's investment decisionmaking process is greatly simplified.
No minimum beginning-balance requirements. Participant-directed profit-sharing/401(k) plans allow individuals to select any of the available investment alternatives without the need to first accumulate a minimum initial investment.
Payroll deduction. Individuals who participate in 401(k) plans like the convenience of payroll deduction. In fact, more than 60 percent of respondents to a recent nationwide poll said that having money taken directly out of their paycheck and put into a retirement-savings plan is an "absolutely essential" or "very important" plan feature.⁶ This attitude reflects the well-established psychological principle that people do not miss what they never had.
Dollar-cost averaging. In 401(k) plans, individuals typically invest a fixed amount with each paycheck. This allows them to avoid the timing mistakes that could occur if they committed all their assets at a single point in time.
Flexibility to adjust to changing needs and goals. Profit-sharing/401(k) plans often allow individuals to adjust their saving and investment strategies to meet changing personal needs and goals by making it easy to change the amount that they save or how their assets are invested. In addition, the amount of time that is needed to effect those changes has been shortened dramatically through computer and voice-response technology.
Lower investment-management fees. Individuals who participate in employer-sponsored retirement-savings plans may benefit because investment-management fees as a percentage of assets under management often decline as the asset base increases and because broker commissions are lower on large transactions. In addition, individuals typically do not pay front-end or back-end sales commissions on their investment purchases and sales through their employer’s profit-sharing/401(k) plan.
Loans from accumulated assets. Unlike some other tax-deferred savings plans, profit-sharing/401(k) plans may permit individuals to borrow from their accounts and repay the loan with interest at market rates. Plan loans, therefore, allow individuals to preserve their retirement savings while satisfying immediate financial needs.

As a result of all these benefits, the popularity of profit-sharing/401(k) plans is growing. For example, among those individuals whose employers offer a 401(k) plan, the percentage who chose to participate rose to 67 percent in 1993 from 60 percent in 1988.⁷ PSCA's annual survey indicates that participation is even higher-84 percent of eligible employees at the responding companies chose to participate in their employer's 401(k) plan in 1996.⁸

How profit-sharing/401(k) plans contribute to a culture that educates and stimulates individuals to save and invest for retirement
To ensure retirement-income security, American social and political culture must educate and stimulate individuals to save and invest for the long-term, particularly to save and invest for retirement. Profit-sharing/401(k) plan participants are more receptive to cultural messages about saving and investing because their plans give them a personal and highly visible economic interest in learning more about their financial needs in retirement.

As their account balances grow over time, profit-sharing/401(k) plan participants seek out more information about both basic investment concepts and specific investment options. They turn to their employers, families, friends, investment consultants and the media for help in developing a financial plan that will allow them to achieve retirement-income security.

Profit-sharing/401(k) plans build on cultural messages that stress the importance of saving and investing for the long-term in many other ways, as well, including:

Employer encouragement to save. Employers constantly seek to increase both the number of individuals who contribute to profit-sharing/401(k) plans and the amount that they save. For example, employer-matching contributions to 401(k) plans have proven to be a highly effective method for encouraging greater plan participation. A 1995 survey found that while the overall average 401(k) participation rate is 65 percent, the average participation rate for 401(k) plans in which an employer match is not offered is only 41 percent.⁹
Employer-provided investment education. Many profit-sharing/401(k) plan sponsors are increasing their commitment to educating individual plan participants about basic investment concepts, as well as the specific investment vehicles that are available through the plan. A recent survey found that more than half of the responding plan sponsors that offer investment-education programs have established them since 1992.¹⁰ These employers provide educational seminars, videotapes, workbooks, forecasting software, newsletters and even personalized financial planning.

How government may provide an environment that encourages individuals and employers to save and invest assets for retirement through profit-sharing/401(k) plans
In a society where individuals traditionally have had a finite working lifetime, followed by a period of retirement, "it is best to prepare for the days of necessity."¹¹ With a government-supported environment that encourages individuals and employers to save and invest assets through profit-sharing/401(k) plans, American workers can accumulate significant assets for retirement.

Government currently provides several advantages to profit-sharing/401(k) plans:

Plan contributions and investment earnings are tax deferred. Profit-sharing/401(k) plans greatly enhance the compounding effect of investment earnings on assets because an individual's and his or her employer's contributions to the plan are not subject to federal income tax or to most state and local income taxes until they are withdrawn. Likewise, investment earnings on plan assets are not taxed until they are withdrawn.
Account balances are portable. Current law encourages individuals who change jobs or who temporarily leave the workforce to preserve their plan assets in tax-deferred accounts. Individuals can leave their accumulated assets in their former employer's plan (if the amount exceeds $5,000), transfer them into an individual retirement account or, in some cases, transfer them into a new employer's plan.
Distributions at retirement age are eligible for special tax treatment. Special taxation rules may apply to lump-sum plan distributions made to individuals who retire. These rules are designed to generally prevent individuals from being taxed at a higher rate because of the plan distribution. This special tax treatment particularly benefits individuals who were in the lower income brackets during their working years.

However, there is much government could do to further encourage companies to sponsor profit-sharing/401(k) plans and individuals to participate.

Set reasonable contribution and benefit limits. The current limits on individual and employer contributions to profit-sharing/401(k) plans restrict the amount that many people at all income levels can save for retirement. Further, these limits discourage some employers from sponsoring plans. Government should set contribution and benefit limits at levels that provide sufficient incentive for individuals to participate and corporate decisionmakers, particularly owner/managers of small and mid-size companies, to sponsor plans.
Ease the administrative burden. The cost of complying with current government regulations discourages many companies, particularly small companies, from sponsoring retirement plans. For example, in 1992 (the most recent year for which this data is available), just 33 percent of full-time employees who worked for companies with fewer than 100 employees had access to a defined-contribution plan. In contrast, nearly 50 percent of full-time employees who worked for companies with 100 or more employees in 1993 (the most recent year for which this data is available) had access to a defined-contribution plan.¹² Government could encourage greater plan sponsorship and participation by providing a stable, simple and understandable regulatory structure.
Provide a resonable and coherent tax policy. The purpose of tax policy that affects plan accumulations and distributions should be to encourage retirement savings. However, current tax policy actually discourages retirement savings and successful investment strategies. For example, as annual contribution limits have been lowered over the past decade and as the non-discrimination testing rules have been changed, the amount that individuals-especially those in the middle class-can save in 401(k) plans has been adversely affected.

How profit-sharing/401(k) plans provide the flexibility that employers need to design retirement programs that both assist individuals in meeting their retirement goals and address the employer's unique business needs
As stated earlier, profit-sharing/401(k) plans provide many advantages to individuals who are saving and investing for retirement. In addition, employers may provide additional profit-sharing/401(k) benefits:

Employers may contribute to individuals' accounts. Most employers match individual 401(k) plan contributions, which gives individuals an immediate return on their savings. In 1996, for example, lower-paid employees contributed an average of 5 percent and higher-paid employees contributed 6.1 percent of their pay to their 401(k) plans and received an average employer match of 2.6 percent of pay.¹³
Employers may share profits. Over 60 percent of the profit-sharing and 401(k) plans that responded to PSCA's most recent annual survey base at least some portion of their company's plan contribution on profits.¹⁴
Employers can encourage employee-ownership. Many profit-sharing/401(k) plans permit participants to invest in their employer's stock. According to PSCA's annual survey, 21.7 percent of profit-sharing/401(k) plans offer a company-stock fund for participant contributions and 16.3 percent offer one for company contributions.¹⁵ Until recently, there was more employer stock in profit-sharing and 401(k) plans than in employee stock-ownership plans.¹⁶

Employers sponsor retirement plans for a variety of reasons. In some cases, it is to attract, retain and motivate employees in order to create a stable and qualified work-force. In other cases, it is a result of employee demands in collective bargaining.

A company's size and age also may determine which retirement-plan type best suits its situation. Profit-sharing/401(k) plans are attractive for small, mid-size and start-up companies, which play a critical role in the U.S. economy and contribute greatly to the United States' worldwide economic parity. Without a history of profits, it is difficult to budget fixed benefit contributions each year.

The variety of profit-sharing/401(k) plan arrangements that are available help employers to meet their needs for flexibility. They can choose plan designs that range from profit-sharing plans with simple discretionary-contribution allocations based on a percentage of salary to more sophisticated matching plans tailored to employee turnover and profit centers within a particular company. They can make contributions on a discretionary basis each year: in good years, they can make larger contributions, subject to government limitations; in lean years, they can make smaller or no contributions. In 401(k) plans in which the company matches employee contributions, the company can set aside a safety net of matching contributions each year, as well as an additional discretionary profit-sharing contribution.

Conclusion

The traditional model in which individuals, employers and government share the responsibility for ensuring retirement-income security must be re-evaluated. The demographic, social and economic challenges that the United States face are so fundamental that we must develop a new framework if Americans are to maintain their pre-retirement standard of living after they retire.

This new framework recognizes that individuals are primarily responsible for ensuring their own financial security in retirement, although government and employers will continue to play significant roles. For the new framework to succeed, individuals, American social and political culture, government and employers all must participate in a system that emphasizes individual savings and investment. A system already exists, although it must be improved.

Individuals prefer to save and invest for retirement through profit-sharing/401(k) plans because these plans give them control over how much they save and, in most cases, how to invest their assets. As their account balances grow, profit-sharing/401(k) plan participants become more attuned to cultural messages about saving and investing for retirement. This growing awareness causes them to seek out additional information about basic investment concepts and specific investment options.

By providing tax incentives to individuals to participate in and employers to sponsor profit-sharing/401(k) plans, government has created a tax-efficient means of contributing toward retirement-income security for millions of Americans. However, it could make these plans more attractive to individuals and employers by setting reasonable contribution and benefit limits and by simplifying the regulatory structure in which these plans operate. Increases in plan participation and sponsorship would not only help individuals to accumulate substantial assets for retirement, but also would contribute to the sponsoring companies' success while increasing the pool of capital that is invested in the U.S. economy.

The Profit Sharing/401(k) Council of America encourages individuals, government and employers to participate in open dialogue to identify the most effective ways to expand profit-sharing/401(k) plan coverage in order to ensure retirement-income security for all Americans.

Endnotes

¹ Internal Revenue Code § 414(i).

² Private Pension Plan Bulletin: Abstract of 1993 Form 5500 Annual Reports. Washington: U.S. Department of Labor, Pension and Welfare Benefits Administration. Winter 1997.

³ Survey of Experiences in Profit Sharing and Possibilities of Incentive Taxation. Report of the Subcommittee of the Senate Committee on Finance. Washington: U. S. Government Printing Office. June 19, 1939.

⁴ Kruse, Douglas L. Profit Sharing: Does It Make A Difference? Kalamazoo, Mich.: W. E. Upjohn Institute for Employment Research. 1993.

⁵ Private Pension Plan Bulletin: Abstract of 1993 Form 5500 Annual Reports.

⁶ Results of Profit Sharing/401(k) Council of America/Profit Sharing/401(k) Education Foundation Take Control Poll, a nationwide survey of 1,010 individuals, conducted on July 14, 1995.

⁷ Reich, Robert B. Testimony before the Senate Finance Subcommittee on Deficits, Debt Management and Long-Term Growth. December 7, 1994.

⁸ 40th Annual Survey of Profit Sharing and 401(k) Plans. Chicago: Profit Sharing/401(k) Council of America. 1997.

⁹ Retirement Benefits in the 1990s: 1995 Survey Data. Los Angeles: KPMG Peat Marwick. 1995.

¹⁰ Financial Education for Employees: What's Working? Survey Results. New York: William M. Mercer Inc. 1995.

¹¹ Jacobs, Joseph (ed.). "The Ant and the Grasshopper." The Fables of Æsop. New York: Schocken Books Inc. 1966.

¹² Employee Benefits in Small Establishments, 1992. Washington: U.S. Department of Labor, Bureau of Labor Statistics. 1993; and Survey of Employee Benefits in Medium and Large Private Establishments, 1993. Washington: U.S. Department of Labor, Bureau of Labor Statistics. September 1994.

¹³ 40th Annual Survey of Profit Sharing and 401(k) Plans.

¹⁴ Ibid.

¹⁵ Ibid.

¹⁶ Blasi, Joseph. "Feudalism & Capitalism: Two Attitudes Behind Profit Sharing." Speech presented at PSCA's 42nd National Conference. San Diego, Calif. Oct. 27, 1989.

Appendix A - Defined-contribution plan types

Profit-sharing plan
Plan established and maintained by an employer to provide for the participation in its profits by its employees or their beneficiaries. Company contributions may be determined either by fixed formula or at the discretion of the board of directors.

Current profit-sharing plan (cash). Profits paid directly to employees in cash, check or stock as soon as profits are determined.
Deferred profit-sharing plan. A qualified program of retirement benefits wherein the employer provides retirement benefits subject to a written agreement and based on the limitations described in the Internal Revenue Code. The employees' benefits at retirement are based strictly upon the sum total of the contributions made and the investment result thereon.

The plan must provide a definite predetermined formula for allocating contributions made to the plan among participants and for distributing funds accumulated under the plan after a fixed number of years, attainment of a stated age or upon prior occurrence of some event such as layoff, illness, disability, retirement, death or severance of employment. Deferred profit-sharing plans are subject to the participation, vesting, reporting and disclosure and fiduciary rules of ERISA. They are excluded from the funding and plan-termination provisions of the act.

Cash-or-deferred arrangement (CODA)
Section 401(k) of the Internal Revenue Code allows employers to offer employees a choice between receiving compensation and having a contribution made on their behalf to a qualified plan. See also 401(k) plan.

401(k) plan
A defined-contribution plan, established by an employer. It enables employees to make pre-tax contributions by salary-reduction agreements structured within the format of a cash or deferred plan.

Money-purchase plan
A type of defined-contribution plan in which the employer's contributions are determined for, and allocated with respect to, specific individuals, usually as a percentage of compensation. The benefits for each employee are the amounts that can be provided by the sums contributed to his or her account. Unlike a profit-sharing plan, however, forfeitures are not added to participants' accounts; they are used to reduce the employer's contributions.

An individual account plan, as defined in Section 3(34) of ERISA, other than a profit-sharing plan or a stock-bonus plan, in which the employer's contributions are fixed or determinable.

Target-benefit plan
Contributions are based upon an actuarial valuation designed to provide a target benefit to each participant upon retirement. The plan does not guarantee that such benefit will be paid; its only obligation is to pay whatever benefit can be provided by the amount in the participant's account. A hybrid of a money-purchase plan and a defined-benefit plan.

Employee stock-ownership plan (ESOP)
A qualified stock-bonus plan or a qualified stock-bonus and money-purchase plan. Like a stock-bonus plan, the contributions need not be dependent on profits, and benefits are distributable in the stock of the employer corporation. Typically, the ESOP is used as a financing vehicle for the employer corporation: the plan borrows money from the employer or uses the employer's credit and purchases employer stock. The borrowed money is paid to the employer for its stock. The loan is repaid with annual employer contributions.

Simplified employee-pension plan (SEP)
Essentially, an individual retirement account (IRA) to which an employee and his or her employer may contribute. Any employer contributions are excluded from an employee's income. Elective deferrals to a SEP are treated like elective deferrals to a qualified CODA.

Stock-bonus plan
A plan established and maintained by an employer to provide benefits similar to those of a profit-sharing plan, except that the contributions by the employer are not necessarily dependent upon profits and the benefits are distributable in stock of the employer company. For the purpose of allocating and distributing the stock of the employer that is to be shared among employees or their beneficiaries, such a plan is subject to the same requirements as a profit-sharing plan.

Reprinted with permission from Employee Benefit Plans: A Glossary of Terms, 8th Edition, published by the International Foundation of Employee Benefit Plans, Brookfield, Wis.

Appendix B - Plan sponsorship and participation

Companies that sponsor tax-qualified retirement plans, such as deferred profit-sharing and 401(k) plans, are required to file annual Form 5500 reports on their plans with the Inter-nal Revenue Service. The U.S. Department of Labor's Pension and Welfare Benefits Admin-istration uses that data to report on retirement-plan sponsorship, participation, contributions and assets. In 1993 (the most recent year for which complete D.O.L. data is available) there were 618,501 qualified defined-contribution plans covering over 43 million people. In addition, 154,527 defined-contribution plans covering more than 25 million people had 401(k) features.

Table 1. Number of private defined-contribution plans, participants, contributions and assets

Plan type Number
of plans^a Total
participants^b
(in thousands) Active
participants
(in millions) Total
contributions^c
(in millions) Total
assets^d
(in millions)

Profit sharing and
   thrift savings
Money purchase
Target benefit
Stock bonus
Other
Totals

477,054
114,997
8,955
1,542
15,953

618,501

36,115
4,197
202
1,658
1,431
43,603

33,013
3,753
192
1,432
1,229
39,619

$88,483
7,633
781
1,906
2,716
$101,519

$913,848
95,854
7,090
23,876
27,424
$1,068,092

Source: Private Pension Plan Bulletin: Abstract of 1993 Form 5500 Annual Reports. Washington: U.S. Depart-ment of Labor, Pension and Welfare Benefits Administration. Winter 1997.

Table 2. Number of private 401(k)-type plans, participants, contributions and assets

Plan type Number
of plans^a Total
participants^b
(in thousands) Active
participants
(in millions) Total
contributions^c
(in millions) Total
assets^d
(in millions)

Profit sharing and
   thrift savings
Money purchase
Target benefit
Stock bonus
Other
Totals

152,506
1,282
84
47
608

154,527

24,344
202
258
1
508
25,313

22,138
194
221
1
584
23,138

$66,524
403
868
1
1,536
$69,332

$592,579
2,911
8,000
14
12,794
$616,316

Source: Private Pension Plan Bulletin: Abstract of 1993 Form 5500 Annual Reports.

Notes:

Excludes plans covering only one participant
Includes active, retired and separated vested participants not yet in pay status. Also includes double counting of workers in more than one plan.
Asset amounts shown exclude funds held by life insurance companies under allocated insurance contracts for pay-ment of retirement benefits. These funds make up roughly 10 to 15 percent of total private retirement-fund assets.
Includes both employer and employee contributions.

Appendix C - Calculation of lump-sum and annuity benefits

In our example, a profit-sharing/401(k) participant can expect to retire at age 65 with an account balance of $240,589. This figure was arrived at using the following assumptions:

Years of plan participation:	40
Final salary:	$35,000
Average annual plan contributions:	7.5 percent of pay*
Average annual return on investment:	8 percent
Average annual salary increase:	4 percent

* Contributions are made annually at year end.

The plan-contribution assumption is based on the results of PSCA's Annual Survey of Profit Sharing and 401(k) Plans from 1991 to 1994 (participant-contribution data was not collected prior to 1992). Lower-paid participants' contributions during those years averaged 4.5 percent of pay; higher-paid participants' contributions averaged 5.6 percent. Employer 401(k) plan contributions averaged 3 percent of payroll during the same period; profit-sharing contributions were even higher, bringing the average employer contribution among survey respondents to 6.4 percent of payroll. The investment-return assumption is conservative based on data from the Employee Benefit Research Institute. According to EBRI's Quarterly Pension Investment Report (4th quarter 1994), defined-contribution plans earned an average 10.6 percent rate of return over the five years ended December 31, 1994.

The chart below shows the rate at which contributions and earnings would accrue.

graph

If the participant used his or her total account balance at retirement to purchase a lifetime annuity, the annual payment received would be $27,824 (man) or $24,443 (woman).
(Annuity calculations provided by Hewitt Associates.)

Appendix D - Research relating to profit-sharing/401(k) plans

Profit-sharing/401(k) plans and retirement-income security

In testimony he presented before the Senate Finance Committee on Feb. 2, 1995, David A. Wise of Harvard University reported that research he conducted with colleagues James Poterba and Steven Venti showed that employees who are eligible to participate in 401(k) plans have increased their personal savings without substituting 401(k) contributions for other financial-asset savings. They also found that younger employees have consistently larger financial assets than their older counterparts had at the same age because the younger employees are saving for retirement through 401(k) plans.
In conducting research for How Will Defined-Contribution Pension Plans Affect Retirement Income? (1993), Andrew A. Samwick of the National Bureau of Economic Research and Jonathan Skinner of the University of Virginia and NBER found that defined-contribution plans yield a higher average return for nearly every participant than do defined-benefit plans and reduce income inequality among retired participants.

Profit sharing and employee empowerment

In Participation, Productivity and the Firm's Environment (1989), David Levine and Laura D'Andrea Tyson of the University of California at Berkeley found that "[j]ust as participation can lead to demands for profit sharing, profit sharing can lead to demands for participation. When there is profit sharing, workers' incomes depend on the decisions of the firm and the workers want to have a say in these decisions." They also report: "One can imagine profit sharing without participation and vice versa, but in fact the two are likely to go together in participatory systems. In the short run, participation may be its own reward for many employees. In the long run, however, sustained, effective participation requires that employees be rewarded for the extra effort which such participation entails, and that they receive a share of any increased productivity or profits." (Note: this paper was published by The Brookings Institution in Paying for Productivity: A Look at the Evidence.)

Profit sharing and labor stability

For their 1990 report, Study of Small Businesses Supports Link Between Profit Sharing and Employment Stability, James Chelius of Rutgers University and Robert S. Smith of the New York School of Industrial and Labor Relations at Cornell University examined about 3,000 small business' experiences with profit-sharing, labor turnover, product price and sales in a 1989 study which reported that profit-sharing firms experience greater labor stability during sales downturns.
Annual surveys conducted jointly by PSCA and Hewitt Associates between 1973 and 1988 found that the average participant turnover rate at profit-sharing companies is 13 percent, a figure substantially lower than the 21.6 percent national rate reported by the Bureau of Labor Statistics in 1987.
In a 1987 study, Profit Sharing and Employment Variability: Microeconomic Evidence on the Weitzman Theory, Douglas L. Kruse of Rutgers University found that manufacturing companies with profit-sharing plans had smaller employment decreases than other manufacturing companies during business downturns. When the unemployment rate increased by one point, manufacturing companies in which all employees participated in a profit-sharing plan had a 2.0-percent decrease in employment, compared with a 3.1-percent decrease for non-profit-sharing companies.
The groundbreaking study that generated much of the subsequent interest in profit sharing among academics was published in 1984 by Martin Weitzman of the Massachusetts Institute of Technology. In The Share Economy Weitzman theorized that employees of profit-sharing companies should have greater employment stability over the business cycle but show greater wage variability than other employees-assuming that profit-sharing contributions introduce a variable component into the compensation schedule. When profits fall, employees' wages decrease, allowing employers to retain more employees at approximately the same relative cost. In contrast, with a fixed-wage compensation arrangement, wage costs only can be reduced by laying off workers.

Profit sharing and organizational commitment

For his 1989 Ph.D. dissertation, The Organizational Impact of Profit Sharing, Gary W. Florkowski of Syracuse University found a significant statistical relationship between organizational commitment, job satisfaction and profit sharing.
In a 1987 random-sample survey of 4,060 employees of British profit-sharing companies by D. Wallace Bell and Charles G. Hanson, 73 percent of survey respondents indicated that profit sharing had improved their attitudes and 68 percent felt that the introduction of profit sharing had improved their view of the company as an employer. Their paper, Profit Sharing and Profitability, reported on profit sharing's impact on companies' financial performance, as well as employee attitudes.

Profit sharing and productivity

For his 1993 book, Profit Sharing: Does It Make A Difference?, Douglas L. Kruse studied the relationship between productivity and the adoption and presence of profit sharing using survey data from 500 U.S. companies (half with profit sharing and half without) matched to 1971 through 1991 company performance. He also collected data on the types of profit sharing, as well as union activity and human-resources policies (such as employee-involvement programs) that may complement or compete with profit sharing in affecting employee behavior. He concluded that the adoption of a profit-sharing plan was associated with a 3.5-percent to 5-percent increase in productivity. (For additional details, see Table 1.) In addition, he found that cash profit sharing and deferred profit sharing have different effects on productivity. Cash profit sharing has a more immediate effect on productivity, while deferred plans have a longer-term impact.
For Profit Sharing and Productivity (1989), Martin L. Weitzman of Harvard University and Douglas L. Kruse reviewed 16 studies examining the link between profit sharing and productivity. They concluded that the studies, taken as a whole, indicate that companies experience a median 4.4-percent productivity increase when they share profits. (Note: this paper and the one cited immediately below were published by The Brookings Institution in Paying for Productivity: A Look at the Evidence.)
In Alternative Pay Systems, Firm Performance and Productivity (1989), Daniel J. B. Mitchell of the University of California-Los Angeles, David Lewin of Columbia University and Edward Lawler of the University of Southern California found that profit sharing was associated with higher productivity and improved employee performance during the 1980s.
In his 1987 Ph.D. dissertation, The Effect of Profit Sharing on Productivity, Edward Morse Shepard III of Boston College reported a significant positive link between productivity and deferred profit sharing in a 1987 study of U.S. chemical firms.

Profit sharing and profitability

The U.S. Chamber of Commerce for its 1989 Employee Benefits Report sought to determine whether companies that offer profit-sharing benefits are more profitable than companies that do not offer such benefits. The Chamber used four measures to define profitability -profit margin on sales, basic earning power, return on assets and return on stockholder equity-and calculated each profitability measure by taking a weighted average of these four ratios for each company. With a random sample of 50 companies-13 with profit sharing and 37 without-the Chamber found that the profitability ratio was .019 for the profit-sharing companies and 0.95 for the non-profit-sharing ones.
In Profit Sharing Firms Out-Perform Non-Sharers in '87, the Profit Sharing Research Foundation reported that its 1988 study of 796 of the largest U.S. companies found that the 386 that share profits are more profitable than the 410 that do not.

Profit sharing and total compensation

For its 1989 Employee Benefits Report, the U.S. Chamber of Commerce used cross-sectional data from its 1987 report to determine whether companies offer profit-sharing benefits as a supplement or substitute to other existing benefits or money wages. The sample was divided into four groups: manufacturing firms with profit sharing; non-manufacturing companies with profit sharing; manufacturing firms without profit sharing; and non-manufacturing companies without profit sharing. The Chamber then calculated the average compensation levels of benefits excluding profit sharing in terms of dollars per hour for each of the four groups. To reduce a bias from the aggregation of industries that have different average pay levels, they indexed each industry's payroll and compensation to the industry classifications used by the Department of Commerce's Bureau of Economic Analysis. The result: average benefits excluding profit sharing per hour are higher for both manufacturing and non-manufacturing companies without profit-sharing plans than for those with profit-sharing plans. However, if profit-sharing benefits are included, profit-sharing companies pay more benefits than those that don't share profits. (See Table 2.)

Table 1. Productivity gains experienced by profit-sharing companies


			      Yearly growth            Yearly growth  
                                 in sales              in value added*
                              per employee (%)         per employee (%)
                            ____________________     ____________________
                                  Within-industry	   Within-industry
                            All	     pairs**	     All      pairs**
                           _______________________________________________

All profit-sharing plans       
 Year of adoption	    4.4        4.3	     5.0	   3.5
 Subsequent trend	    0.2        0.8	     1.0	   1.9
						
Cash vs. deferred plans						
   Cash profit sharing						
      Year of adoption	     3.5       6.5	     3.6	   4.3
      Subsequent trend	     0.5      -0.4	    -0.3	   0.8
   Deferred profit sharing						
      Year of adoption	     1.8       0.9	     1.4	  -1.1
      Subsequent trend	     0.2       2.5	     3.6	   2.7
						
Plan formulas						
   Percent-of-profits plan						
      Year of adoption	     4.8       2.2	     7.9	   1.4
      Subsequent trend	    -0.2       3.7	    -2.5	   0.5
   Discretionary plan					
      Year of adoption	     7.7       3.8	     9.2	  10.5
      Subsequent trend	    -0.4       3.5	     2.1	   5.0
   Percent-of-pay plan						
      Year of adoption	     2.2       3.3	    -1.6	   4.4
      Subsequent trend	    -1.7       2.4	    -2.8	  -5.1
   Other plan formula						
      Year of adoption	     1.6       2.9	     0.7	   1.6
      Subsequent trend	    -0.1      -0.9	    -0.4	  -1.2

Source: Profit Sharing: Does It Make a Difference?
Notes: * Value added - (the sales price minus the value of raw materials) divided by the number of employees. ** Within-industry pairs results are the difference between profit-sharing and non-profit-sharing companies in the same industry and year.

Table 2. Profit sharing’s effect on hourly benefits, wages and total compensation

Hourly	 Hourly	  Profit-Sharing   Hourly Total 
		       Wages	Benefits     Benefits 	   Compensation
________________________________________________________________________
Manufacturing
   Profit sharing	$11.01	  $3.88	       $.43 	     $15.32
   Non-profit sharing	 11.04     4.03			      15.08

Non-manufacturing
   Profit sharing	  10.73	   3.33         .47	      14.53
   Non-profit sharing	  10.10	   3.44			      13.53

Source: Employee Benefits Report

References

Annual Survey of Profit Sharing and 401(k) Plans. Chicago: Profit Sharing Council of America. 1957-95.

Employee Benefits Report. Washington: U.S. Chamber of Commerce. 1989.

"Profit Sharing Firms Out-Perform Non-Sharers in '87." Report 1988-1. Chicago: Profit Sharing Research Foundation. 1988.

Bell, D. Wallace and Charles G. Hanson. Profit Sharing and Profitability. London: Kogan Page Limited. 1987.

Blinder, Alan S. (ed.). Paying for Productivity: A Look at the Evidence. Washington: The Brookings Institution. 1990.

Chelius, James and Robert S. Smith. "Study of Small Businesses Supports Link Between Profit Sharing and Employment Stability." Report 1990-1. Chicago: Profit Sharing Research Foundation. 1990.

Florkowski, Gary W. The Organizational Impact of Profit Sharing. Ph.D. Dissertation. Syracuse University. 1989.

Kruse, Douglas L. Profit Sharing: Does It Make a Difference? Kalamazoo, Mich.: W.E. Upjohn Institute for Employment Research. 1993.

Kruse, Douglas L. "Profit Sharing and Employment Variability: Microeconomic Evidence on the Weitzman Theory." Industrial and Labor Relations Review. April 19, 1991.

Samwick, Andrew A. and Jonathan Skinner. "How Will Defined Contribution Pension Plans Affect Retirement Income?" Presented at Public Policy Towards Pensions conference sponsored by the Association of Private Pension and Welfare Plans and the Center for Economic Policy Research. Stanford University. October 7-8, 1993.

Shepard, Edward Morse III. The Effect of Profit Sharing on Productivity. Ph.D. Dissertation. Boston College. 1987.

Weitzman, Martin L. The Share Economy. Cambridge, Mass.: Harvard University Press. 1984.

Wise, David A. "IRAs, 401(k)s, and Saving." Testimony before the Senate Finance Committee. February 2, 1995.

Acknowledgments

PSCA gratefully acknowledges the assistance provided by the following people and organizations during the preparation of this paper.

PSCA's National Retirement-Income Policy Task Force:

Brian Fagan, Director of Benefits Accounting, Ogden Services Corp.
Sheila Forsberg, Manager of Benefits Planning, Motorola
John Greenwell, Principal, Arthur Andersen & Co. S.C.
David A. Hildebrandt, Senior Partner, Dow Lohnes & Albertson
Linda P. Holleman, Senior Vice President, Godwins Booke & Dickenson
Deborah R. Iwig, Vice President-Retirement Benefits, Marriott International
Michael L. Johnston, Actuary/Principal, Hewitt Associates
Robert F. Karsch, Vice President, Bankers Trust Co.
Richard L. Menson, Partner, Gardner Carton & Douglas
Rita D. Metras, Director of Benefits Policy, Pension & Savings Plans, Eastman Kodak Co.
Robert H. Smith, Senior Tax Counsel, Exxon Corp.
Allan W. TeRonde, Vice President, American Grinding & Machine Co.
Pamela Toussaint, Manager of Benefit Delivery, Ameritech