November 2003
Vol. VII, No. 1
ERISA, EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION NEWSLETTER
This past year has been busy indeed as a result of numerous legal changes brought about by Congress (Sarbanes-Oxley Act and various ERISA and tax bills) and pronouncements by the Internal Revenue Service, Department of Labor and Pension Benefit Guaranty Corporation. For the benefit of our clients and business associates, this newsletter summarizes these important changes in the employee benefits area. The newsletter is not intended as, and cannot be considered to constitute, specific legal advice, as each individual circumstance is unique. However, we are prepared to assist our clients and business associates in reviewing their employee benefit programs and in making any necessary or desirable revisions to take into account changes in the law. [1]
Since our last newsletter, Marcia S. Wagner has continued to lecture and write extensively, and has been named as one of the top ERISA/employee benefits attorneys in Massachusetts by the prestigious Corporate Counsel Journal. She has also been quoted in several major news publications, including Newsweek and Pension & Investments, and has provided numerous seminars for the American Bar Association, Society of Enrolled Actuaries, Internal Revenue Service and others. Marcia has also authored a well-received article for the Bureau of National Affairs Tax Management Compensation Planning Journal entitled "Managed Accounts: Are They the Answer?" She has also received the 2002 New England Employee Benefits Council "Best Practices" Award and has been appointed as a Delegate to Harvard Law School. Ari J. Sonneberg continues his work at the Tax Section Council of the Massachusetts Bar Association. John R. Keegan, Esq., Jon C. Schultze, Esq., Virginia Peabody and Rebecca Watson have joined the firm.
In the event you desire legal advice or consultation or wish
to discuss the appropriate timing of necessary plan amendments
or any other benefits issues, please feel free to contact Attorney
Marcia S. Wagner, Attorney Christopher J. Sowden, Attorney John
R. Keegan, Attorney Katharine Butler Nesta, Attorney Ari J. Sonneberg,
or Attorney Jon C. Schultze.
Footnotes appear in [ ] at end of the article.
__________________
TABLE OF CONTENTS
__________________
COST OF LIVING ADJUSTMENTS
I. TAX-QUALIFIED PLANS
A. VOLUNTARY FIDUCIARY CORRECTION PROGRAM
B. DOL SIMPLIFIES DFVC PROGRAM; IRS AND PBGC WAIVE
PENALTIES
C. SMALL PLAN AUDITS
D. IRS MODIFIES EPCRS VOLUNTARY PLAN CORRECTION PROGRAM
E. FINAL 204(H) NOTICE REGULATIONS
F. IRS PROVIDES WAIVER OF 60-DAY ROLLOVER RULE IN CERTAIN
CASES
G. ERISA'S FIDUCIARY STANDARDS FOR SELECTING ANNUITY
PROVIDERS
H. JOB CREATION AND WORKER ASSISTANCE ACT OF 2002
I. REMEDIAL AMENDMENT PERIODS
J. IRS CLARIFIES PLAN QUALIFICATION NOTICE REQUIREMENTS
K. IRS FINALIZES MINIMUM REQUIRED DISTRIBUTION RULES
L. IRS MODIFIES RULES FOR EARLY PLAN DISTRIBUTIONS
M. ENRON LITIGATION
N. GUIDANCE ON CLAIMS PROCEDURE REGULATIONS AFFECTS
PENSION PLANS
II. DEFINED BENEFIT PENSION PLANS
A. CASH BALANCE PLANS
B. IRS MODIFIES RULES FOR EXPLAINING DEFINED BENEFIT
DISTRIBUTION OPTIONS
C. IRS CLARIFIES TREATMENT OF DEFINED BENEFIT PLAN
ANNUITY OVERPAYMENTS
D. ELIMINATION OF COLA BENEFITS FOR RETIREES DOES NOT
VIOLATE ANTI-CUTBACK RULES
III. DEFINED CONTRIBUTION PLANS 2
A. IRS PROPOSES MODIFICATIONS TO OPTIONAL FORMS OF
BENEFIT REGULATIONS TO CONFORM TO EGTRRA
B. DOL GUIDANCE ON PAYING EXPENSES FROM PLAN ASSETS
C. IRS GUIDANCE ON DEEMED IRAS
D. FINAL REGULATIONS ON QUALIFIED PLAN LOANS COVER
MAXIMUM TERM OF LOANS, LOANS MADE
AFTER A DEEMED DISTRIBUTION, LOAN REFINANCING, AND MULTIPLE LOANS
E. IRS LETS EMPLOYEE LEASING GROUPS CONVERT TO MULTIPLE
EMPLOYER PLANS
F. MONEY PURCHASE PENSION PLAN'S CONVERSION OR MERGER
INTO PROFIT SHARING PLAN NOT
PARTIAL TERMINATION, BUT REQUIRES PARTICIPANT NOTICE
G. GUIDANCE ON RESTORATIVE PAYMENTS
H. 401(K) PLANS
I. PROSPECTUS PROFILE COMPLIES WITH ERISA SECTION 404(C)
IV. EXECUTIVE COMPENSATION
A. GOLDEN PARACHUTE PROPOSED REGULATIONS
B. REVISED RULES ON SECTION 457 PLANS
C. SPLIT-DOLLAR REGULATIONS FINALIZED
V. SARBANES - OXLEY
A. BACKGROUND
B. DOL FINAL REGULATIONS
C. SEC FINAL REGUALTIONS
D. EXECUTIVE COMPENSATION ASPECTS OF THE SARBANES-OXLEY
ACT
E. INDEPENDENCE RULES
F. REGISTERED PUBLIC ACCOUNTING FIRMS
G. ENRON AND SIMILAR PENSION LITIGATION
VI. WELFARE BENEFIT PLANS
A. OPEN ENROLLMENT ISSUES
B. IRS OVERHAULS WELFARE BENEFIT FUND RULES TO CURB
DEDUCTION ABUSE
C. COBRA ISSUES
D. IRS RULES ON DEDUCTIBLE MEDICAL EXPENSES
E. CAFETERIA PLAN AND FLEXIBLE SPENDING ACCOUNT ARRANGEMENTS
F. HIPAA
G. FRINGE BENEFIT PLANS RELIEVED FROM SCHEDULE F REPORTING
REQUIREMENT
H. HEALTH REIMBURSEMENT ARRANGEMENTS
VII. MISCELLANEOUS
A. DOL RENAMES PWBA TO BE THE EMPLOYEE BENEFITS SECURITY
ADMINISTRATION (EBSA)
B. IRS FINAL REGULATIONS REQUIRE TAX SHELTER DISCLOSURE
STATEMENTS FOR PLANS
C. MILITARY LEAVE OBLIGATIONS
COST OF LIVING ADJUSTMENTS
This newsletter reports the 2004 index limits for Social Security benefits, the Internal Revenue Service ("IRS") limits for qualified retirement plans, the Pension Benefit Guaranty Corporation ("PBGC") guarantee limit and the Medicare rates.
| 2003 | 2004 | |
| Maximum annual payout from
a defined benefit plan at or after age 62 |
$160,000* | $165,000* |
| Maximum annual contribution to an individual's defined contribution account | $40,000 | $41,000 |
| Maximum Section 401(k), 403(b) and 457(b) elective deferrals | $12,000** | $13,000** |
| Section 401(k) and Section 403(b) catch-up limit for individuals aged 50 and older | $2,000** | $3,000** |
| Maximum amount of annual compensation
that can be taken into account for determining benefits or contributions
under a qualified plan |
$200,000 | $205,000 |
| Test to identify highly compensated
employees, based on compensation in preceding year |
$90,000 | $90,000 |
| Wage Base: For Social Security Tax | $87,000 | $87,900 |
| For Medicare | No Limit | No Limit |
| Maximum Social Security Benefit for a worker
retiring at age 65 and 2 months in 2003 or retiring at age 65 and 4 months in 2004 |
$1,741/month | $1,825/month |
| Earnings Test Early Retirement (Age 62)
(amounts that can be earned before benefits are cut)*** |
$11,520/year*** | $11,640/year*** |
| PBGC Maximum Guarantee | $3,664.77/month | $3,698.86/month |
* There are late-retirement adjustments for benefits starting
after reaching age 65.
** These are calendar year limitations.
*** Under the Senior Citizens' Freedom to Work Act of 2000, people
who are covered by Social Security can receive their full benefits
once they reach Social Security normal retirement age (age 65
and 2 months in 2003 and age 65 and 4 months in 2004) regardless
of how much they work and earn.
I. TAX-QUALIFIED PLANS
A. Voluntary Fiduciary Correction Program
1. Voluntary Fiduciary Correction Program In General.
Under the Voluntary Fiduciary Correction ("VFC") program, plan officials, sponsoring employers, and certain parties to eligible prohibited transactions may apply to the Department of Labor ("DOL") for relief in connection with their voluntary correction of specific violations of the law. Applicants must fully correct any prohibited transactions, calculate any losses, and restore those losses with interest or profits, and distribute any supplemental benefits owed to eligible participants and beneficiaries. If properly corrected, plan officials will receive a "no action" letter indicating there will be no further enforcement action by the Department on the corrected transaction.
In March 2000, the DOL instituted on an interim basis the VFC program, under which plan fiduciaries (and others) can avoid the assessment of civil penalties under ERISA Section 502(l) for breaches of fiduciary duties by self-correcting the breaches and reporting them to the DOL. The VFC program was adopted as final on March 28, 2002 (PWBA Notice RIN 1210-AA76, 67 Fed. Reg. 15062).
In response to the concern that participants in the VFC program might be held liable for the Internal Revenue Code (the "Code") Section 4975 excise taxes on prohibited transactions solely due to their participation in the VFC program, the DOL, when finalizing the VFC program, also issued a proposed Prohibited Transaction Class Exemption ("PTCE") that provides limited excise tax relief for the correction of certain transactions under the VFC program. The DOL has now granted the proposed PTCE (Prohibited Transaction Class Exemption 2002-51, 11/25/2002). This PTCE provides excise tax relief for the correction of the first four transactions listed below ((a)-(d)).
The list of fiduciary breaches that are eligible for correction under the VFC program are:
(a) Late payment of participant contributions to pension or
welfare plans;
(b) Loans to or from parties-in-interest at below market interest
rates;
(c) Purchase or sale of assets between a plan and a party-in-interest;
(d) Sale and leaseback of property to a sponsoring employer;
(e) Purchase or sale of assets between a plan and an unrelated
party at below-market value;
(f) Under- or over-payment of benefits due to inaccurate valuation
of plan assets;
(g) Payment of duplicate, excessive or unnecessary compensation;
and
(h) Payment of dual compensation to a fiduciary.
2. Notice Requirements.
Although the interim VFC program's notice requirement (requiring
that plan participants and other interested parties be notified
of a plan's participation in the VFC program) was eliminated
when the VFC program was adopted as final, an applicant taking
advantage of the excise tax relief under PTCE 2002-51 must satisfy
the exemption's notice provisions. These
provisions require that:
(a) written notice of the transactions that the applicant is seeking relief for under the VFC program and PTCE 2002-51, as well as the method of correcting the transactions, be given to interested persons within 60 calendar days following the date the VFC program application is submitted to the appropriate DOL regional office;
(b) the notice must include a description of the transaction and the steps taken to correct it. The notice must be written in a manner that can be reasonably understood by the average plan participant; and
(c) the notice must provide for a 30-day comment period, beginning on the date the notice is distributed, for interested persons to provide comments to the appropriate DOL regional office, and must include the address and telephone number of that office.
The notice may be given in any manner that is reasonably calculated to result in the interested parties receiving it. This includes posting, regular mail, or electronic mail, or any combination thereof.
Comment: In most cases, we strongly recommend that the VFC program be utilized to correct breaches of fiduciary duty.
B. DOL Simplifies DFVC Program; IRS And PBGC Waive Penalties
The DOL issued notice of modifications to its Delinquent Filer Voluntary Compliance ("DFVC") program providing reduced civil penalties under ERISA and simplified filing procedures for delinquent Form 5500 filers who voluntarily file late Forms 5500 under the program (67 Fed. Reg. 15052-15060 (2/28/2002). Simultaneously with that notice, the IRS in AdvNotice 2002-23, 2002-15 IRB, 4/15/2002 issued a separate notice of relief, waiving certain civil penalties normally assessed against delinquent Form 5500 filers if they comply with, and participate in, the revised DFVC program.
1. Chart of DOL Penalties.
To encourage participation in the DFVC program, the DOL modified the DFVC program penalty structure to offer reduced per-day penalties for all plans, a special penalty cap for "single" violations, and a per-plan cap for submissions reporting all annual reporting violations under a particular plan.
| PENALTY CATEGORY | NEW PENALTY |
| Per day late filing penalty | $10 |
| Maximum per 5500 penalty | Small plans -$750 Large plans - $2,000 |
| Maximum per plan penalty | Small plans - $1,500 Large plans - $4,000 |
2. IRS Notice 2002-23 and PBGC relief under the DFVC Program.
The IRS and PBGC have agreed to provide penalty relief for delinquent Form 5500 submissions made in conjunction with the DFVC program. Thus, plan administrators that participate in the revised DFVC program are eligible for waiver of the penalties assessed for certain Form 5500-related filing violations under the Internal Revenue Code (the "Code") and ERISA.
The PBGC is providing similar relief from the assessment of the penalty under ERISA Section 4071, which is imposed for late Form 5500 submissions.
Under Notice 2002-15, if a late filer satisfies the requirements of the revised DFVC program and pays the applicable penalty, the IRS will waive all penalties. The waivers will be automatic, without the need for any application for relief, and IRS will coordinate its waiver determinations with the DOL.
Note: The reduced DOL penalties and the IRS and PBGC relief are good news for those who have failed to timely file Form 5500s. This relief will be particularly useful for employers that acquire noncompliant plans as a result of a merger or acquisition, or who fail to file because they exceeded the 100 participant threshold for welfare plans and were not aware they needed to file.
C. Small Plan Audits
1. Department of Labor Proposes Annual Audits.
Under current law, any tax-qualified plan with 100 or more participants at the beginning of a plan year must obtain an annual audit of the plan and its operations from an independent qualified public accountant. Small plans (those with fewer than 100 workers) are exempt from this requirement.
Concerned about the vulnerability of small plans to asset misappropriation and other abuses, the DOL believes additional protection may be needed for the assets of those plans.
Under proposed regulations, generally a small plan must obtain an annual audit of the plan and its operations from an independent qualified public accountant. A small pension plan may claim an exemption from the audit requirement, if three conditions are satisfied:
(a) At least 95 percent of the plan's assets are qualifying plan assets ("QPA") (generally, assets that carry very little risk of loss due to fraud or dishonesty, such as publicly traded stocks, bonds and mutual funds) or any person who handles plan funds is bonded for at least the value of the assets that are not QPAs. (Note: This is more onerous than current bonding rules, which generally require the bond value to be only 10 percent of the funds handled);
(b) The summary annual report provided to plan participants contains additional information on the plan assets and entities holding the plan's assets; and
(c) The administrator makes available for examination a statement from any regulated financial institution holding the plan's assets and evidence of any bond required by regulation. This condition is met only if the plan administrator furnishes copies, free of charge, to any participant who requests this information.
2. Qualifying Plan Assets.
The new regulations classify plan assets as "qualifying plan assets," when the asset falls into any one of the following six categories: (i) qualifying employer securities as defined in ERISA Section 407(d)(5); (ii) a participant loan; (iii) assets that are held by any of the following institutions: (a) bank or similar financial institution; (b) insurance company; or (c) registered broker-dealer or any other organization authorized to act as trustee for individual retirement accounts under Code Section 408; (iv) shares issued by a registered investment company registered under the 1940 Act; (v) investment and annuity contracts issued by an insurance company; and (vi) assets in individual accounts of participants or beneficiaries over which the participants or beneficiaries have the opportunity to exercise control and where statements from a registered financial institution reflecting such assets are given to the participants or beneficiaries on an annual basis.
3. Summary Annual Report ("SAR") Rules.
Currently all plans are required to provide a summary of the financial information that is included in Form 5500 by preparing and distributing the SAR to each plan participant and beneficiary. Small plans that claim an exemption from the audit requirement will now have to include in the SAR additional information on the institutions holding qualifying plan assets, the name of the surety company issuing the ERISA bond and a notice on obtaining additional information on the plan assets and the ERISA bond.
D. IRS Modifies EPCRS Voluntary Plan Correction Program
1. Introduction.
The IRS has updated and streamlined its Employee Plans Compliance Resolution System ("EPCRS"), a comprehensive system of correction programs for sponsors of retirement plans that have not met the Code's qualification requirements (Rev. Proc. 2003-44, 2003-25 IRB; IR 2003-74, 6/4/2003 and Rev. Proc. 2002-47, IRB 2002-9). EPCRS permits plan sponsors to correct qualification failures, thereby continuing to provide participants with retirement benefits on a tax-favored basis.
2. Background.
In the early 1990s, the IRS introduced a number of pilot programs to encourage compliance among tax-qualified retirement plan sponsors by enabling them to correct plan defects without incurring harsh penalties.
Since its official introduction, EPCRS has been successful in promoting compliance among plan sponsors by giving them the ability to correct most defects in their plans, thus enabling plan sponsors to maintain the tax-qualified status of their plans. Due to the continued success of EPCRS, the IRS has sought to streamline and expand the program to accommodate a wide variety of plan sponsors and eliminate barriers that complicate compliance with applicable law.
Note: Marcia Wagner has been influential in the creation and development of EPCRS and this law firm sub-specializes in rectifying plan disqualification issues. Ms. Wagner has also authored a Bureau of National Affairs Tax Management Portfolio on EPCRS, and has lectured extensively on this topic.
EPCRS continues to be driven by three main components:
(a) Self-Correction Program ("SCP"). Employers or plan administrators identify operational and other failures and self-correct the problems pursuant to IRS guidelines without seeking IRS approval.
(b) Voluntary Correction Program ("VCP"). Plan sponsors submit proposed correction methods for all qualification failures (operational, plan document, demographic, and employer eligibility) to the IRS for approval, pay a compliance fee, and receive written assurance that the IRS has approved the correction methodology. Such submissions may be anonymous.
(c) Audit Closing Agreement Program ("Audit CAP"). Plan sponsors negotiate with the IRS about correcting defects discovered during an audit, and request a lesser sanction in lieu of disqualification.
3. Changes made to EPCRS by Rev. Proc. 2002-47.
Rev. Proc. 2002-47 retains the existing core structure of EPCRS, including its key components. Thus, the Rev. Proc. 2002-47 changes are consistent with the IRS's intention to periodically update and improve the EPCRS revenue procedure based on comments received and IRS experience in administering the program.
The Revenue Procedure:
(a) extends the duration of the self-correction period under SCP for correcting significant operational compliance failures where the plan sponsor assumes the plan in conjunction with a corporate merger, acquisition or similar transaction to the last day of the first plan year that begins after the corporate merger, acquisition or other similar employer transaction;
(b) extends the Anonymous Submission Procedure indefinitely;
(c) expands the Anonymous Submission Procedure to permit the submission of more types of plan failures;
(d) expands the Anonymous Submission Procedure to VCGroup and VCSEP submissions;
(e) expands "employer eligibility failure" to include the adoption of a 401(k) plan by any ineligible employer;
(f) broadens the VCGroup procedures to permit eligible organizations to submit operational and plan document failures in a single submission;
(g) increases the de minimis threshold amount from $20 to $50 for purposes of making any corrective distributions to make an affected participant or beneficiary whole (for example, a distribution to correct an earlier underpayment of a participant's benefit under a defined benefit plan);
(h) adds a de minimis rule for correcting certain overpayments i.e., benefit payments in excess of the Code's limits excusing a plan sponsor from correcting plan overpayment if the total amount of an overpayment to a participant or beneficiary does not exceed $100;
(i) clarifies that failures under a terminated plan are eligible for correction under VCP;
(j) clarifies what items may be excluded from the initial submission under the Anonymous Submission Procedure. Items that a plan sponsor may exclude from an initial submission under the Anonymous Submission Procedure are the name of the plan or plans and the name of the plan sponsor or sponsors (or other filer). The materials included in the submission package may have this information redacted, and the application need not include a power of attorney or a penalty of perjury statement;
Comment: Rev. Proc. 2002-47 clearly provides that, until a plan sponsor provides the identifying information to the IRS, the IRS is not precluded from beginning an examination of the plan or plan sponsor. If IRS were to begin an examination before entering an agreement with the plan sponsor and receiving the appropriate identifying information, the plan and plan sponsor lose eligibility for both the Anonymous Submission Procedure and VCP.
(k) updates the requirement that, if a plan must have received a favorable determination, opinion, or advisory letter for eligibility for a particular program, the plan must have received a letter or certification that considers GUST, [2] as well as earlier laws;
(l) clarifies the factors considered under Audit CAP in determining a sanction amount by focusing more specifically on the steps taken to prevent, identify, and halt the continued progression of any failures under the plan; and
(m) revises the VCP Checklist for assuring that a VCP application is complete, and which is submitted to IRS as part of a VCP submission, to include questions relating to the transfer of plan assets pursuant to a plan merger or similar transaction relating to a corporate business transaction, and the waiver of federal excise under Code Section 4974 (for excess accumulations because of a failure to comply with the minimum distribution requirements under Code Section 401(a)(9)).
4. Changes to EPCRS Made by Rev. Proc. 2003-44.
Rev. Proc. 2003-44 modifies and supersedes Rev. Proc. 2002-47, but maintains the basic structure and changes to EPCRS described above.
The Revenue Procedure contains the following modifications:
(a) EPCRS is now available for the correction of failures in SIMPLE IRA plans;
(b) Voluntary Compliance of Operational Failures Standardized procedure ("VCS") has been eliminated;
(c) VCP, which previously consisted of seven sub-programs categorized by type of failure, has now been consolidated into a single program;
(d) The payment structure for VCP has been simplified;
(e) SIMPLE IRAs and SEPs may utilize the Anonymous and Group Submission programs;
(f) Plans which have failed to adopt good faith amendments to comply with the Economic Growth and Tax Relief Reconciliation Act of 2001 may use EPCRS to obtain approval of late amendments;
(g) A correction method for the failure to obtain spousal consent has been added: in the event that spousal consent cannot be obtained due to spousal refusal, failure to respond, or because the spouse cannot be located, the spouse is entitled to a benefit equal to the portion of the qualified joint and survivor annuity that would have been payable to the spouse upon the death of the participant had a qualified joint and survivor annuity been provided to the participant under the plan at his or her retirement;
(h) EPCRS was revised to clarify the special exception to full correction for imprecise or unavailable data: reasonable estimates can be used in calculating the appropriate correction where it is not possible to make precise calculations; and
(i) As in the previous version of EPCRS, a plan sponsor is not required to seek the return of a small overpayment (less than $100) from a beneficiary or participant, but now is required to notify the participant or beneficiary that the overpayment is not eligible for favorable tax treatment accorded to distributions from qualified plans.
E. Final 204(h) Notice Regulations
1. Background.
The IRS has issued final regulations under Section 204(h) of ERISA and Section 4980F of the Code concerning advance notice of a reduction in future pension benefits (Reg. Section 54.4980F-1). The final regulations, which are quite similar to the rules proposed last year, affect defined benefit and money purchase pension plans.
2. When Notice is Required.
The notice requirement is triggered by a plan amendment that
may result in a significant reduction in either the rate of future
benefit accruals or an early retirement benefit or
retirement-type subsidy. This includes:
(a) the dollar amount or percentage of compensation on which benefit accruals are based;
(b) the definition of service or compensation used in calculating benefit accruals;
(c) the method of determining compensation for calculating benefit accruals;
(d) the definition of normal retirement age in a defined benefit plan;
(e) benefit offset provisions; and
(f) minimum benefit provisions.
The final regulations add two new rules:
(a) A change in a document to which a plan refers in determining benefit amounts, such as a collective bargaining agreement, is considered a plan amendment for which notice must be given before the rate of benefit accrual can decline. Thus, if a multiemployer plan incorporates a collective bargaining agreement by reference, and if that collective bargaining agreement significantly reduces the rate of future benefit accruals, a 204(h) notice is required; and
(b) The conversion of a money purchase pension plan to a profit sharing plan is always considered an amendment reducing benefits, even if employer contributions are expected to stay at the same level.
Notices are not required for changes in plan features that are not protected from reduction by Code Section 411(d)(6) (e.g., provisions for plan loans and disability benefits).
3. Required Content.
The notice must give enough information to enable recipients to understand the effect of the change, including the scope of the possible benefit reduction.
(a) Accrual Rate Reduction. The notice must include a description of the benefit formula before and after the amendment, and the effective date of change. If the likely magnitude of the change is not reasonably apparent from that description, the notice must also include more detailed explanation, typically with examples; and
(b) Reduction in Early Retirement Benefit. The notice must include a description of how the benefit is calculated before and after the change, and its effective date. As with the notice for accrual rate reductions, more information is required if this description does not give a reasonable picture of the full impact of the change.
4. Delivery Deadline.
In general, notice must be given 45 days before the effective date of the amendment. However, small plans (i.e., those with fewer than 100 participants with accrued benefits on the amendment's effective date) only have to give notice 15 days in advance. Fifteen days is also the notice deadline for plan amendments reducing benefit accrual rates in connection with corporate mergers or spin-offs. For corporate transaction-related amendments that only reduce early retirement benefits or retirement type subsidiaries, not accrual rates, the deadline is 30 days after the effective date of the amendment.
If participants are given a choice between the old and new formulae, they must be provided with adequate information in order to make informed decisions early enough to allow for careful consideration of their choices.
5. Notice Delivery.
A Section 204(h) notice must be provided by first-class mail, hand delivery or approved electronic means. For electronic notices, participants must be alerted to the significance of the notice (e.g., by marking e-mail "urgent") and informed that they can receive a free paper copy upon request. Electronic notice standards are met for anyone who consents to, and provides an address for, electronic delivery, after having been informed that this consent can be withdrawn at any time.
6. Failure to Comply.
If the failure to give a required notice is "egregious," all participants whose benefits would be reduced significantly by the amendment are entitled to their benefit under the terms of the plan before the amendment, if that is higher than the revised benefit. An "egregious violation" is an intentional failure to provide the required notice, failure to provide most of the information to most of the people who should be receiving such information, or a failure to correct an unintentional violation once it is discovered. There is a $100 per day excise tax which will be waived if the IRS determines that the plan sponsor exercised "reasonable diligence" in arranging for distribution of the notice, did not know of the violation, and corrected the violation within 30 days after discovering the violation.
F. IRS Provides Waiver of 60-day Rollover Rule in Certain Cases
1. Background.
An individual can exclude from gross income in the year of receipt certain distributions from qualified plans and individual retirement accounts ("IRA") if the distribution is rolled over to another qualified plan or an IRA within 60 days of receipt of the distribution (the "60-day rule"). A distribution rolled over after the 60th day following the day on which the distributee receives the distribution does not qualify as a tax-free rollover.
EGTRRA amended the Code to allow the IRS to waive the 60-day rule if an individual suffers a casualty, disaster, or other event beyond his reasonable control, and not waiving the 60-day rule would be against equity or good conscience.
Under a newly-issued Revenue Procedure, the IRS will automatically waive the 60-day rollover rule if the failure to satisfy the rule is caused exclusively by bank error and certain other conditions are met. Otherwise, taxpayers may apply for a private letter ruling to obtain a hardship waiver (Rev. Proc. 2003-16, 2003-4 IRB).
2. Automatic Waiver for Failures caused by Bank Error.
Automatic approval of a waiver of the 60-day rule will be
granted if a bank error caused the rollover to be untimely. That
is, the waiver is available if the failure was due solely to
an error on the part of the financial institution. Thus, the
automatic waiver will be granted only if:
(a) the financial institution received the funds prior to the expiration of the 60-day rollover period;
(b) the taxpayer followed all procedures required by the financial institution for depositing the funds into an eligible retirement plan within the 60-day period (including giving instructions to deposit the funds into an eligible retirement plan); and
(c) there would have been a valid rollover, if the financial institution had deposited the funds as instructed.
Further, the funds must actually be deposited into an eligible retirement plan within one year from the beginning of the 60-day rollover period.
3. Private Letter Ruling Process for Obtaining Waiver of the 60-day Rule.
If the automatic approval procedure for obtaining a waiver of the 60-day rule is unavailable, taxpayers may still be able to obtain a waiver by applying for a private letter ruling. Under this process, IRS will waive the 60-day rule where failing to do so would be against equity or good conscience, including casualty, disaster or other events beyond the reasonable control of the taxpayer. More specifically, IRS will consider all relevant facts and circumstances, including:
(a) errors committed by a financial institution;
(b) the taxpayer's inability to complete a rollover due to death, disability, hospitalization, or incarceration;
(c) restrictions imposed by a foreign country;
(d) postal error;
(e) if and how the amount distributed was used (for example, in the case of payment by check, whether or not the check was cashed); and
(f) the time elapsed since the distribution occurred.
Taxpayers must apply to IRS for the hardship exception to the 60-day rule in accordance with the procedures for issuing letter rulings accompanied by the appropriate user fee.
G. ERISA's Fiduciary Standards for Selecting Annuity Providers
In an advisory opinion, the DOL stated that ERISA's fiduciary standards for selecting insurers for pension plan benefit distributions, as set forth in ERISA Interpretive Bulletin 95-1, apply to fiduciaries of defined contribution plans as well as to fiduciaries of defined benefit plans (ERISA Advisory Opinion Letter No. 2002-14A).
1. Background.
In 1995, the DOL issued ERISA Interpretive Bulletin 95-1, to address concerns about plan fiduciaries who had purchased benefit distribution annuities from insurers who had invested a substantial portion of their assets in high-yield securities, known as "junk bonds." Because of the greater risk of default presented by non-investment grade securities, these obligations offer higher rates of return than investment grade securities. Several insurers who had invested heavily in junk bonds, such as the Executive Life Insurance Company, were later forced out of business when the once booming market for junk bonds collapsed in the early 1990s.
2. ERISA Interpretive Bulletin 95-1.
ERISA Interpretive Bulletin 95-1 clarifies that the process of selecting an annuity provider for benefit distribution is a fiduciary act that is governed by the fiduciary standards of ERISA. This includes a fiduciary's duty to act prudently, and solely in the interest of the plan's participants and beneficiaries. The Interpretive Bulletin provides that plan fiduciaries must take steps that are designed to procure the safest annuity available, unless it would be in the interest of the participants and beneficiaries not to do so.
The Interpretive Bulletin also provides factors that should be considered when determining a provider's creditworthiness and claims paying ability, as follows:
(a) the quality and diversification of the annuity provider's investment portfolios;
(b) the size of the insurer relative to the proposed contract;
(c) the level of the insurer's capital and surplus;
(d) the lines of business of the annuity provider and other indications of an insurer's exposure to liability;
(e) the structure of the annuity contract and the guarantees supporting the annuities, such as the use of separate accounts; and
(f) the availability of additional protection through state guaranty associations and the extent of their guarantees.
If a fiduciary does not have the expertise required to evaluate these factors, the fiduciary must be advised by a qualified, independent expert.
The Interpretive Bulletin provides that there are situations where it may be in the interest of participants and beneficiaries to purchase an annuity other than the safest available one; for example, where one annuity is only marginally safer, but much more expensive than a competing annuity. However, increased costs or other considerations can never justify placing participants and beneficiaries at risk by purchasing an unsafe annuity.
3. Application to Defined Contribution Plans.
The Metropolitan Life Insurance Company ("MetLife") sought guidance from the DOL regarding the application of ERISA Interpretive Bulletin 95-1 to the selection of annuity providers for distributions from defined contribution plans.
In response to the questions raised by MetLife, the DOL stated that the fiduciary principles set out in ERISA Interpretive Bulletin 95-1 apply equally to defined benefit and defined contribution plans.
With regard to state guarantees, MetLife requested clarification as to the scope of a fiduciary's consideration. According to the DOL, plan fiduciaries should determine if the annuity provider and the annuity product are covered by state guarantees and the extent of those guarantees, in terms of amounts (e.g., percentage limits on guarantees) and individuals covered (e.g., coverage limited to state residents only).
MetLife expressed concern that fiduciaries should be able to evaluate annuity providers without having to hire an expert in annuity matters. According to the DOL, if the fiduciary who is responsible for selecting an annuity provider has, at the time of the selection, a sufficient level of expertise or knowledge to meaningfully evaluate the claims paying ability and creditworthiness of an annuity provider, the fiduciary would not be required to hire an independent expert.
MetLife also sought confirmation that, in evaluating competing annuity products, cost is an appropriate consideration for the fiduciary of a defined contribution plan where the participant would receive an increased benefit due to the reduced costs. While agreeing that it is appropriate for the fiduciary of a defined contribution plan to take into account the costs and benefits to the participant or beneficiary of competing annuity products, the DOL said that a lower cost cannot justify purchasing an unsafe annuity, even if that annuity would pay a higher benefit amount to the participant or beneficiary.
H. Job Creation and Worker Assistance Act of 2002
Numerous pension and benefit provisions are affected by the Job Creation and Worker Assistance Act of 2002 ("JCWAA"). JCWAA modifies the funding rules applicable to pension plans and makes several technical corrections to pension and benefit measures enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA").
1. Funding Changes.
In response to the increased funding requirements imposed on employers incident to the discontinuation of the 30-year Treasury bond, JCWAA authorizes a temporary increase in the maximum interest rate to be used in determining current liability from 105% to 120% of the weighted average interest rate of 30-year Treasury bonds for plan years beginning after December 31, 2001 and before January 1, 2004. Thus, for plan years beginning in 2002 and 2003, the permissible range of interest rates that may be used in determining the current liability component of the full funding limitation must be a rate that is not less than 90% or greater than 120% of the weighted average interest rate during the 4-year period prior to the beginning of the plan year.
Comment: The discontinuation of the 30-year Treasury bond, announced by the IRS in October 2001, had precipitated further erosion in yields on the bond, resulting in increased required plan contributions by employers, higher insurance premium payments to the PBGC, and larger lump-sum benefit payments to employees who had terminated employment. The higher interest rate in the expanded range reduces a plan's current liability and, thus, lessens the amount of any additional funding contributions that may be required.
2. Technical Corrections to EGTRRA.
The technical corrections include modifications to amendments enacted by EGTRRA that affect plan design and administration and employee retirement planning. In general, JCWAA:
(a) modifies the funding rules governing the use of prior year valuation dates;
(b) provides for the aggregation of plans for the purpose of determining the limit on 401(k) catch-up contributions that may be made by an eligible participant and makes other clarifying corrections;
(c) details the effect of distributions consisting of after-tax contributions on the amount of an individual's saver's credit under Code Section 25B;
(d) clarifies the timing of the employer deductions for ESOP dividends under Code Section 404(k);
(e) explains that after-tax contributions may only be rolled over to a qualified defined contribution plan or an IRA (not a defined benefit plan);
(f) provides ordering rules for the rollover of distributions of pre-tax and after-tax contributions;
(g) allows deemed IRAs to be established under qualified employer plans maintained by governmental employers;
(h) extends the application of the ERISA administration and enforcement rules to deemed IRAs;
(i) clarifies that distributions made upon "severance from employment" will be considered for only one year in determining a plan's top-heavy status;
(j) provides that the 25% deduction limit that generally applies when an employer maintains both a defined benefit plan and a defined contribution plan will not be imposed if the only contributions made to the defined contribution plan are elective deferrals;
(k) corrects the drafting oversight in EGTRRA that limited an employer's contribution to a SEP to 15%, rather than 25% of compensation;
(l) sets forth new rules under Code Section 415(c) for church
plans;
and
(m) allows for the electronic delivery of Forms 1099-R and other information statements to taxpayers, with their consent.
3. JCWAA Subject to EGTRRA's Sunset Provisions.
The technical corrections implemented by JCWAA generally apply to years beginning after December 31, 2001, which is the effective date of most of the amendments enacted by EGTRRA. In addition, the technical corrections to EGTRRA implemented by JCWAA are subject to EGTRRA's sunset provision, pursuant to which all amendments enacted by EGTRRA cease to apply after December 31, 2010.
I. Remedial Amendment Periods
1. IRS Extends GUST Filing Deadline and Minimum Distribution Amendments.
The IRS has recently released Rev. Proc. 2003-72, extending the time for many retirement plans to submit GUST [3] plan amendments for determination letters. The new rules apply to "eligible plans," plans which have a GUST remedial amendment period ("RAP") deadline which generally expires as of September 30, 2003. This includes most prototype and volume submitter plans. The Rev. Proc. has no effect on a plan which had a GUST RAP expiring prior to September 30, 2003, such as an individually designed plan where the plan sponsor did not timely certify an intention to adopt a pre-approved plan.
Under the new Revenue Procedure:
(a) If the sponsor timely restates the plan to conform to GUST within the existing RAP (i.e., September 30, 2003 for most plans), and the sponsor submits a determination letter request by January 31, 2004, the request will be deemed to be within the plan's RAP;
(b) If the sponsor fails to adopt a "bona fide" GUST restatement prior to the end of the existing RAP, a determination letter request by January 31, 2004 will nonetheless be considered timely and entitled to the extension described in paragraph (a), provided the employer submits a $250 compliance fee, payable to the U.S. Treasury, with the determination letter request. This is to be in addition to (and a separate check from) the normal user fee; and
(c) A plan which is not timely amended and submitted, or which does not comply with the procedures in the Rev. Proc., is subject to the late amender rules under EPCRS.
The guidance defines a "timely" GUST plan amendment as an amendment prior to the end of the GUST RAP which is a "bona fide effort" to comply with the GUST requirements. The fact that the sponsor, or the IRS upon plan review, after the GUST RAP expires discovers the need for other amendments does not mean that the sponsor's "timely" GUST amendment did not represent a "bona fide effort" to amend for GUST.
If a plan is not entitled to reliance on an opinion or notification letter for a pre-approved plan (e.g., if a modification is made to a volume submitter specimen plan or prototype plan), the sponsor must timely apply for a determination letter in order to take advantage of the GUST RAP.
2. Minimum Required Distributions Defined Contribution Plans.
Under Revenue Procedure 2003-72, the IRS also extended the deadline for defined contribution plans to amend to conform to the final Code Section 401(a)(9) regulations regarding minimum required distributions until the later of the last day of the plan year beginning in 2003 or the end of the GUST RAP. The Revenue Procedure does not, however, extend the December 31, 2003 deadline by which sponsors of pre-approved plans must amend their defined contribution plans to comply with the new 401(a)(9) rules, and in the case of master and prototype plans, to furnish copies of the amendments to adopting employers. (See Section I.K. of this Newsletter for details regarding the minimum required distribution rules.)
3. Minimum Required Distributions Defined Benefit Plans.
The IRS has postponed the deadline by which defined benefit plans must be amended to comply with the final Code Section 401(a)(9) regulations regarding minimum required distributions. The compliance deadline is postponed until the end of the EGTRRA remedial amendment period, which ends "not prior to the last day of the first plan year beginning on or after January 1, 2005".
4. Updated Mortality Table Amendments.
In Revenue Ruling 2001-62, the IRS updates the mortality tables to be used by defined benefit plans to determine maximum benefit limitations and the present value of accrued benefits for certain purposes. The new mortality tables must be used for distributions with annuity starting dates beginning on or after December 31, 2002.
Plans that need to be amended to include the new mortality tables have until the last day of the plan year that contains the effective date (i.e., December 31, 2002 for calendar year plans) to make such amendments. The Revenue Ruling contains two model amendments that may be used under certain circumstances to adopt the new mortality tables. Plans that make a good faith amendment on a timely basis have the extended EGTRRA remedial amendment period to make corrections (i.e., until the end of the 2005 plan year).
J. IRS Clarifies Plan Qualification Notice Requirements
The IRS has issued final regulations eliminating the requirement that notice to interested parties concerning the filing of a determination application on the qualified status of a retirement plan be in writing.
Formerly, IRS Regulations Sections 7476-1(a)(1) and 7476-2(b) required that, in order to receive a determination on the qualified status of a retirement plan, an applicant had to provide evidence that individuals who qualify as interested parties receive written notice of the determination letter application. The final regulations provide for electronic notification, by stating that the notice may be provided by any method that reasonably ensures that all interested parties will receive it.
The final regulations contain a safe harbor under which plans will satisfy the notice requirement if: (i) the electronic medium is reasonably designed to provide the notice in a manner no less understandable to the distributee than a written paper document, and (ii) at the time the notice or summary is provided, the distributee is advised that he or she may receive a free written paper notice.
K. IRS Finalizes Minimum Required Distribution Rules
1. Introduction.
The IRS has issued long-awaited final regulations on required minimum distributions for qualified plans, 457 plans, tax-sheltered annuity plans and IRAs. In conjunction with the new rules, IRS Notice 2002-27 provides guidance on reports that trustees, custodians and issuers are required to make with respect to minimum distributions from IRAs.
The final regulations retain the simplified rules contained in the proposed regulations issued in 2001, including the uniform lifetime table for determining minimum distributions, but add new provisions relating to life expectancy and beneficiary designations.
2. Life Expectancy Tables.
EGTRRA instructed the Treasury Secretary to modify the life expectancy tables in Code Section 72 in order to reflect current life expectancy. Accordingly, the final regulations adopt new life expectancy tables taking into account increased longevity.
Comment: The new tables, by extending the period over which minimum distributions must be taken, allow employees and beneficiaries to spread out payments and effectively lessen their tax.
3. Determination of Designated Beneficiary.
The final regulations adjust the deadline for determining a designated beneficiary from December 31 of the plan participant's year of death to September 30 of the year following the plan participant's year of death.
4. Default Rule for Post-Death Distributions.
The 2001 proposed regulations and final regulations provide that where an employee who has a designated beneficiary dies before the required beginning date, the life expectancy rule, rather than the five-year rule, is the default distribution rule. Absent a plan provision or election of the five-year rule, the life expectancy rule will apply in all cases in which the employee has a designated beneficiary, and the five-year rule will apply if the employee does not have a designated beneficiary.
5. Annuity Payments.
The rules dealing with annuity payments have been substantially changed from the 2001 proposed regulations and have been issued as temporary and proposed regulations.
Under the temporary rules, annuity payments may be provided for a period certain that is as long as the period under the uniform lifetime table for the employee's age in the year in which the annuity starting date occurs, regardless of who is the employee's designated beneficiary. The same rule applies if the annuity also includes a life annuity or a joint and survivor annuity.
The temporary and proposed regulations also make a number of changes that expand the situations in which increasing annuity payments are permitted. The additional situations are generally only available to annuities purchased from insurance companies.
6. IRA Reporting Requirements.
In Notice 2002-27 the IRS requires trustees, custodians and issuers of IRAs to report the required minimum distribution amounts to the IRA owners, or to calculate it for the owners upon request, but will not require trustees to report the required distribution amount to the IRS. The first report will be due January 31, 2003, alerting IRA owners to the distribution they must take for 2003.
Beginning with required minimum distributions for 2004, the IRA trustee must identify to the IRS each IRA for which a minimum distribution is required for the year, but need not indicate the amount.
L. IRS Modifies Rules for Early Plan Distributions
1. Backround.
Code Section 72 prescribes certain rules for distributions from qualified retirement plans and IRAs. Generally, under these rules, distributions before age 59-1/2 are subject to a 10% excise tax in addition to the normal income tax, unless a distribution is on account of death or disability, or is in the form of substantially equal periodic payments. The periodic payments must be based on the recipient's life expectancy or on the joint life expectancy of the recipient and beneficiary.
Code Section 72 provides that if a recipient's periodic payment amount is modified before the later of age 59-1/2 or 5 years after payments begin, the recipient is subject to the 10% excise tax on payments received, plus interest from the original date to the modification date.
2. Prior Law.
In 1989, the IRS released Notice 89-25, which included three safe harbor methods for determining if payments are substantially equal periodic payments. Under the required minimum distribution method ("RMD") in Notice 89-25, the annual payment is determined by dividing the account balance (including investment gains and losses) by a number taken from a life expectancy table. The annual distribution is redetermined each year based on the remaining account balance and life expectancy. Under the fixed amortization and fixed annuitization safeharbor methods, a distribution amount is determined once in the first year of distribution and the amount remains the same thereafter.
The annual recalculation under the RMD method takes into account investment gains and losses. Under the other two methods, no adjustments are made to the amount initially determined. Therefore, if investment results are unfavorable, the account balance could be exhausted before the life or joint life expectancy of the recipient and/or beneficiary.
3. Revenue Ruling 2002-62.
The IRS provides relief for recipients of distributions from IRAs and tax qualified retirement plans who have elected a fixed method of substantially equal periodic payments. According to the ruling, such individuals have a one-time opportunity, if the plan permits, to switch to the RMD method and, at the same time, change the life expectancy table used. As noted above, the RMD method annually recalculates the distribution amounts based on the remaining life expectancy and account balance, which reflects investment gains or losses. Also, according to the ruling, once a change to the RMD method is elected, the method must be used for determining distributions in all subsequent years.
M. Enron Litigation
The DOL filed an amicus curiae brief in Tittle v. Enron, which argues that Enron executives may be held personally liable for retirement plan losses as a result of their breach of fiduciary duties.
The DOL's brief makes the following legal points:
1. Fiduciaries responsible for monitoring an administrative committee that directly manages a 401(k) plan have an affirmative duty under ERISA to ensure that the committee is properly performing its duties and that the committee has the tools and information necessary to do so.
2. Fiduciaries may not deceive plan participants or allow others to do so; fiduciaries have the obligation to take appropriate actions to carry out this responsibility. This may include investigating allegations of fraud, disclosing facts to participants, other fiduciaries or the public and stopping further investment in company stock.
3. Fiduciaries have an obligation to ensure that investments in employer stock in a 401(k) plan are prudent, notwithstanding the plan provisions that favor such investments.
4. Directed trustees cannot follow directions that they know or should know are imprudent or violate ERISA. In the Enron case, the plaintiffs allege that there were sufficient red flags suggesting the imprudence of the lockdown, such that the directed trustee may have had a duty to override the fiduciary's direction to freeze participants' accounts.
In its brief, the DOL went beyond the positions it has stated in the past. For example, with respect to the DOL's discussion of the duty to monitor a fiduciary, it is at best unclear what actions a company's board of directors should take with respect to supervising a plan fiduciary appointed by the board. Apparently, the DOL believes that the appointing fiduciary has a duty to disclose information to the appointed fiduciary that the appointed fiduciary may not be aware of and could affect the plan. This creates a slippery slope concerning the dissemination of sensitive corporate information.
In light of the brief, holding of employer stock in a tax-qualified plan has become somewhat riskier. The DOL brief assumes that the fiduciary knows that there is a cataclysmic event pending. However, fiduciaries may not know that the event is cataclysmic until it is too late. When viewed in hindsight, an event might be disastrous for the company, but while in the middle of the situation, it might not look so bad. It is unclear what standard will be used to judge a fiduciary's actions.
Furthermore, ERISA says that the fiduciaries must follow the terms of the plan document. For example, many plans provide that the employer match must be made in employer stock and that employees cannot diversify out of the employer stock. In this case, it would seem that the plan design would protect the fiduciaries, whereas the DOL appears to be saying that the fiduciaries may, in certain circumstances, have an affirmative duty to override the plan design.
In general, the DOL is of the view that the company owes a higher duty to disclose information to plan participants than it owes to its shareholders generally.
Comment: This brief could merely be an example of bad facts creating bad law, but plan sponsors should re-evaluate the holding of employer stock in their tax qualified plans and the conditions under which such employer stock will be held.
Comment: On September 30, a United States District Court issued the first substantive decision in the Enron ERISA litigation (Tittle v. Enron Corp., 2003 WL 22245394 (S.D. Tex. Sept. 30, 2003)). The court ruled that most of the fiduciary claims against Enron's officers, directors, and plan administrators could proceed. Although the decision does not resolve these claims, it adopts many of the theories of fiduciary liability that the Department of Labor had advanced in its brief.
We will follow this case development closely, as it could well portend the significant expansion of the boundaries of fiduciary liability for plans invested in employer stock.
N. Guidance on Claims Procedure Regulations Affects Pension Plans
The DOL issued guidance, in the form of frequently asked questions ("FAQs"), regarding its final regulations for claims procedures. Although the final regulations apply to all employee benefit plans subject to ERISA, the most significant changes apply to group health plans and plans providing disability benefits. Pension plans are generally still subject to the regulations issued in 1977.
The regulations contain minimal changes for pension plans, but the DOL's position in Q&A-9 of the FAQs, contrary to the position in final regulations, is that a disability benefit provided under a pension plan is subject to the disability benefit rules in the regulations. This is an important distinction because DOL Regulations Section 2560.503-1(d) provides specific requirements for the claims procedures for disability benefits that would not ordinarily apply to pension plans. These rules include: de novo review; a consultation requirement for medical determinations; limits on appeal levels; time limits for deciding disability claims; and disclosure requirements regarding extensions of time. Thus, a pension plan must then have a separate claims procedure for disability benefits.
The DOL explains that a pension plan may avoid the more stringent
procedures for a disability benefit and the necessity of maintaining
a separate claims procedure by having the participant's disability
determination be made by a party other than the plan. Two examples
of this type of independent determination are: a participant
is considered disabled (i) by the Social Security Administration
or (ii) under the employer's long-term disability plan.
II. DEFINED BENEFIT PENSION PLANS
A. Cash Balance Plans
1. Proposed Regulations.
In a positive development for cash balance plan sponsors, the IRS has issued long-awaited proposed regulations that confirm that the basic cash balance plan design does not discriminate on the basis of age. The proposed regulations also provide acceptable approaches for converting a traditional plan to a cash balance plan to avoid age discrimination. Cash balance plans are a type of "hybrid" defined benefit plan under which a "hypothetical account" for each employee is created and credited with hypothetical "pay credits" and "interest credits." The proposed regulations require that conversions must be age-neutral.
(a) The Issue. Employees enrolled in a cash balance plan receive benefits based on the status of their account balances. Unlike most traditional defined benefit plans, they are more likely to receive benefits in a lump sum.
When a traditional pension plan is converted to a cash balance plan, an employee's benefit under the old plan may exceed the amount determined to be his or her benefit under the cash balance plan. When this occurs, the employee may not earn any additional benefits until his or her benefit earned under the cash balance plan exceeds the benefit earned under the traditional defined benefit plan. This event is known as a "wear away" period and is at the heart of employee disenchantment with cash balance plans.
Older workers, who have been employed by the same company for many years, charge that wear away periods are a form of age discrimination because they produce a lower benefit accrual rate for older participants, since older, longtime employees have fewer years before retirement in which to accrue new benefits.
(b) The Solution. The proposed regulations require that conversions be age neutral. A converted plan must satisfy one of two alternative rules.
(i) The converted plan must determine each participant's benefit as not less than the sum of the participant's benefit accrued under the traditional defined benefit plan and the cash balance account.
(ii) The converted plan must establish each participant's opening account balance as an amount not less than the actuarial present value of the participant's accrued benefit under the traditional defined benefit plan.
A plan satisfying the first alternative will not have a wear away period for benefits accrued under the traditional plan. A plan satisfying the second alternative may have a wear away period.
Comment: The moratorium that the IRS presently has in place on approval of conversions will be lifted when final regulations are published. The IRS states that finalization of the regulations is a high priority.
(c) A Wrinkle. In Announcement 2003-32, the Treasury withdrew a portion of the proposed regulations governing disproportionate benefits to highly compensated employees under Code Section 401(a)(4). The proposed age-discrimination provisions in the regulations for cash balance plans or cash balance conversions remain unaffected by the withdrawal.
2. IBM and Xerox Cases.
Recent court decisions have added another degree of uncertainty to cash balance plans. In the cases of IBM and Xerox, the courts have ruled certain pension designs as being impermissibly age discriminatory, while such formulae would likely be acceptable to IRS and Treasury under the proposed regulations discussed above.
(a) IBM. In Cooper v. IBM Pers. Pension Plan, 2003 U.S. Dist. LEXIS 13223 (S.D. Ill, July 31, 2003), the U.S. District Court for the Southern District of Illinois held that the employer violated the age discrimination provisions of ERISA when it amended its traditional defined benefit plan in the 1990s, first by adopting a pension equity plan and then by converting it to a cash balance plan.
IBM initially amended its defined benefit plan by adopting a pension equity plan under which participants earned a specific number of base points determined by the employee's age in the year worked. Excess points could be earned if a participant's five year average earnings exceeded the social security wage base. Next, IBM converted the plan into a cash balance plan under which participants accumulated pay credits at a rate of five percent of salary and an interest credit at a rate of one percentage point higher than the rate of return on one-year Treasury securities.
The court held that both amendments violated ERISA. The benefit conversion factor contained in the pension equity plan violated ERISA Sections 204(b)(1)(G) and (H) because it reduced a participant's accrued benefit based solely on increases in age and service and the participant's rate of benefit accrual decreased because of the attainment of a certain age. The cash balance plan formula also violated Section 204(b)(1)(H) because the interest credits were more valuable for younger employees, which resulted in benefit accruals becoming progressively smaller as the participant grew older.
Comment: IBM recently released a statement indicating that it will appeal the ruling.
(b) Xerox. In Berger v. Xerox Corp. Ret. Income Guar. Plan, 2003 U.S. App. LEXIS 15427 (7th Cir., Aug. 1, 2003), the Seventh Circuit Court of Appeals upheld a class action judgment of $300 million against a cash balance plan in favor of participants because the plan's method of computing participants' lump-sum entitlements violated ERISA. The plan's cash balance benefit formula was substantially the same as the formula applied in the IBM case. However, the issue in Xerox concerned the appropriate method for calculating the amount of the distribution to which workers were entitled.
Under the terms of the cash balance plan, employees who left Xerox could elect to take a lump sum payment based on their hypothetical account balance or they could defer taking their pensions until they reached age 65. Employees who deferred their pensions continued to accrue future interest credits under the terms of the plan until age 65. However, in determining the amount of the lump sum distribution that employees opting for the current distribution were entitled to, the plan applied a discount rate prescribed by the Pension Benefit Guaranty Corporation ("PBGC").
The PBGC rate lowered the amount of the distribution that employees would receive, had the plan applied the future interest credits. In other words, employees who elected to take the lump sum payments did not receive the actuarial equivalent of what they would have received had they deferred receipt until age 65. The court held that ERISA requires that lump sum substitutes must represent the actuarial equivalent of the substituted benefit.
B. IRS Modifies Rules for Explaining Defined Benefit Distribution
Options
The IRS issued final regulations that define the conditions under which a defined benefit plan may furnish an explanation concerning a participant's right to choose between a qualified joint and survivor annuity ("QJSA") and other forms of payment after the date that the annuity payments are to start ("annuity starting date"). The rule allowing for the provision of the explanation subsequent to the annuity starting date was created by the Small Business Job Protection Act of 1996. The final regulations are generally identical to previously-issued proposed regulations.
1. Background.
Generally, all distributions under a defined benefit plan must be made in the form of a QJSA. Code Section 417 provides an exception, whereby a participant may waive the QJSA, subject to spousal consent, in favor of another distribution method, such as a single life annuity or a lump sum. Plans generally must provide a QJSA explanation to each participant, within a reasonable time before the annuity starting date, describing the QJSA, the right to waive the QJSA, and the rights of the participant's spouse.
Pursuant to the Small Business Job Protection Act of 1996, QJSA explanations may be furnished after the annuity starting date if the applicable election period is extended for at least 30 days after the date on which the explanation is furnished. Since the annuity starting date may be earlier than the date on which the QJSA explanation is provided, retroactive benefit payments may be made which are attributable to the period before the QJSA explanation is provided.
The final regulations clarify the rules under which a defined benefit plan may send the QJSA explanation after the annuity starting date, creating a retroactive annuity starting date, and explain how payments are made when there is a retroactive annuity starting date, as well as providing other rules for the use of a retroactive annuity starting date. Generally, a retroactive annuity starting date may only be applied if the plan document permits it and if the participant affirmatively elects and the spouse consents to the use of the retroactive annuity starting date. If the participant elects a retroactive annuity starting date, the participant must be put in the same position he or she would have been in had benefits actually commenced on the retroactive annuity starting date.
C. IRS Clarifies Treatment of Defined Benefit Plan Annuity Overpayments
In Revenue Ruling 2002-84, the IRS clarifies how overpayments of annuity benefits from a defined benefit pension plan made in a single year, over several years, or as a lump-sum distribution can be corrected by the plan and taxed to the participant. The IRS states that, in the case of a miscalculation that results in an excess distribution to a participant in a single year, the following year's distributions can be reduced by the excess amount plus interest. If excess payments are distributed over several years, future payments to the participant may be reduced in a manner actuarially equivalent to the excess payments plus interest based on the plan's interest rate factors. Overpayment of a lump sum is properly included in gross income but is deductible when repaid.
D. Elimination of COLA Benefits for Retirees Does Not Violate Anti-Cutback Rules
In Board of Trustees of the Sheet Metal Workers' National Pension Fund (4th Cir., January 31, 2003), the Fourth Circuit held that a plan could abolish a cost of living adjustment ("COLA") for retirees without violating ERISA's anti-cutback rule which generally bars the reduction or elimination of accrued benefits. The court held the COLA for participants who had retired before it was added to the plan is a gratuitous benefit, which could be eliminated. In other words, for a benefit to be treated as an accrued benefit, it has to be earned during the time of the participant's employment.
Comment: This decision provides opportunities for plan sponsors, particularly those in distress, to reduce pension obligations attributable to COLAs for participants who retired before the COLA was adopted.
III. DEFINED CONTRIBUTION PLANS
A. IRS Proposes Modifications to Optional Forms of Benefit Regulations to Conform to EGTRRA
The IRS has issued proposed regulations that modify final regulations concerning optional forms of benefit by changing the circumstances under which certain forms of distribution previously available to participants can be eliminated from qualified defined contribution plans (Proposed Regulations Section 1.411(d)-4, Q&A 2(e)).
1. Background.
Instead of requiring plans to continue to maintain nearly all existing alternative forms of payment (annuity, lump-sum, payment-in-kind, etc.), the optional form of benefit regulations (Regulations Section 1.411(d)-4) allow defined contribution plans to be amended to eliminate or restrict a participant's right to receive payment of accrued benefits under a particular optional form of benefit, without violating the Code Section 411(d)(6) anti-cutback rules, if:
(a) Once the plan amendment takes effect for a participant, the alternative forms of payment that remain available include payment in a lump sum that is "otherwise identical" (e.g., applicable to the same portion of the account balance, available in the same timeframes, etc.) to the eliminated or restricted optional form of benefit, and
(b) The amendment does not apply to a participant for any distribution with an annuity starting date before the earlier of: (i) the 90th day after the participant receives a summary that reflects the plan amendment; or (ii) the first day of the second plan year following the plan year in which the amendment is adopted.
2. EGTRRA Change.
EGTRRA amended Code Section 411(d)(6) to provide that a defined contribution plan is not treated as reducing a participant's accrued benefit where a plan amendment eliminates a form of distribution previously available under the plan, if:
(a) a lump sum distribution is available to the participant, and
(b) the lump sum distribution is based on the same or greater portion of the participant's account as the form of distribution eliminated by the amendment.
EGTRRA also instructed IRS to issue regulations, under both the Code and ERISA, implementing these changes.
3. Proposed Regulations.
To reflect the EGTRRA change, IRS has issued proposed regulations that would modify the existing final regulations by eliminating the 90 day advance notice rule discussed in Section III, A.1.(b) above.
B. DOL Guidance on Paying Expenses from Plan Assets
1. Background.
Under ERISA, assets of an employee benefit plan must be used exclusively to pay benefits to plan beneficiaries and, if the plan so provides, to defray reasonable expenses of administering the plan. According to the DOL, it is the responsibility of plan fiduciaries to determine whether a particular expense is a reasonable administrative expense under ERISA, which can be paid for with plan assets.
In a 1987 information letter (the "Maldonado Letter"), the DOL identified certain services that are provided by employers in connection with the establishment, termination and design of plans that are not services performed exclusively for the benefit of plan participants. The information letter went on to state that such functions (referred to as "settlor functions") were related to the business of the employer and, therefore, should not generally be paid from the assets of an employee benefit plan.
In response to a request for specific guidance on the payment of certain expenses incurred in seeking a determination letter upon a plan's termination, the DOL issued Advisory Opinion 97-03A, wherein the DOL stated its position that expenses related to settlor functions are not reasonable expenses of a plan that may be paid from plan assets. Further, it provided that a plan's tax-qualified status confers benefits on both a plan's participants and beneficiaries and the plan sponsor. Therefore, it concluded that only a portion of the expenses incurred in maintaining tax qualification are reasonable plan expenses that are payable from plan assets. This was interpreted to mean that the DOL required the apportionment between plan and sponsor of all tax qualification expenses. Moreover, some practitioners construed Advisory Opinion 97-03A to require that an independent fiduciary was needed to determine such apportionment.
In response to a request for clarification of its position on the payment of plan expenses from plan assets, the DOL issued Advisory Opinion 2001-01A, and recently Field Assistance Bulletin 2003-3.
2. Advisory Opinion 2001-01A.
In Advisory Opinion 2001-01A, the DOL indicates that it does not agree that Advisory Opinion 97-03A requires an apportionment of expenses between the plan and sponsor for all tax qualification-related expenses. However, DOL Advisory Opinion 2001-01A does not supersede Advisory Opinion 97-03A.
Advisory Opinion 2001-01A reconfirms the DOL's position that a wide range of expenses relating to plan formation, rather than plan management, are settlor functions that cannot reasonably be paid from a plan. Thus, the formation of a tax-qualified plan is a settlor activity, but the DOL opines that the implementation of this settlor decision may require plan fiduciaries to undertake activities relating to maintaining the plan's tax-qualified status that may be paid by the plan to the extent that they are reasonable in light of the services rendered. Examples of implementation activities include: drafting plan amendments required by changes in the tax law, nondiscrimination testing, and requesting IRS determination letters. However, expenses incurred in analyzing options for amending the plan would be settlor expenses.
The DOL restates that it is a plan fiduciary's obligation to determine whether certain plan-related functions are settlor or non-settlor expenses incurred in maintaining a plan. Importantly, the Advisory Opinion clarifies that the incidental benefit of having a tax-qualified plan should not be considered in determining whether plan-related costs are plan or sponsor expenses.
Whether certain other expenses (e.g., plan drafting and plan amendments) should be allocated depends on the particular facts and circumstances of the situation. According to the Advisory Opinion, costs associated with studies of compliance alternatives in response to required legal changes would not be payable from plan assets. An example in the Advisory Opinion clarifies that the cost of an amendment to comply with a board resolution, such as the addition of a loan feature, is a settlor expense payable by the plan sponsor. However, the maintenance costs of the loan feature (e.g., participant communications, processing loan applications) would be appropriate plan expenses that could be paid from plan assets.
3. DOL Hypothetical Fact Patterns.
The DOL issued six hypothetical fact patterns to illustrate its position on determining appropriate plan expenses, versus expenses incurred for settlor activities. In each case, the DOL confirms its position that, although settlor activities do not constitute reasonable plan expenses, expenses incurred in connection with the implementation of settlor decisions still may constitute reasonable expenses which the plan may pay.
(a) Plan Spinoff as Part of Sale of Business Unit. Expenses incurred in conducting a plan design study in connection with a plan spinoff are considered settlor expenses that cannot be paid by the plan. Expenses incurred in amending a plan to effect a plan spinoff as part of the sale of a business unit should be treated as settlor plan design expenses, since no implementation responsibilities exist under the plan until the plan actually is amended. However, expenses incurred in determining the amount of plan assets to be transferred from the seller's plan to the buyer's plan would be permissible plan expenses, if the expenses are incurred in implementing the seller's decision to spin off certain participants, versus assisting the seller in formulating the spinoff.
Expenses incurred in conducting any negotiations with any unions affected by the plan spinoff and sale would be settlor expenses that are not payable under the plan. The DOL notes that these types of union negotiations typically occur in advance of plan changes and that activities taking place in advance of, or in preparation for, a plan change nearly always constitute settlor versus plan activities.
(b) Reduction in Staff in Conjunction with Early Retirement Window. In analyzing a situation involving a company that decides to reduce its staff and implement an early retirement window to cut expenses, the DOL concludes that the expenses incurred fall within three basic categories: plan design, benefit computation, and communication expenses.
The DOL's position is that plan design expenses which generally are incurred before the plan is adopted or amended constitute settlor expenses that are not payable by the plan. The cost incurred in calculating the benefits to which a participant is entitled, however, is an administrative expense of the plan and accordingly is payable by the plan. Similarly, the communication of plan information to participants and beneficiaries is a plan activity that constitutes permissible plan expenses.
(c) Plan Amendments to Add Participant Loan Program and Early Retirement Window. Plan design activities involve settlor activities for which a plan cannot pay, but the expenses incurred in implementing the decision to maintain a tax-qualified plan might result in reasonable plan expenses. In applying that principle, the expenses incurred in amending the plan to comply with the applicable tax changes and to conduct routine nondiscrimination testing may constitute reasonable expenses of the plan. On the other hand, expenses incurred in connection with amending the plan to establish a participant loan program would be a plan design or settlor expense, since the plan fiduciaries have no implementation obligations under the plan until the plan is amended. Expenses incurred in operating the plan loan program, however, would be implementation expenses that are eligible for treatment as plan expenses. If a single expense is attributable to both plan design and settlor activities (e.g., amending the plan to establish an early retirement window) and implementation activities (e.g., obtaining an IRS determination letter), the plan must obtain from the service provider a determination of the specific expenses attributable to each for the plan to pay any portion of the expense as a plan implementation expense.
(d) Nondiscrimination Testing and Amendment of Plan for Law Changes. Expenses incurred in amending the plan to maintain the plan's tax-qualified status, submitting the plan for a determination letter, and performing any required nondiscrimination testing are considered plan maintenance expenses that are permissible plan expenses. Even if the nondiscrimination testing is required because of a union-negotiated plan amendment, the expense continues to be a permissible plan expense. On the other hand, if the expense was incurred as part of the union negotiations by the employer, in advance of the adoption of the plan amendment necessitating the testing, that expense is a settlor not plan expense. Similarly, consulting fees incurred in analyzing the sponsor's options for complying with changes in the law would be plan design or settlor expenses.
(e) Plan Disclosure Expenses Preparation and Distribution of Plan Information to Participants. The DOL states that plans may pay expenses incurred in complying with ERISA's disclosure requirements. Thus, the expenses incurred in producing and distributing individual benefit statements to participants are permissible plan expenses. Also, expenses incurred in preparing the participant benefit books are permissible plan expenses. The plan sponsor should pay the portion of the booklet expenses relating to non-plan matters (for example, describing any employee fringe benefits such as company outings). The plan must pay only those reasonable expenses that relate to that particular plan, with each of the plans paying its proportionate share of the expenses.
(f) Outsourcing Benefit Administration Start-up Fees and Research. To the extent that the services provided by an outside benefits administrator are necessary to the plan's administration, the start-up fee and ongoing administrative fees paid to that service provider may constitute reasonable plan expenses.
4. Field Assistance Bulletin 2003-3 - Expenses Attributable to Specific Plan Participants. The above discussion concerns plan-wide expenses that are borne by the plan as a whole (with respect to defined contribution plans, either pro rata on each account balance or from the forfeiture or suspense account). On May 19, 2003, the DOL issued a Field Assistance Bulletin (FAB 2003-3) that significantly changes the DOL's position on charging individual participant's accounts for certain plan-related expenses. The DOL's new position enables the plan to pass through certain charges relating to an individual participant to his or her account, rather than requiring allocation of such charges to all participants in proportion to account value.
In earlier guidance, the DOL stated than an individual participant's account could not be charged for expenses incurred as a result of exercising his or her rights under the law. As a result, costs associated with activities such as reviewing whether domestic relations orders constitute qualified domestic relations orders (which grant benefit rights to former spouses or dependent children) and processing distributions had to be charged to the plan overall, and not solely to the affected participant's account. On the other hand, the earlier guidance allowed a plan to charge an individual participant's account for privileges not guaranteed under ERISA, such as processing loans or directing investments.
In FAB 2003-3, the DOL, noting that some ERISA provisions specifically permit plans to charge an individual participant for certain expenses, such as obtaining copies of documents, concludes "except for the few instances in which ERISA specifically addresses the imposition of expenses on individual participants, [ERISA] places few constraints on how expenses are allocated among plan participants."
Under the DOL's new position, if a plan document specifically provides for an individual participant's account to be charged for certain expenses, the plan administrator and other fiduciaries must follow the document. If the document leaves the charging of expenses up to the plan administrator's (or other fiduciary's) discretion, the determination of whether to charge an individual participant's account or the plan as a whole is a fiduciary decision that is subject to ERISA's fiduciary standards that is, the decision on how to allocate the expense must be made prudently and in the sole interests of plan participants and beneficiaries.
The DOL position, as currently set forth in the FAB, expressly permits the allocation of the following common expenses directly to an individual participant's account. These expenses include the costs to:
(a) Determine if domestic relations orders meet the requirements to be considered qualified domestic relations orders or qualified medical child support orders.
(b) Process hardship withdrawals. Presumably this would include fees involved both in determining if the requirements for a hardship are met and expenses involved in making the distribution.
(c) Process benefit distributions. This includes check writing fees.
(d) Maintain accounts for terminated vested participants.
The DOL now specifically permits the sponsor or plan to pay the
expenses to maintain accounts for active participants, while
not paying for the costs for the accounts for participants who
have left the company.
Comment: The IRS and the tax rules may make some of these charges
impermissible. In particular, Treasury Regulations require that
a consent to distribution (which is required if the amount being
distributed is more than $5,000) is not valid if a significant
detriment is imposed on a participant who does not consent to
a distribution. If the charge to maintain the account is considered
by the IRS to be a "significant detriment," it may
be impermissible notwithstanding the DOL's position.
Comment: If plans are not amended to include guidance on allocating plan expenses, fiduciaries would be burdened with establishing guidelines for properly allocating expenses, which could lead to significant legal exposure. Therefore, if plan sponsors and fiduciaries determine to charge individual accounts for permissible expenses, they should review their methodology for allocating such expenses and amend the plan and summary plan documents in order to appropriately inform participants of fees that will be charged to accounts and how and when such fees will be charged.
C. IRS Guidance on Deemed IRAs
1. Background.
EGTRRA added Code Section 408(q) which permits employers to amend their qualified plans to allow for voluntary employee contributions to a separate account established under the plan. These accounts, called "deemed IRAs", must satisfy the requirements applicable to traditional or Roth IRAs. If these conditions are met, the accounts will be treated as IRAs, and not as part of the qualified plan. Also, deemed IRAs are not subject to Title I of ERISA other than those sections relating to the exclusive benefit rule and fiduciary and co-fiduciary responsibilities.
2. Revenue Procedure 2003-13.
The IRS issued Revenue Procedure 2003-13, which provides employers with an extended period of time to amend their plans to provide for deemed IRAs, provided the plan satisfies the EGTRRA remedial amendment period requirements.
Notwithstanding the general rule that deemed IRA provisions must be in place prior to accepting employee voluntary contributions, Revenue Procedure 2003-13 permits plan sponsors to adopt the necessary amendments after a plan begins accepting contributions for plan years beginning in 2003. Thus, plan sponsors have until the end of the 2003 plan year to adopt a deemed IRA plan provision even though contributions may be received by the plan from the beginning of that plan year.
3. Proposed Regulations.
The IRS issued proposed regulations on deemed IRAs that set
forth the conditions, restrictions and requirements that must
be satisfied for a qualified employer plan to
establish a deemed IRA, as follows:
(a) Eligible Plans. Qualified employer plans that may establish a deemed IRA include a Section 401(a) qualified plan, a Section 403(a) or 403(b) annuity or a governmental Section 457(b) plan.
(b) Eligible IRA. Only IRAs that meet the requirements of either a traditional or Roth IRA may be a deemed IRA. SEPs and SIMPLE IRAs are not eligible deemed IRA vehicles.
(c) Separate Entities. A deemed IRA must be a separate entity from the qualified employer plan under which it is maintained. The deemed IRA and the qualified employer plan generally must independently satisfy the rules applicable to each entity (e.g., eligibility, participation, disclosure, nondiscrimination, minimum distribution, maximum limits) and each must have a separate trust. Contributions to a deemed IRA, up to the limits permitted for a traditional or Roth IRA, will not be taken into account for purposes of a participant's elective deferral limit to a 401(k), 403(b) or governmental 457(b) plan or for purposes of Section 415 maximum limits because they are not treated as contributions to the qualified employer plan.
However, the proposed regulations contain an exception to the separate entity requirement with respect to the commingling of IRA assets with other plan assets. The exception permits the assets of a deemed IRA to be commingled for investment purposes with the assets of a qualified employer plan. However, separate accounts must be maintained for allocating gains and losses.
The regulations contain another exception to the separate entity rule, that is, if a deemed IRA fails to meet any of the requirements of a traditional or Roth IRA, then the qualified employer plan that elected to provide for voluntary employee contributions to a deemed IRA will fail to meet its qualification requirements. On the other hand, if a qualified employer plan fails to satisfy any qualification requirement, the account that was intended to be a deemed IRA may, nevertheless, be treated as a traditional or Roth IRA, provided it satisfies the requirements for these types of IRAs.
(d) Correction of Qualification Failures. A qualified plan or deemed IRA that fails to satisfy any applicable requirement may correct such failure through the Employee Plans Compliance Resolution System.
(e) Distributions. Distributions from deemed IRAs are treated independently from distributions under qualified plans. For example, withdrawals from a deemed IRA may be made before an individual is eligible to retire under the qualified plan. Similarly, minimum required distributions must be calculated separately for the deemed IRA and qualified plan. Minimum required distributions from the qualified employer plan, in general, would have to commence at the later of the April 1 following the attainment of age 70-1/2 or retirement of the employee. However, required minimum distributions from deemed IRAs would have to commence by the April 1 following the attainment of age 70-1/2 even if the employee is still working.
D. Final Regulations on Qualified Plan Loans Cover Maximum Term of Loans, Loans Made After a Deemed Distribution, Loan Refinancing, and Multiple Loans
1. Background.
Under Code Section 72(p), a loan from a qualified plan to a participant is treated as a taxable distribution unless certain conditions are satisfied. In general, the loan may not exceed the lesser of 50% of the participant's vested account balance or $50,000. The repayment term of the loan may not be more than 5 years unless it is for the purpose of acquiring a principal residence. Payments must be substantially level and must be made no less frequently than quarterly.
The IRS issued two sets of proposed regulations on these criteria in 1995 and 1998. In 2000, the IRS issued final regulations and also issued a new set of proposed regulations. The IRS has now finalized the 2000 proposed regulations. The final regulations provide guidance on the suspension of loan repayments during a military leave of absence, new loans following a deemed distribution of a prior loan, loan refinancing and multiple loans.
2. Military Leaves of Absence.
A suspension of loan payments while a participant is on a military leave of absence will not cause the loan to be deemed distributed, regardless of the length of the leave. For other unpaid leaves of absence, the suspension period may not exceed one year. In general, the loan must be reamortized over the remaining term plus the period of military leave either to provide for higher periodic payments, or to provide the same payments as before the leave but with a balloon payment at the end. As with other leaves of absence, the periodic repayment amount may not be less than it was before the military leave. Furthermore, the final regulations provide that loan repayments can be revised at the end of a military leave to extend the repayment schedule in the event the loan originally had a term of fewer than five years, but the extension may not exceed the period of the military leave.
Example: If the repayment period for a loan made before a participant's leave for military service was three years, the final regulations would allow the loan to be repaid by the end of five years (the latest permissible loan term absent a leave of absence) plus the period of military service.
Interest must continue to accrue during a military leave of absence. The final regulations clarify that the maximum interest rate that may be charged during a military leave is 6% per year as required by the Soldiers' and Sailors' Civil Relief Act of 1942.
3. Effect of Deemed Distribution on Subsequent Loans.
When a loan is deemed distributed, e.g., the participant has defaulted on the loan, it is treated as outstanding for purposes of determining whether additional loans can be made. No future payout made to the participant can be treated as a loan unless either of the following conditions is met with respect to the new loan:
(a) The repayments are made by payroll deduction; or
(b) The plan receives adequate security other than the participant's vested accrued benefit under the plan.
If the condition for allowing the subsequent loan ceases to be met (e.g., the participant revokes the payroll deduction agreement), the loan, unless repaid, will be deemed distributed.
Comment: Loans are deemed distributed when a participant loan goes into default status. The plan must issue a 1099-R for the amount of the defaulted loan. The loan balance cannot be distributed until the participant experiences a distributable event (e.g., termination of employment), and as a result the loan balance continues to accrue interest. This can cause a significant problem for multi-employer plans or other plans when loan repayments are not made by salary reduction.
4. Refinanced Loans.
If a loan is replaced by another loan (a replacement loan), and the term of the replacement loan ends after the latest permissible term of the loan it replaces, the final regulations treat both loans as outstanding on the date of the transaction. Thus, for example, if: (a) the term of the replacement loan ends after the latest permissible term of the replaced loan, and (b) the sum of the amount of the replacement loan and the amount of the replaced loan fails to satisfy the dollar limits on plan loans, then the replacement loan results in a deemed distribution in the amount by which this sum exceeds the dollar limit on plan loans.
However, the above rule will not apply to treat both the replacement loan and the original loan as outstanding, if the terms of the replacement loan would satisfy the regulations for Code Section 72(p)(2), applied as if the replacement loan consisted of two separate loans, to wit: (a) the replaced loan (amortized in substantially level payments over a period ending no later than the last day of the latest permissible term of the original replaced loan), and (b) a new loan in the amount by which the replacement loan exceeds the amount of the replaced loan (i.e., the lesser of one-half of a participant's vested account balance or $50,000 less the largest outstanding loan balance during the 1-year period preceding the refinance date), with the new loan amortized in substantially level payments over a period ending not later than the latest permissible term of the replacement loan.
Example: A participant whose vested account balance was $200,000 borrowed $30,000 on January 1, 2001 with loan payments to be made quarterly over a 5-year period. On January 1, 2002, the participant decided to refinance the remaining loan balance ($25,000) to take advantage of lower interest rates. That would not be a problem if payments under the refinanced loan were scheduled to end no later than 5 years after the original loan date. However, Code Section 72(p) would preclude the extension of the payment period to a new 5-year period without adverse tax consequences because the refinanced loan could not exceed $20,000 ($50,000 less the largest outstanding loan balance during the 1-year period preceding the refinancing date, or $30,000 in this example). Thus, an attempt to refinance the $25,000 over a new 5-year period would result in a taxable distribution of $5,000. If, however, the refinanced loan payment period were to end no later than December 31, 2005 (the end of the original loan period), the participant could borrow up to an additional $20,000 to be paid over a new 5-year period because the $25,000 refinanced loan would not be treated as a new loan.
5. Multiple Loans.
The final regulations do not restrict the number of loans a participant may take in a 12-month period. A plan, however, may restrict the number of loans a participant may have outstanding.
Comment: This provision accommodates so-called "credit card" plan loans.
E. IRS Lets Employee Leasing Groups Convert to Multiple
Employer Plans
1. Background.
The IRS has provided a framework under which defined contribution plans sponsored by employee leasing organizations (referred to as professional employer organizations, or "PEOs") will not be disqualified for violating the exclusive benefit rule solely because those plans provide benefits to "worksite employees" who are not PEO employees. To obtain this relief, a PEO that maintains a defined contribution plan must either convert the plan into a multiple employer plan that benefits worksite employees, or terminate the plan before a specified date.
An employee leasing arrangement involves the interaction of three parties: the PEO, the client organization ("CO"), and worksite employees. Usually, a PEO enters into an agreement with a CO under which employees receive payment from a PEO for providing services to a CO under a service agreement between the PEO and the CO. The employees are referred to as "worksite employees".
If the PEO has a retirement plan, the issue is whether the worksite employees are employees of the PEO or the CO. A retirement plan that provides benefits for individuals who are not employees of the employer maintaining the plan violates the exclusive benefit rule. Thus, a retirement plan maintained by a PEO can be qualified only if it provides benefits exclusively for its own employees.
Whether a worker is an employee of a particular entity is generally based on which entity has the right to direct and control the individual performing the services. If it is found that the CO, and not the PEO, is the employer, then the plan maintained by the PEO that benefits worksite employees would fail the exclusive benefit rule.
A plan that would fail the exclusive benefit rule because it covers employees of employers other than the employer maintaining the plan can satisfy the exclusive benefit rule if it is a multiple employer plan (i.e., a plan maintained by more than one employer). In determining whether a multiple employer plan complies with the exclusive benefit rule, all participants are treated as employees of all employers who maintain the plan.
2. Relief from Disqualification.
If a PEO has a defined contribution plan that: (i) is in existence on May 13, 2002, (ii) benefits "worksite employees", and (iii) is intended to be qualified, the PEO plan will not be treated as disqualified solely on the grounds that the plan violates (or has violated) the exclusive benefit rule for plan years beginning before the "compliance date" (discussed below) by benefiting worksite employees who are not the PEO's employees, if a PEO satisfies the relief requirements described below.
To obtain relief from potential disqualification, the plan sponsor of the PEO plan must either (i) terminate the plan, or (ii) convert the plan into a multiple employer plan.
If, as of the compliance date, a PEO does not either terminate its plan covering worksite employees or convert the plan to a multiple employer plan, the relief from disqualification is not available. After the compliance date, a PEO may not rely on a determination letter for a plan that covers worksite employees performing services for COs, regardless of when the letter was issued.
3. Dates for Remedial Action.
Generally, all remedial actions and other relief requirements must be completed by the "compliance date"-i.e., the last day of the first plan year of the PEO's plan beginning on or after January 1, 2003. For a calendar year plan, the compliance date is December 31, 2003.
F. Money Purchase Pension Plan's Conversion or Merger into Profit Sharing Plan Not Partial Termination, but Requires Participant Notice
1. Background.
The IRS has ruled that a money purchase pension plan will not be treated as having been partially terminated because of its merger or conversion into a profit sharing plan. However, employees must be given formal ERISA Section 204(h) notice of the change (Rev. Rul. 2002-42, 2002-28 IRB).
Comment: With a money purchase pension plan, contributions must be made in accordance with a formula usually expressed as a percentage of the participant's compensation. By contrast, with a profit sharing plan, contributions generally vary with the fortunes of the employer, although contributions may continue to be made even in the absence of profits.
2. Plan Conversion or Merger.
The ruling addressed two situations in which an employer merges or converts a money purchase pension plan into a profit sharing plan. Employers X and Y each maintain a money purchase pension plan. Employer Y also maintains a profit sharing plan.
(1) Employer X converts its money purchase pension plan into a profit sharing plan covering the same employees as the money purchase pension plan and containing the same vesting schedule.
(2) Employer Y amends its money purchase pension plan to cease future employer contributions and merges it into its profit sharing plan in a transaction that satisfies the requirements of Code Section 414(l). Following the merger, the profit sharing plan covers the same employees and contains the same vesting schedule as the money purchase pension plan.
In both situations, assets and liabilities in the profit sharing plan that originated in the money purchase pension plan retain their money purchase pension plan attributes (e.g., amounts are still subject to the qualified joint and survivor rules) (in accordance with Rev. Rul. 94-76).
3. Notice Must be Provided.
To avoid the Code Section 4980F excise tax, and to satisfy ERISA Section 204(h), a plan amendment that provides for a significant reduction in the rate of future benefit accruals must be accompanied by a notice from the plan administrator describing the reduction to each affected individual whose benefit is adversely affected by the reduction, and to each employee organization representing these individuals. The IRS states that the conversion or merger of a money purchase pension plan into a profit sharing plan necessarily involves a significant reduction in the rate of future benefit accrual under the money purchase plan. Therefore, Employers X and Y must provide notice of the conversion or merger to affected employees under Code Section 4980F and ERISA Section 204(h).
4. Reasons to Convert to a Profit Sharing Plan.
Before EGTRRA, there was a 10-percentage point difference in the maximum deductible amount that could be contributed to a profit sharing plan (15% of compensation) as opposed to a money purchase pension plan (25% of compensation). Further, for purposes of determining an employer's maximum deductible contribution, elective deferrals to 401(k) plans were treated as employer contributions. EGTRRA raised the deductible contribution percentage to 25% for profit sharing plans, and eliminated the provision requiring that employee elective deferrals be treated as employer contributions for purposes of the deductible contribution limit.
Thus, employers may now make the same contributions to a profit sharing plan as to a money purchase pension plan, without incurring the obligation to so contribute inherent in money purchase pension plans.
G. Guidance on Restorative Payments
In Rev. Rul. 2002-45, the IRS provided guidance on whether an employer payment to a defined contribution plan to make up for substantial investment losses should be classified as a contribution or a restorative payment. This distinction is important because restorative payments (unlike plan contributions) are not subject to the various nondiscrimination requirements and deduction limits of the Code. [4]
In the two situations discussed in the ruling, the employer paid an amount to the plan to compensate for the loss of a significant amount of plan assets due to a high risk investment. The payment was allocated among the accounts of all participants and beneficiaries in proportion to each account's investment in the high risk asset. The only difference between the two situations is that, in one, the payment was made as part of a settlement due to a lawsuit filed by the plan participants against the employer alleging breach of fiduciary duty. In the other situation, no suit was filed, but the employer was aware that participants were concerned about the investment and were considering legal action. The IRS ruled that the payment to the plan in both situations was restorative rather than a contribution. While pointing out that a facts-and-circumstances test applies for characterizing restorative payments, the IRS nonetheless established two guidelines for determining if payments constitute restorative contributions: (i) the payment is made to restore losses resulting from the action or omission by a fiduciary for which there is a reasonable risk of liability for breach of fiduciary duty, and (ii) similarly situated plan participants are treated similarly with respect to the payment.
The IRS offered specific examples of what types of payments constitute restorative payments. Payments made pursuant to DOL or court-approved settlement are restorative payments, while payments required under the terms of a plan or necessary to comply with a Code requirement are not restorative payments, even if the payments are delayed contributions or are otherwise made in circumstances in which there has been a breach of fiduciary duty. Payments of delinquent Section 401(k) contributions under the Voluntary Fiduciary Correction Program are not restorative payments. However, payments under Employee Plans Compliance Resolution System of adjustments to reflect lost earnings are treated as restorative payments. Payments made to make up for losses due to market fluctuations and that are not attributable to a fiduciary breach are generally treated as contributions rather than restorative payments.
H. 401(k) Plans
1. 401(k) Proposed Rules Consolidate and Modify Existing Guidance.
The IRS has issued a comprehensive set of proposed regulations setting out the requirements for cash or deferred arrangements ("CODA") under Code Section 401(k) and for matching contributions and employee contributions under Code Section 401(m). The proposed regulations reflect the relevant tax law changes and IRS rulings that have come into effect since 1994.
(a) Introduction. The proposed rules implement modifications designed to simplify plan administration and ensure benefits for rank-and-file employees.
(b) Prohibition of Pre-Funded Contributions. The IRS has stated that prefunding elective and matching contributions is inconsistent with Code Sections 401(k) and 401(m). As a result, the proposed regulations would not allow an employer to prefund elective contributions to accelerate the deduction.
(c) Aggregation of Plans with ESOPs. The proposed regulations would change the treatment of a CODA under a plan that includes an ESOP. Current rules provide that the portion of a plan that is an employee stock ownership plan ("ESOP") and the portion that is not an ESOP are treated as separate plans for purposes of the Code Section 410(b) minimum coverage rules. Thus, these plans have to apply two separate actual deferral percentage ("ADP") tests: one test for elective contributions going into the ESOP (and invested in employer stock), and a second test for elective contributions going in the non-ESOP portion of the plan.
The proposed regulations would eliminate disaggregation of the ESOP and non-ESOP portion of a single plan for purposes of ADP testing. The same rule would apply for actual contribution percentage ("ACP") testing under Code Section 401(m). In addition, the proposed regulations would provide that, for purposes of applying the ADP test or the ACP test, an employer could permissively aggregate two plans, one that is an ESOP and one that is not.
(d) Distributions Upon Severance from Employment. EGTRRA repealed the same desk rule by allowing employers to amend their plans to authorize distributions attributable to elective deferrals to be made to participants upon severance from employment, rather than separation from service. Accordingly, 401(k) plan participants are no longer prohibited from receiving distributions in the event they continue on the same job for a different employer following a liquidation, merger, consolidation, or other corporate transaction. However, an employee will not be treated as having experienced a severance from employment if the employee's new employer maintains the 401(k) plan in which the employee participates (e.g., by continuing to sponsor the plan or by accepting a transfer of plan assets and liabilities).
(e) Hardship Distributions. The proposed rules clarify the changes to the hardship distribution rules implemented by EGTRRA, including the six-month suspension of elective deferrals following a distribution. In addition, the proposed rules require a representation by an employee in support of a claim that a distribution is necessary to satisfy an immediate and heavy financial need to establish that the need cannot reasonably be relieved by any available distribution or nontaxable plan loan. However, an employee would not be required to take a commercial loan if a loan sufficient to meet the employee's needs would not be available on reasonable commercial terms. If the plan has a loan provision, the participant must take loans from the plan before requesting a hardship distribution.
(f) Distribution Restrictions Under Transferee Plans. Plans that receive plan-to-plan transfers that include elective deferrals, QNECs or QMACs must contain the statutory withdrawal restrictions. The proposed rules would further require the transferor plan to "reasonably conclude" that the transferee plan provides for the applicable withdrawal restrictions.
(g) Specify Nondiscrimination Testing Method. The proposed rules require plans to specify the nondiscrimination testing method and the optional choices being used under that method. For example, a plan would need to specify whether the current year or prior year ADP testing method is used. In addition, the rules prohibit plans that use the safe harbor nondiscrimination method from reserving the right to use the ADP method in the event that the safe harbor conditions are not met.
(h) Disregarding Excludable Participants in ADP Test. The proposed rules reflect Code Section 401(k)(3)(F), as enacted by EGTRRA, pursuant to which nonhighly compensated employees who do not meet ERISA's minimum age and service requirements may be disregarded for purposes of the ADP and ACP tests. This option is "permissive" and plans may continue to use the existing testing option under which a plan is disaggregated and the ADP and ACP tests are separately performed for eligible and excludable employees.
(i) Calculating the ADR of HCEs in Multiple Plans. The proposed rules require the actual deferral ratio for each highly compensated employee ("HCE") participating in more than one CODA to be determined by aggregating the HCE's elective deferrals that are made within the plan year of the CODA being tested. The modification is designed to ensure that each of the employer's CODAs will use 12 months of elective deferrals and 12 months of compensation in determining the ADR for an HCE who participates in multiple plans, even if the plans have different plan years.
Similar rules apply to the determination of the actual contribution ratio under the ACP test for an HCE who receives matching contributions or makes employee contributions under two or more plans.
(j) Restrictions on "Bottom-Up" QNECs. The proposed rules would continue to allow plans, subject to conditions specified in the existing regulations, to correct failures of the ADP test by making QNECs. However, the proposed rules would add a new condition that would limit the use of the bottom-up leveling technique, pursuant to which employers attempt to pass the ADP test by targeting high percentage QNECs to a small number of part-time, terminated, or other short-service NHCEs with the lowest compensation during the year (raising each such NHCE's ADR), rather than providing contributions to a broad group of NHCEs. The bottom-up leveling method, which has become increasingly popular in the wake of EGTRRA's increase in Code Section 415 annual additions limit to 100% of a participant's compensation, enables an employer to pass the ADP test by contributing a small amount of money to select NHCEs, which, because the ADP test is based on the unweighted average of ADRs, has the effect of increasing the average contributions for NHCEs.
Under the proposed rules, a plan would be treated as providing an impermissible targeted QNEC if less than one-half of all NHCEs are receiving QNECs or if the QNECs exceed 5% of the NHCE's compensation and is more than twice the QNEC that other NHCEs are receiving, when expressed as a percentage of compensation. Specifically, QNECs that exceed 5% of compensation could be taken into account for ADP testing purposes only if the contribution, when expressed as a percentage of compensation, does not exceed two times the plan's "representative contribution rate."
Similar restrictions would apply to QNECs taken into account in ACP testing. In order to prevent employers from using targeted matching contributions to avoid the restrictions on targeted QNECs, the proposed rules would not allow matching contributions to be taken into account under the ACP test if the matching rate for the contribution exceeds the greater of 100% or two times the representative matching rate.
(k) Apportioning Corrective Distributions to HCEs in Multiple Plans. The proposed regulations provide a special rule for correcting excess contributions for HCEs who participate in multiple 401(k) plans. Specifically, in determining the HCE who will be apportioned a share of the total excess contributions to be distributed for the plan, all contributions in CODAs in which the HCE participants are aggregated and the HCE with the highest dollar amount of contributions is apportioned excess contributions first. However, distributions would be limited to actual contributions under the plan undergoing correction, rather than all of the contributions considered in calculating the employee's ADR. If additional corrections are needed, the HCEs with the next highest dollar amount of contributions are apportioned the remaining excess contributions, until the excess contributions are completely apportioned.
(l) Safe Harbor Rules. Code Section 401(k) provides a design-based safe harbor method under which a CODA is treated as satisfying the ADP test if the arrangement meets certain contribution and notice requirements. In addressing the requirement for safe harbor plans, the proposed regulations generally follow the rules established under Notice 98-52 and Notice 2000-3. Thus, a plan would satisfy the Code Section 401(k) safe harbor if it makes specified QMACs for all eligible NHCEs. The matching contributions could be provided using a basic matching formula that provides for QMACs equal to 100% of the first 3% of elective contributions and 50% of the next 2%, or using an enhanced matching formula that is at least as generous in the aggregate, provided the rate of matching contributions under the enhanced matching formula does not increase as the employee's rate of elective contributions increases. In lieu of QMACs, the plan is permitted to provide QNECs equal to 3% of compensation for all eligible NHCEs. In addition, notice must be provided to each eligible employee, within a reasonable time before the beginning of the year, of his or her right to defer under the plan.
The proposed regulations clarify that a Code Section 401(k) safe harbor plan must generally be adopted before the beginning of the plan year and be maintained throughout a full 12-month plan year, but would adopt the exception to this requirement that was provided in Notice 2000-3. Thus, under the proposed regulations, an employer is allowed to amend its safe harbor plan to eliminate matching contributions for future elective deferrals, provided that (i) the matching contributions are made with respect to pre-amendment elective deferrals, (ii) employees are provided with notice of the change and the opportunity to change their elections, and (iii) the plan satisfies the ADP or ACP test for the plan year using the current year testing method.
(m) Accounting for Elective Contributions in ACP Safe Harbor. Under the ACP safe harbor, an HCE may not have a higher rate of matching contributions than any NHCE. The proposed rules require any NHCE who is an eligible employee under a safe harbor CODA to be taken into account