The administration views certain savings for retirement to be a tax loophole. The just released budget, in its Overview, states: “[The budget] ends a loophole that lets wealthy individuals circumvent contribution limits and accumulate millions in tax-preferred retirement accounts.” [There is no acknowledgement that these dollars are subject to ordinary income tax when withdrawn nor is there an explanation of how these wealthy folks get around contribution limits which apply regardless of income.] In the section of the budget that is titled Providing Middle Class Tax Cuts and Rebalancing the Tax Code through Tax Reform, there is a description of the President’s attack on retirement savings that states:
Prohibit Individuals from Accumulating Over $3 Million in Tax-Preferred Retirement Accounts. Individual Retirement Accounts and other tax-preferred savings vehicles are intended to help middle class families save for retirement. But under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving. The Budget would limit an individual’s total balance across tax-preferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement, or about $3 million for someone retiring in 2013. This proposal would raise $9 billion over 10 years.
In a budget that claims to simplify the tax code, this provision, if it becomes law, is fraught with complexity and will result in reams of new regulations. Some of the issues that would require regulation might include:
- In measuring an “individual’s total balance across tax-preferred accounts” are defined benefits ignored? Nope, not according to the “Greenbook.” (As opposed to one of these “green books“.)
- Since annuities are interest-rate sensitive, account balances falling under the “about $3 million” threshold would increase as interest rates rise – assuming they ever do. How would those adjustments apply and when?
- What are the variables that determine an annuity of $205,000 per year? The “Greenbook” states it’s a joint and 100% survivor annuity commencing at age 62.
- Does the limit apply at any time or only when someone reaches some undisclosed retirement age? The “Greenbook” states that the determination will be made annually and by taking each account balance and converting it into an actuarial equivalent annuity (presumably for all participants). No administrative cost there!
- And what happens if you go over the limit? The “Greenbook” suggests that there will be a cessation of contributions and accruals, but earnings can continue. However, that point underscores just how ineffective this cap is likely to be at limiting retirement savings (which is a poor goal to begin with). In many cases, large retirement account accumulations (particularly in IRAs) are not the result of excessive contributions, but of investment of assets. Generally speaking, at the point at which someone’s account reaches $3 million dollars, the investment return has the potential to be significantly more valuable in growing the account than additional contributions.
- Of course, if the limitation increased, contributions and accruals could start again. Certainly every employer looks forward to addressing these additional administrative headaches. And, it would seem that every American participating in both a 401(a) plan and an IRA will have to employ her own actuary.
- Do Roth earnings count toward the limit or is it just traditional pre-tax dollars and their earnings that count?
- Will the limit be indexed on some basis?
Surely there are many more issues that will need attention before this type of limitation might be implemented. The cost of implementation by government and the private sector may even challenge the $9 billion in proposed federal savings!
An unintended consequence of such a limit may be that business owners whose own accounts could reach the limit, or who don’t want the added administrative cost, either terminate their company plans or eliminate employer contributions to those that continue in operation. That would be detrimental to the middle class that the administration believes it is protecting. If the idea is to put a limit on the tax-favored savings of the so-called “wealthy” [actually many may just be smart savers and investors], it is fraught with the potential to backfire and harm the middle class. On the other hand, this may all be smoke and mirrors. EBRI followed up the release of the budget by demonstrating that about 1% of all account holders would be affected in today’s interest environment. However, EBRI points out that the threshold would decrease dramatically, cover many more accounts and have the most significant impact on the younger generations as time goes by. But if so few are impacted, why would any employer want the additional headache? And will the DOL let the plan pay for this – probably not – after all, it only affects the wealthy, right?
Best of all, this is intended to go into effect for taxable years beginning January 1, 2014 – if it becomes law.
Yesterday, the Ninth Circuit issued an opinion in Tibble v. Edison International (Case: 10-56406, 03/21/2013), affirming the Central District of California district court’s ruling in a 401(k) fee case brought under ERISA. The district court had rejected most claims but had entered judgment totaling just over $300,000 for the plaintiff beneficiaries on claims regarding the selection of certain mutual fund investment options, where lower-priced share classes were available in the same funds. Highlights from the decision include:
Statute of Limitations
- The Ninth Circuit rejected a “continuing violation theory” in favor of a bright-line rule that the act of designating an investment for inclusion starts the running of ERISA’s six-year SOL.
- Beneficiaries did not have “actual knowledge” of the alleged deficiencies in the process for selecting retail class mutual funds for the plan’s investment line-up, and, therefore, ERISA’s three year SOL does not apply.
- The panel also held that Section 404(c) (a “so-called” safe harbor that can relieve a plan fiduciary from liability arising from the investment choices made as a direct and necessary consequence of a participant’s exercise of control) did not preclude a merits consideration of plaintiffs’ claims.
- The panel declined to consider defendants’ arguments that class certification was improper since this issue was raised for the first time on appeal.
Revenue Sharing and Standard of Review of Fiduciary Breach Claims
- The Ninth Circuit panel affirmed the district court’s grant of summary judgment to defendants on the claim that revenue sharing between mutual funds and the administrative service provider violated the plan’s governing document and was a conflict of interest. Looking to the Supreme Court’s prior holdings (Firestone Tire & Rubber Co. v. Bruch, Metropolitan Life Insurance Co. v. Glenn and Conkright v. Frommert) on standard of review and agreeing with the holdings of the Third and Sixth Circuits (and rejecting the rulings of the Second Circuit), the Ninth Circuit panel held that, as in cases challenging denials of benefits, a “usual” abuse of discretion standard of review applied to this case which concerns potential violations of fiduciary duties and conflicts-of-interest because the plan granted interpretive authority to the administrator.
Use of Mutual Funds, Short-Term Investment Fund and Unitized Stock Fund
- The Court also ruled that defendants did not violate their duty of prudence under ERISA by including in the plan’s investment menu (i) mutual funds, (ii) a short-term investment fund “akin” to a money market fund, and (iii) a unitized company stock fund.
Finally, the panel affirmed the lower court’s holding, after a bench trial, that the defendants were imprudent in deciding to include retail-class shares of three specific mutual funds in the plan menu because Edison failed to investigate the possibility of institutional-class alternatives.
Target date retirement funds generally refer to a related group of investment funds that automatically rebalance and become more conservative as a participant moves towards a designated retirement year. Many 401(k) and profit sharing plans use target date retirement funds as the qualified default investment alternative (QDIA). In that case, when a participant fails to make an affirmative election regarding how his or her qualified defined contribution plan accounts should be invested, contributions are allocated to a target date fund based on the date the participant will attain retirement age, usually designated as age 65. Use of a QDIA relieves a plan fiduciary of liability related to the return generated on the investment fund. Also, participants who do not want to actively manage their accounts are increasingly using target date retirement funds.
In February 2013, the Department of Labor (DOL) issued tips for ERISA plan fiduciaries regarding the selection and monitoring of target date retirement funds in an ERISA plan. The fact sheet can be found on the DOL’s website. The list of tips includes the following:
- Establish a process for comparing and selecting the target date retirement funds
- Establish a process for the periodic review of selected funds
- Understand the fund’s investments – the allocation in different asset classes, individual investments, and how these will change over time
- Review the fund’s fees and investment expenses
- Inquire about whether a custom or non-proprietary target date fund would be a better fit for your plan
- Develop effective employee communications
- Take advantage of available sources of information to evaluate the fund and recommendations you received regarding the fund selection
- Document the process
The DOL fact sheet explains each of these tips in greater detail and provides a roadmap for complying with ERISA’s fiduciary duty requirement for selecting and monitoring these types of funds. You can use these tips to ensure compliance by your ERISA plan fiduciaries.
With over 1,100 federal statutory provisions in which marital status is a factor in determining access to statutory benefits, rights, or privileges, the outcome of the challenge to the constitutionality of laws adversely impacting same-sex marriages could have a significant effect on employee benefits.
Under the federal Defense of Marriage Act (DOMA), for purposes of federal law, the word “marriage” means only a legal union between a man and a woman, and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. This means that under current law, Federal benefits available to opposite-sex spouses are not available to same-sex spouses even when they are legally married under state law.
Later this month, the Supreme Court will hear oral arguments on two cases that could change this result. Windsor v. United States is a constitutional challenge to Section 3 of DOMA, which defines marriage to exclude same-sex marriages. Hollingsworth v. Perry is a constitutional challenge to Proposition 8, a California ballot initiative that amended the state constitution to ban same-sex marriage.
So far, over 300 employers including many of America’s top companies, e.g., Amazon.com, Apple, Citigroup, Ernst & Young, Google, Intel, Microsoft, Starbucks, Walt Disney, have signed a petition in a brief submitted to the Supreme Court urging that the Court declare Section 3 of DOMA unconstitutional. Similar briefs have been filed to declare Proposition 8 unconstitutional. Final decisions on the cases are expected this summer.
If the Supreme Court decides that Section 3 of DOMA is unconstitutional under Windsor, employee benefits and protection mandated under federal law would be extended to spouses of same-sex spouses. For example, employee benefits, rights, or privileges required for opposite-sex spouses under FMLA, COBRA, HIPAA, qualified retirement plans (spousal and death benefits) would also be required for same-sex spouses. And, same-sex spouses could receive nontaxable benefits under employer health plans. However, overturning Section 3 alone would not equalize same-sex spouses and opposite-sex spouses; states would still be able to decide whether or not to recognize same-sex marriages/spouses for employee benefits governed by state laws.
The Supreme Court’s decision under Hollingsworth could have a much greater impact. The Court could endorse the lower court’s narrow holding and limit Hollingsworth to California’s Proposition 8. Alternatively, the court could take a broader view and rule generally that any state law prohibiting same-sex marriage violates the equal protection clause of the 14th Amendment, in effect legalizing same-sex marriage in the United States.
Employers are advised to follow the Supreme Court’s decisions in the upcoming months, and determine whether to amend their federally mandated benefits plans as well as their non-mandated plans accordingly.
Continuing our series of posts reporting on the recent TE/GE meetings, today we focus on the audit trends and issues that the IRS officials in attendance identified. In addition to providing insight on the IRS’s focus, the list serves as a good compliance checklist for plan sponsors. Are you making these errors? If so, you can (and should) fix them now before the IRS comes knocking.
Areas of Focus. At the outset, it’s helpful to know where the IRS is looking for trouble, so you can have some idea where agents are coming from when you get the dreaded audit letter. The officials at TE/GE gave these insights:
- Most audits are focused on 3 or 4 particular issues depending on the market segment (i.e., the business of the employer) and the size of the plan (generally less than 100 participants is a small plan while other plans are considered large). The IRS did not give examples of the issues on which they are focusing, but to the extent you or your advisors are aware of other IRS audits in your market segment and for plans of your size, you may be able to identify them.
- There is no current targeted audit project for governmental plans.
- 403(b) plans will be an area of focus going forward.
- With regard to 401(k) audits, there will be a heavy emphasis on internal controls. They mentioned this multiple times, so it’s a good idea to review and document your internal controls now so that you are prepared when the IRS audits.
- For defined benefit plans, they said they will focus on “issues around [the Pension Protection Act].” They did not elaborate, but presumably this will involve a focus on operational compliance with PPA changes.
Audit Trends. The IRS also identified a few common audit trends. Most of these are unsurprising, but again, serve as a good checklist for plan sponsors.
- First, they identified the following general trends:
- Failure to timely amend documents for law changes
- Failure to follow plan terms
- Using the incorrect definition of compensation for contribution, benefit calculation, or testing purposes
- Eligibility compliance issues, such as failing to exclude ineligible employees or include eligible ones
- On a more specific note, they identified the following as issues that were particularly prevalent in 401(k) plans:
- Failing to have internal controls (did we mention that they thought this was important?)
- Increases in plan loan defaults due to administrative errors (see our prior post about doing a quarterly checkup)
- Failing to make the top heavy minimum contribution in a top heavy plan (this is a bigger issue for smaller plans)
- In the 403(b) area, they reported that the following issues were common:
- Deferrals exceeding the 402(g) limit ($17,500 for 2013)
- Failure to comply with the universal availability rules
- Contributions in excess of the maximum limits under 415 ($51,000 for 2013)
- Plan loans that violate the loan rules on maximum loan amounts or maximum repayment periods (and, in some cases, have no documentation at all for the loan)
- Hardship distributions where insufficient documentation is obtained to demonstrate the hardship.
One of the sadder tasks encountered by a plan administrator is sorting out who is the appropriate recipient of benefits when a participant has been murdered by the intended beneficiary of such benefits. Over time, we have advised many plan administrators in handling situations like this one dealing with their pension, 401(k), life insurance and accidental death plans and, in doing so, have developed a variety of alternatives each with varying levels of cost and risk. These alternatives, each of which is summarized in more detail below, include: (1) commencing an interpleader action, (2) securing a receipt, release, and refunding agreement, and (3) obtaining an affidavit of status (e.g., heirship).
In arriving at these alternatives, we have considered applicable law, including state statutes and ERISA preemption. Most individual states have enacted so-called “slayer” statutes, which generally provide that an individual who kills the decedent cannot benefit from his or her crime and, therefore, forfeits all benefit rights he or she possessed as the primary beneficiary. While some courts have held that these state slayer laws may be preempted under ERISA’s broad preemption doctrine, a similar result is likely to be reached through applicable federal common law principles. In fact, an Eastern District of Pennsylvania court recently addressed this situation in In re Estate of Burklund (January 28, 2013). The Burklund court declined to decide the ERISA preemption issue since the Pennsylvania state law and the federal common law that would apply if ERISA preempted Pennsylvania’s slayer’s act are essentially the same in a “slayer” situation and further noting that several district courts have taken this approach. In this case, the court ruled that the wife (also the primary beneficiary of her husband’s employer-sponsored life insurance and accidental death policy) was barred from receiving any benefits from her husband’s insurance policy following her first-degree murder conviction for the husband’s death. The son was, instead, deemed to be the appropriate beneficiary since he had been designated as the contingent beneficiary named under such policies.
When a substantial amount of benefits are involved and/or a plan administrator is aware of multiple parties who will potentially assert a claim on the benefits, an interpleader action may be the most appropriate course of action. In essence, an interpleader action involves the plan administrator paying the entire benefits into the court and having the potential claimants become parties to the litigation. The claimants proceed against each other and the court determines which of the claimants is legally entitled to the benefits. While an interpleader may be prohibitively expensive (and burdensome from a time and cost perspective) for a plan administrator if a small amount of benefit is involved, it is one of the only manners in which a plan administrator can gain certainty that it will not have to pay out the dispute benefits to more than one party making such a claim. Thus, the time and money invested may be worthwhile.
Receipt and Refunding Agreement
In situations where a plan administrator chooses not to proceed with an interpleader action (perhaps on account of the cost or time involved with such an action), obtaining a receipt, release, and refunding agreement may serve as an attractive alternative. By securing such an agreement, the signing payee/beneficiary acknowledges that he/she has received the proceeds, and further agrees to immediately refund to the plan(s) the amount of any excess or improper distribution. A receipt, release, and refunding agreement may be used in conjunction with an affidavit of the party’s relationship with the participant (discussed below) to minimize the chance the recipient would need to refund any amount that was initially distributed. However, unless the signing payee/beneficiary voluntarily agrees to repay the inappropriately distributed amounts, a plan administrator may have to commence litigation to enforce the agreement. Even if that litigation is successful, there is a possibility that a plan administrator may not be able to secure repayment if the signing payee/beneficiary is “judgment proof.” Thus, this alternative is not without risk.
Affidavit of Status
Where a plan administrator is paying out benefits to a party on account of their relationship to the decedent/participant, a plan administrator may choose to secure an affidavit from the payee/beneficiary as to that relationship. For example, if (1) a participant in a 401(k) plan dies without a designated (i.e., named) beneficiary, (2) his spouse murdered him and, (3) the plan provides that the surviving children of the participant would be the appropriate beneficiary, then it might make sense to secure an “affidavit of heirship” from a surviving child stepping forward affirming that such child is and ever was the only known child of the decedent/participant. As suggested above, by using this type of affidavit in conjunction with a receipt, release, and refunding agreement, the plan administrator preserves an “undo” feature to the initial distribution in case another beneficiary is subsequently discovered.
In no way do the enumerated alternatives described above constitute an exhaustive list. We are constantly seeking more creative and effective methods to ensure that the proceeds are paid to the appropriate recipient. In addition, the appropriate strategy to undertake largely depends on the factual circumstances facing the plan administrator. Do you have any other alternatives that you’d like to share?
In this second post in our series of reflections from the recent Tax Exempt/Government Entities meeting with IRS and DoL officials, we’ll focus on the areas the DoL officials identified as enforcement priorities and some of the specific items they highlighted.
Health Plans. As we previously posted, the DoL is starting to look at health plans and compliance with health care reform specifically. They have also discovered that many plans lack what they consider to be a formal plan document. They are starting to ask not just for proof of the plan document’s existence, but also proof of when it was adopted, going back to January 1, 2010. Plan sponsors who have not adopted wrap plan documents for their health plans may want to consider implementing those soon.
ESOPs. ESOP enforcement continues to be a priority. The officials stated that they believe appraisers are arguably already fiduciaries on the theory that they are providing investment advice (although, in our view, that position is not without its flaws). They noted that trustees still have a duty to prudently select the appraisers and that, even if the appraiser is prudently selected, the trustee still has an obligation to make sure the assumptions on which the valuation is based are reasonable under the circumstances. They also said that trustees should be wary of a seller’s role in selecting the appraiser. Oh, and trustees should also read the appraisal.
Officials identified the following more egregious practices that they see (which serves as a good list of “watch-outs” when reviewing valuations):
- No discount applied for lack of marketability;
- Failure to take into account the risk associated with having only a single supplier or customer;
- Inflated projections;
- Inconsistencies between the narrative of the valuation and the math in the appendices;
- Use of out of date financial information;
- Improper discount rates;
- Incomparable comparable companies – for example using a large public company as a comparable to a small private company; and
- Failure to test the underlying assumptions.
ERISA Accounts/Budgets. While not an enforcement area, officials expressed the view that excess revenue sharing, 12b-1, and other investment fees that are held in ERISA Accounts or ERISA Budgets should be used to pay proper plan expenses. If there are excesses, they should ideally be allocated to the individuals whose investments generated the fees. However, they acknowledged that this is an area where “rough justice” may be necessary, especially if the excess revenue sharing, 12b-1, and other investment fees are small.
Other Areas. Other areas of focus include:
- Direct investigations of consultants and advisors to plans and plan administrators
- Bankruptcies of plan sponsors – particularly with regard to employee contributions which the Bankruptcy Code expressly states are not part of the Bankruptcy estate and may not be used to satisfy creditors
- Appellate & Amicus participation – The DoL has been very active filing Amicus briefs in employee benefits litigation as part of an effort to influence the court’s outcome. The official from the DoL Solicitor’s office said that one practitioner referred to them as “officious intermeddlers” to which he (jokingly) replied, “That’s what we’re shooting for.”
As we have said before, these statements, the statements are informal and non-binding, and thus cannot be relied upon as official guidance.
Last week I (Chris) had the good fortune to travel on Lisa’s behalf to Baltimore to attend an annual meeting of benefits practitioners with government representatives from the DoL and IRS national offices. It served as a great opportunity to hear what guidance may be in the pipeline and what enforcement issues are catching the government’s attention. Plan sponsors should take heed because those items getting the government’s regulatory or enforcement attention tend to (1) be very common and (2) serve as a good compliance check. Over the next week or so, we’ll cover what they said and what you should be looking for coming down the pike. First up: the Department of Labor’s regulatory agenda. Based on statements from DoL officials:
- No additional guidance is planned on the ERISA 408(b)(2) service provider fee disclosures at this time. They talked with many service providers and felt that, in general, where there was ambiguity, the providers made reasonable interpretations.
- Regarding the reproposal of the definition of “fiduciary,” they are looking to draw a bright-line distinction between investment education (non-fiduciary) and investment advice (fiduciary). They may also include a prohibited transaction exemption for individuals who accidentally cross the line.
- On lifetime income options in DC plans, there are three areas of focus:
- Showing the income stream the participant’s account balance could generate (this will likely be the first area on which guidance will be issued).
- Including education about retirement planning (e.g., whether to select an annuity).
- Guidance for plan administrators on selecting annuity providers.
- For target date funds, they said they hope to have a final rule on required disclosures in November. They also are hoping to release tips for plan sponsors on selecting TDFs.
- Finally, on the advisory opinion front, they are considering whether to release an advisory opinion on whether so-called “ERISA Accounts” or “ERISA Budgets” are considered plan assets and how they should be handled. These are accounts that contain rebates of revenue sharing and other fees from mutual funds and have been a regulatory gray area ever since they first appeared on scene. (The DoL representative also alluded to an opinion on the clearing of swaps under Dodd-Frank, which has already been released.)
As with all statements by government representatives, the statements are informal and non-binding, and thus cannot be relied upon as binding. However, in the absence of any other information, the DoL’s comments should give plan sponsors some idea of the developments they can expect to see from the DoL in the weeks and months to come.
With a down economy, many employers are seeing an increase in loan requests from retirement plan participants. With an increase in loan requests comes an increase in loan administrative concerns. In fact, IRS officials have informally stated that they are seeing an increase both in loan applications and in loan defaults.
One way to help head off administrative issues at the pass is to do a quarterly loan checkup. Plan sponsors should check with their third party recordkeepers on a quarterly basis to check on the status of any loans for which payment is not current. Ideally, this checkup should occur a month or six weeks before the end of the calendar quarter to allow time to correct any loans that could inadvertently go into default (such as when a plan sponsor fails to process loan repayment elections due to a payroll error).
Plan sponsors may also want to consider checking up after the end of the quarter to make sure that any loans that went into default have either been offset from the participant’s account balance or are on a list to be treated as a deemed distribution. In addition, plan sponsors should check up in January of each year to make sure that all offsets and deemed distributions are appropriately recorded on Forms 1099-R. While such a checkup is not explicitly required, it is a good practice to head off possible issues down the road. Furthermore, IRS officials have recently stated that they are focusing on reviews of internal controls as a part of plan audits. By doing this checkup, plan sponsors may be able to avoid having difficult loan issues that would require voluntary correction filings with the IRS and will save themselves headaches if they are audited.