Pension Plans: Everything You Need to Know, But Were Afraid to Ask

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Pension Plans Everything You Need to Know, But
Were Afraid to Ask

• Marcia S. Wagner, Esq.

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Introduction

• I. Overview of ERISA
• II. Tax-Qualified Retirement Plans
• IRA Plans and IRAs
• Nonqualified Retirement Plans
• Fiduciary Responsibilities Under ERISA
• Which Type of Retirement Plan is Right for You?

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I. Overview of ERISA

• Employee Retirement Income Security Act of
  1974 (ERISA)
• Federal law governing private retirement plans.
• ERISA is divided into four titles.
• Title I U.S. Department of Labor (DOL) and
  fiduciary rules
• Title II Internal Revenue Service (IRS) and
  tax-qualification rules under Internal
  Rev. Code (IRC)
• Title III Coordination of federal agencies
• Title IV Pension Benefit Guaranty Corporation
  (PBGC) and pension plan termination insurance

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II. Tax-Qualified Retirement Plans

• Definition
• Pension plan which also meets the qualification
  requirements under IRC Section 401(a).
• Private employers may adopt tax-qualified plan.
• Advantages of tax-qualified retirement plans.
• Immediate deduction for employer contributions.
• Employees are not taxed currently.
• Earnings on plan trust assets are tax-exempt.
• Tax on distributions can be deferred with
  rollovers.
• Plan assets protected from employer and
  creditors.
• PBGC insurance for benefits under certain plans.

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Defined Benefit Plans (DB Plans)

• DB plan provides stated pension benefit beginning
  at retirement.
• Normally stated in form of life annuity.
• Employer contributions are determined
  actuarially.
• Types of DB plans
• Fixed Benefit Plan fixed amount payable
  annually.
• Flat Benefit Plan of pay payable annually.
• Unit Benefit Plan benefit formula is based on
  years of service (e.g., 1 of pay for each year).
• Cash Balance Plan benefit stated in the form of
  a hypothetical account.

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Defined Benefit Plans (contd)

• Methods for calculating pay
• Final Average Pay pension is based on average
  compensation during defined period.
• Career Average Pay pension is based on pay
  earned during employees entire service period.
• IRS limits on pay
• Plan may not consider more than 245,000 (2010)
  of pay per year.
• Integration with Social Security
• Plan can be designed to provide pension reduced
  for portion of participants Social Security
  benefits.

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Summary of Characteristics of DB Plans

• Employer considerations
• Commitment to contribute to plan.
• Fully financed by employer.
• Investment risk is borne by employer.
• Benefit considerations
• DB plan can recognize past service.
• Easier to provide cost of living adjustments
  (COLA).
• May pay disability and death benefits.
• Generally may not pay layoff or medical benefits.
• No in-service distributions generally.
• PBGC guarantee financed by employer premiums.

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Defined Contribution Plans (DC Plans)

• DC plans maintain separate accounts for each
  covered employee.
• Types of DC plans
• Money Purchase Pension Plan Fixed rate of
  employer contributions (e.g., target benefit
  plan).
• Profit Sharing Plan Employer contributions made
  at discretion of employer.
• 401(k) Plan Covered employees may elect to defer
  compensation, and employer may provide match.
• Stock Bonus Plan Contributions invested and
  benefit payable in employer stock (e.g., ESOP).

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Summary of Characteristics of DC Plans

• Employer considerations
• Flexibility in contribution commitment.
• Lower administrative costs and no actuary
  required.
• Permit employer/employee cost sharing.
• No PBGC premiums.
• Benefit considerations
• Terms and structure easily communicated.
• Generally favor younger employees.
• Investment risk is on employees.
• In-service distributions often permitted.
• Investments may be participant-directed.

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Basic Rules for Tax-Qualified Plans

• ERISA and IRC impose comprehensive set of rules
  for tax-qualified retirement plans.
• Philosophy of tax-qualification plan rules
• To receive tax benefits, plan sponsor must help
  advance governments social policies.
• For example, plan must help secure retirement of
  rank and file employees as well as management.

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Eligibility and Participation Rules

• Minimum age and service conditions.
• Must not exclude on account of age beyond age 21.
• May require service minimum of up to 1 year
  (limited exception for 2-year minimum).
• No maximum age condition permitted.
• 1,000 hour rule applies to minimum service.
• Plan entry may be delayed up to 6 months.
• DB plan must benefit lesser of 50 employees or
  40 of workforce.

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Coverage and Nondiscrimination Rules

• Minimum coverage rules
• Opportunity for Non-Highly Compensated Employees
  (NHCs) to participate in plan must be similar to
  HCEs.
• Must satisfy one of following
  (1) Percentage Test Plan
  covers at least 70 of NHCs
  (2) Ratio Test Ratio of percentage of NHCs
  covered to percentage of HCEs covered is at least
  70
  (3) Average
  Benefit Percentage Test 2-prong test.
• Nondiscrimination rules
• General Test compares actual benefit accruals of
  NHCs against actual benefit accruals of HCEs.
• 401(k) plans are subject to ADP Test (and subject
  to additional ACP Test if plan has a match).

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Minimum Vesting Standards

• DB benefits must fully vest in 5 years or
• Years of Service Vesting Percentage
• Less than 3 0
• At least 3, 4, 5 or 6 20, 40, 60 or 80
• 7 or more 100
• DC benefit must fully vest in 3 years or
• Years of Service Vesting Percentage
• Less than 2 0
• At least 2, 3, 4 or 5 20, 40, 60 or 80
• 6 or more 100
• Must vest upon Normal Retirement Age.
• Year of service based on 1,000 hour rule.

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Top-Heavy Rules

• Purpose
• Participants who are NHCs must receive minimum
  benefit or contribution if plan becomes Top
  Heavy.
• Definition of Top-Heavy plan.
• Disproportionate amount of plans accrued
  benefits are for the benefit of key employees.
• Key employees generally include officers earning
  more than 160,000 (2010) and 1 owners.
• If plan is top-heavy for any year, NHCs must
  receive minimum benefit/contribution.
• Separate minimum vesting schedule also applies.

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Special Accrual and Funding Rules for DB Plans

• Benefit accrual rule for DB plans
• Plan must not provide backloaded benefit
  accruals.
• Benefit must accrue ratably over employees
  career.
• Minimum funding standard for DB plans
• Designed to ensure plans are able to pay benefits
  when they become due.
• Requirements backed by 10 excise tax (and 100
  excise tax if deficiency is not corrected).
• Funding rules do not apply to Profit Sharing
  Plans and Stock Bonus Plans.

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Limitations on Contributions and Benefits

• Annual contribution limit for each DC plan
  participant
• Lesser of 100 of pay, or 49,000 (2010).
• Maximum annual benefit under DB plan
• Lesser of 100 of average pay, or 195,000
  (2010).
• Maximum deduction for plan contributions
• DC plan 25 of participants pay for year.
• DB plan linked to funding standards
  (minimum required contributions always
  deductible).

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IRS and Plan Document Rules

• Written plan requirement
• Tax-qualified plan must have written plan
  document.
• Plan document must be timely updated.
• IRS determination letter program
• Gives employer ability to obtain IRSs blessing
  of plan.
• Plan should be submitted to IRS every 5 years.
• Good faith interim amendments must be adopted
  whenever law change requires it.
• Prototype and IRS pre-approved plans
• Plans are pre-approved by IRS but should be
  reviewed by counsel.

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III. IRA Plans and IRAs

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General Rules for IRAs

• Individual retirement accounts (IRAs)
• Trust or custodial account maintained by bank or
  other qualified person.
• Contributions in cash subject to annual limit.
• No life insurance permitted.
• Account balance must be fully vested at all
  times.
• IRA must be established by written document.
• IRA annuity is subject to similar rules.

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SEP and SEP IRAs

• Simplified Employee Pension Plan (SEP)
• Each eligible employee owns and controls a SEP
  IRA.
• All eligible employees must participate in SEP.
• Eligible if (a) age 21, (b) worked 3 out of 5
  preceding years, and (c) earned 550 in current
  year.
• Requirements for SEP
• Employer contributes to eligible employees SEP
  IRA.
• Allocation formula must be nondiscriminatory.
• Annual limit is lesser of 25 of pay, or 49,000.
  
• Subject to Top-Heavy Rules.
• Annual notice required for eligible employees.

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SIMPLE and SIMPLE IRAs

• Savings Incentive Match Plan for Employees
  (SIMPLE) for small employers only.
• All eligible employees must participate in
  SIMPLE.
• Eligible if received at least 5,000 during any 2
  prior years and expected to earn 5,000 in
  current year.
• Features of SEP
• Ability to defer up to 11,500 (or 14,000 if age
  50).
• Employer must provide 100 match up to 3 of pay,
  or non-elective contribution equal to 2 of pay.
• Contributions must be fully vested, but not
  subject to Top-Heavy Rules or ADP/ACP Tests.

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Traditional and Roth IRAs

• Traditional IRAs
• If employee and spouse are not covered by plan,
  Traditional IRA contributions are fully
  deductible.
• Contribution limit is 5,000 (or 6,000 if age
  50), but deduction is subject to phase-out if
  covered by plan.
• Earnings accumulate on tax-deferred basis.
• Roth IRAs
• Contribution limit is 5,000 (or 6,000 if age
  50), but contribution is subject to phase-out
  based on AGI.
• Contributions are not deductible.
• Qualified distributions are tax-free.

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IV. Nonqualified Retirement Plans

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Types of Nonqualified Plans Under ERISA

• Two types of nonqualified plans
• Excess Benefit Plan provides benefits in excess
  of IRC limitations on contributions and benefits.
• Top Hat Plan covers select group of management
  or HCEs only.
• Both types of plans are unfunded.
• Plans need not satisfy tax-qualification plan
  rules.
• Discriminate in favor of HCEs by design.
• May be informally funded by rabbi trust, where
  assets remain subject to claims of employers
  creditors.

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Qualified Plans v. Nonqualified Plans

• Tax-Qualified Plans
• Qualification rules prohibit discrimination.
• ERISA minimum standards apply. (e.g.,
  eligibility, vesting)
• Plans must be funded.
• Employee not taxed until payment.

• Nonqualified Plans
• Nondiscrimination rules do not apply.
• ERISA minimum standards do not apply.
• Plans must be unfunded.
• Employee taxed at payment or constructive receipt.

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IRC Section 409A and Voluntary Deferred
Compensation

• Key concepts under IRC Section 409A
• Regulates deferral and payment elections under
  nonqualified plans.
• Deferral elections must be made prior to year in
  which pay is earned, except that
• Newly eligible participants can elect within 30
  days.
• Election to defer performance-based pay can be
  made 6 months prior to end of performance period.
• Can defer ad hoc bonus within 30 days if subject
  to forfeiture for at least 1 year after election.
• Special rule if newly eligible in excess plan.

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Requirements Under 409A (contd)

• Payment elections
• Must elect payment time/form with deferral
  election.
• No earlier than separation, disability/death,
  change of control, unforeseeable emergency, or
  fixed date.
• Anti-acceleration rule
• Beneficiary payment election
• Payment election for death benefits must be made
  with Payment Election (but can change
  beneficiary).
• Payment deferral election
• At least 12 months prior to deferred payment
  date, can elect to defer again for minimum of 5
  years.

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V. Fiduciary Responsibilities Under ERISA

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Scope of Title I of ERISA

• Title I imposes fiduciary requirements on
  employee benefit plans only.
• Includes any tax-qualified retirement plan
  sponsored by employer with one ore more
  employees.
• Does not apply to tax-qualified plans without
  employees (e.g., plan for sole proprietor).
• IRA plans are technically subject to Title I, but
  exempt from most requirements.
• Nonqualified plans are technically subject to
  Title I, but exempt from substantive requirements.

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Definition of Fiduciary

• An ERISA plan must have at least 1 fiduciary.
• Fiduciary
• Person with discretionary authority/control over
  management of plan or disposition of plan assets.
• Advisors who provide investment advice.
• Person is not a fiduciary if such individual or
  entity only performs ministerial functions.
• Fiduciary status is determined under a functional
  test.
• If you act or function like a fiduciary, you
  are.

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Fiduciary Responsibilities

• Fiduciary standard of care under ERISA.
• Exclusive purpose of providing benefits - must
  discharge duties solely in interest of plan
  participants.
• Carrying out duties prudently must manage plan
  assets with skill and diligence of prudent person
  familiar with plan investment matters.
• Following terms of plan document must obey
  written terms of plan unless inconsistent with
  ERISA.
• Diversifying plan investments must diversify
  plans investments in order to minimize risk of
  large losses.

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Fiduciary Protection Under ERISA

• Liability protection under ERISA Section 404(c)
• Plan sponsor is responsible for
  participant-directed investments unless plan
  complies with ERISA 404(c).
• Conditions of ERISA Section 404(c)
• Participant must exercise independent control,
  and have enough info to make informed decisions.
• Plan menu must have broad range of inv. options.
• If plan satisfies ERISA 404(c), plan sponsor only
  remains responsible for plans menu.
• Must manage investment options in accordance with
  duties of prudence and diversification.

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Fiduciary Investment Reviews

• Investment Policy Statement (IPS)
• IPS can help plan fiduciarys review process.
• Continuous monitoring
• Ideally, investments should be reviewed annually.
• Replace funds that dont meet criteria.
• Documentation of fiduciary reviews.
• Utilize independent investment expert.
• Evaluate expense ratio/fees.
• Plan fiduciaries must ensure fees are reasonable.

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Reporting and Disclosure Requirements

• Summary Plan Description (SPD)
• Must provide non-technical summary to
  participants.
• Summary of Material Modifications (SMM)
• Written summary of material modifications to
  plan.
• Annual Reports
• Form 5500 must be filed annually with DOL.
• Summary Annual Report (SAR)
• Summary of financial info in Form 5500 filing
  must be distributed to participants annually.

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Purchasing a Fidelity Bond

• ERISA bond required for every person who
  handles plan funds.
• Coverage amount for ERISA fidelity bond
• Must cover 10 of plan assets handled.
• Minimum amount of 1,000 and maximum amount of
  500,000 (1M if plan holds employer securities).
• ERISA fidelity bond is not fiduciary liability
  insurance.
• ERISA bond protects plan.
• Fiduciary liability insurance protects fiduciary.

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VI. Which Type of Retirement Plan Is Right for
You?

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Considerations for Employer and Employees

• Nature of employer and its business goals
• How is business organized? How long in existence?
• Benefits provided by employers competitors?
• Age, years of service, and pay of employees
• Employers past and projected financial condition
• Will benefit costs be shared with employees?
• Needs of employees
• Owners
• Key employees
• Rank and file employees

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Advantages and Disadvantages of Tax-Qualified
Retirement Plans

• Advantages
• Tax benefits, including immediate deductions.
• Disadvantages
• Numerous requirements and restrictions.
• Examples of plans meeting business needs
• To maximally benefit owners or management
• To provide benefits at minimal cost to employer
• To encourage long-term employment
• For contribution flexibility
• To provide fixed contributions with certainty

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Advantages and Disadvantages of IRA Plans

• SEP and SEP IRAs
• Advantages similar to tax-qualified plan
  benefits but fewer requirements must be
  satisfied.
• Disadvantages employer must contribute to SEP
  IRAs of all eligible employees.
• SIMPLE and SIMPLE IRAs
• Advantages similar to 401(k) plans but fewer
  requirements must be satisfied.
• Disadvantages for small employers only, and
  employer must provide 100 match
  (or non-elective contribution equal to
  2 of pay).

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Advantages and Disadvantages of Nonqualified
Retirement Plans

• Advantages
• Best way to provide benefits favoring exclusive
  group of HCEs.
• Not subject to tax-qualification rules.
• Can be designed as a DB plan or DC plan.
• Disadvantages
• Can not be funded.
• No immediate contributions to plan, so no
  immediate tax deductions are available.
• Generally cannot include any rank and file
  employees.

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Pension Plans Everything You Need to Know, But
Were Afraid to Ask

• Questions and Answers
• Marcia S. Wagner, Esq.

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