Evolution of Employee Benefits As Provided through the Internal Revenue Code

1
Evolution of Employee Benefits As Provided
through the Internal Revenue Code

• Professor Kathryn J. Kennedy
• Testimony before the
• Presidents Advisory Panel on Federal Tax Reform
• March 16, 2005

2
INTERNAL REVENUE CODE

• Provides enormous tax savings for employees and
  employers when certain employee benefits are
  provided
• Pension profit sharing benefits
• Health and dental benefits
• Other welfare benefits (e.g., disability,
  dependent care)
• Pension and profit sharing plans provide
  tax-deferred benefits for employees, whereas
  health benefits provide tax-free benefits and
  other welfare benefits provide tax-free benefits
  with maximum caps (e.g., 5,250 for educational
  assistance, 5,000 for dependent care)
• Why are employee benefits offered by employers?
• To compete for workers who look for benefits,
  especially health and retirement, as a condition
  for employment
• To promote economic security by insuring against
  certain risks and to raise living standards
• To add economic stability by securing the income
  and welfare of employees and their families
• To encourage employee savings which contributes
  to capital formation and economic productivity

3
ERISA Additional Layer of Regulation

• ERISA is a federal labor statute passed in 1974
  to regulate employee benefit plans
• Imposes substantive rules for pension/profit
  sharing plans
• Amended portions of IRC 401(a)
• Exempts governmental and church plans
• Since 1974, ERISA and the Code have been amended
  over 30 times to expand and narrow the scope of
  employee benefit plans, resulting in
• A patchwork of conflicting public policy
  concerns
• Increased administrative and legal costs in
  providing benefits
• Undue complexity for employers in deciding to
  adopt plans
• Confusion for employees in understanding plan
  choices
• Due to the complexity of administering
  pension/profit sharing plans and the difficulty
  in making timely amendments due to changes in the
  law
• IRS has adopted a correction program known as
  Employee Plans Correction Resolution System
  (EPCRS) for employers to correct defects

4
Codes Original Retirement Plan Models

• Pension versus Profit Sharing Model
• Pension plans are designed to provide retirement
  benefits and thus restrictions imposed on
  withdrawals, types of distributions (e.g., joint
  survivor annuities for married participants),
  accrued benefits rules, minimum funding
  requirements
• Profit sharing plans are designed as capital
  accumulation plans and thus less restrictions
  imposed on the use of the monies
• Defined Benefit versus Defined Contribution Plan
  Model
• Defined Benefit Plans are always pension plans,
  in which benefits are calculated according to a
  formula (e.g., percentage of pay and related to
  service)
• Defined Contribution Plans can be designed as
  either a pension plan or profit sharing plan, in
  which contributions are allocated to individual
  accounts

5
Choice of Retirement Benefits Confusing under Code

• Choices Vary by Type of Employer
• Taxable Employers can choose 401(a) Qualified
  Plans and 409A Nonqualified Plans, which can be
  either Defined Benefit or Defined Contribution
  Plans
• Employees can make pre-tax deferrals under a
  401(k) profit sharing plan
• Employees can make pre-tax deferrals under 409A
  nonqualified plan (but these are unsecured and
  unfunded)
• For Certain Other Employers, the Code offers
  alternatives
• Tax-Exempt 501(c)(3) Employers and Public School
  Systems may offer 403(b) Tax Deferred Annuities
• Government and Tax-Exempt Employers may offer
  eligible 457(b) and ineligible 457(f) Deferred
  Compensation Plans
• Small Employers may offer SIMPLE Plans under 408
• For Individuals Choices are solely Defined
  Contribution Plans
• IRA under 219 deductible nondeductible
  depending on pay
• Nondeductible Roth IRAs under 408A
• Spousal IRAs under 219

6
Shift from Defined Benefit Model to Defined
Contribution Model Provides a Variety of Choices

• In 1974, Typical Plan Model Noncontributory
  Defined Benefit Plan fairly simplistic in plan
  design
• Number of Defined Benefit Plans peaked in 1983 at
  175,143 declining to a total of 56,405 in 1998
• In 2005, Typical Plan Contributory Defined
  Contribution Plan Model
• Number of Defined Contribution Plans in 1998 at
  673,626, almost half offering employees a
  deductible 401(k) feature (14,000 in 2005)
• Variety of different choices
• Money purchase target benefit (which are
  pension plans) and profit sharing or stock bonus
  (which are profit sharing plans)
• Types of tax-deferred features 401(k) 403(b)
  457(b)
• Small employers SIMPLE IRAs
• Individuals IRAs, Roth IRAs, Rollover IRAs, and
  Spousal IRAs

7
Example of Confusion Facing Small Employers
8
Cost of Employee Benefits For Employers/Employees

• Retirement benefits continue to be the dominant
  type of benefit that employees receive
• Of all benefit dollars, 47 provide retirement
  benefits (virtually unchanged from 1970)
• Major growth has occurred in health benefits,
  which has increased from 21 of all benefit
  dollars in 1970 to 30 in 1999
• Employers have increased the relative proportion
  of compensation spent on employee benefits
  between 1970 to 1999 (wages and salaries
  decreased 4 while spending on benefits increased
  4 )
• Workers are spending proportionately more on both
  retirement and health benefits
• Retirement income accounted for 25 of personal
  spending in 1970, compared to 46 in 1999
  reflective of the demographics
• Health benefits accounted for 9 of personal
  spending in 1970, compared 27 in 1999

9
Need for Simplification of Defined Contribution
Plans

• Although Defined Contribution Plans can be
  designed as pension or profit sharing plans,
  EGTRRA 01 eliminated the disparity in the
  maximum employer contribution levels for Defined
  Contribution pension versus profit sharing plans
• As a result, employer adopting new plans will
  choose the flexibility of a profit sharing plan
• Suggestions
• Provide a single type of Defined Contribution
  Plan a new Savings Plan with the same
  flexibility as permitted under profit sharing
  plans, thereby eliminating the restrictions under
  Defined Contribution pension plans
• Provide a single 401(k) tax-free feature
  regardless of type of employer eliminating
  alternatives and 403(b) and 457(b) features
• Make choices between a Qualified 401(k) and
  SIMPLE IRA simpler for small businesses

10
Health Benefits Provided under the Code

• Employment-based health plans provide coverage to
  nearly two-thirds of nonelderly individuals in
  the US
• Health Benefits are ranked as the most important
  by workers
• For Code purposes
• Health insurance premiums paid by the employer
  are deductible by employers and completely
  tax-free to the employee (IRC 105)
• Flexible spending accounts (FSA under 125)
  permit employees to pay for health care expenses
  (e.g., deductibles and coinsurance) with pre-tax
  dollars
• Self-employed individuals may deduct 100 of the
  amount paid for health insurance
• Individuals without employment-based health
  coverage may deduct total health care expenses
  only to the extent they exceed 7.5 of adjusted
  gross income

11
Skyrocketing Health Care Costs

• Health care costs have increased 59 over the
  past 5 years, leaving all employers with the
  dilemma of how to pay for such costs
• Cost drivers demographic aging population, costs
  of prescription drugs, research and technology,
  and medical malpractice premiums
• Employers have adopted a number of approaches
• Shift more costs to employees
• Foster greater consumerism among employees
  regarding choices
• Adopt disease management, wellness programs,
  non-smoking plans

12
Congressional Initiatives

• Health Care FSAs (Flexible Spending Accounts)
  Pre-tax employee deferrals under a 125 cafeteria
  plan to fund deductibles/coinsurance
• Use it or lose it feature forfeits unused
  amounts at year end
• Irrevocability of elections make it difficult to
  adjust mid-year
• Period of coverage extends 12 months
• HRAs (Health Reimbursement Accounts under Rev.
  Rul. 2002-41) Employer funded accounts to
  reimburse employees for medical expenses
• Can be, but need not be, coordinated with a High
  Deductible Health Plan (HDHP)
• MSAs (Archer Medical Savings Accounts under IRC
  220) 1996 Temporary Initiative for small
  employers 50 employees
• HSAs (Health Savings Accounts under IRC 223)
  2004 initiative requires employers to provide
  HDHP coverage, with pre-tax employee and/or
  employer deferrals to pay for deductibles and
  coinsurance on a tax-favored basis
• Employees with the least discretionary income
  have the least to defer under the HSA and will
  not be covered under the HDHP until the
  deductible kicks in

13
Concluding Thoughts

• Pension Benefits
• Simplification of the Codes Defined Contribution
  Plan model could easily be made
• Making employer choices simpler
• Reducing administrative costs
• Unfortunately the Codes Defined Benefit Plan
  model is out of date
• Public policy concerns
• Since Defined Contribution models shift mortality
  and investment risk to employees, greater
  education is necessary
• Health Benefits
• Reform existing Code provisions or dramatically
  change the Codes models to help curb costs
• Importance of consumer education regarding health
  care choices
• Incentives to adopt disease management, wellness,
  and similar programs?

14
Additional References

• EBRI Research Highlights Retirement Benefits
• Special Report SR-42 (June 2003), available
  at http//www.ebri.org/ibpdfs/0603ib.pdf
• EBRI Research Highlights Health Data
• Issue Brief 229 (January 2001), available
  at
• http//www.ebri.org/ibpdfs/0101ib.pdf