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

III. IRA Plans and IRAs

IV. Nonqualified Retirement Plans

V. Fiduciary Responsibilities Under ERISA

VI. 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 (cont’d)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 employee’s 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 participant’s Social Security benefits.

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Summary of Characteristics of DB PlansEmployer 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 PlansEmployer 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 PlansERISA 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 government’s 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 StandardsDB benefits must fully vest in 5 years or:

Years of Service Vesting PercentageLess 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 PercentageLess 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 RulesPurpose

◦ Participants who are NHCs must receive minimum benefit or contribution if plan becomes Top Heavy.

Definition of “Top-Heavy” plan.◦ Disproportionate amount of plan’s 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 employee’s 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 BenefitsAnnual 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 RulesWritten 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 IRS’s 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 IRAsIndividual 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 employee’s 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 IRAsTraditional 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 ERISATwo 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 employer’s 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 (cont’d)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 ERISATitle 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 ResponsibilitiesFiduciary 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 plan’s investments in order to minimize risk of large losses.

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Fiduciary Protection Under ERISALiability 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 plan’s menu.◦ Must manage investment options in accordance with

duties of prudence and diversification.

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Fiduciary Investment ReviewsInvestment Policy Statement (IPS)

◦ IPS can help plan fiduciary’s review process.

Continuous monitoring◦ Ideally, investments should be reviewed annually.

Replace funds that don’t 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 RequirementsSummary 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 BondERISA 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 employer’s competitors?◦ Age, years of service, and pay of employees◦ Employer’s 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.

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

Questions and Answers

Marcia S. Wagner, Esq.

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