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

1. Pension Plans: Everything You Need to Know, But Were Afraid to Ask Marcia S. Wagner, Esq.

2. 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?

3. 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

4. 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.

5. 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.

6. 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.

7. 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.

8. 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).

9. 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.

10. 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 government’s social policies. • For example, plan must help secure retirement of “rank and file” employees as well as management.

11. 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.

12. 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).

13. Minimum Vesting Standards • DB benefits must fully vest in 5 years or: Years of ServiceVesting 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 ServiceVesting 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.

14. 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 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.

15. 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.

16. 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).

17. 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 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.

18. III. IRA Plans and IRAs

19. 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.

20. 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.

21. 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.

22. 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.

23. IV. Nonqualified Retirement Plans

24. 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 employer’s creditors.

25. Qualified Plans v. Nonqualified Plans Nonqualified Plans • Nondiscrimination rules do not apply. • ERISA minimum standards do not apply. • Plans must be unfunded. • Employee taxed at payment or constructive receipt. Tax-Qualified Plans • Qualification rules prohibit discrimination. • ERISA minimum standards apply. (e.g., eligibility, vesting) • Plans must be funded. • Employee not taxed until payment.

26. IRC Section 409A and Voluntary Deferred Compensation • Key concepts under IRC Section 409A • Regulates deferral and payment elections under nonqualified plans. • Deferral electionsmust 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.

27. 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.

28. V. Fiduciary Responsibilities Under ERISA

29. 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.

30. 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.

31. 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 plan’s investments in order to minimize risk of large losses.

32. 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 plan’s menu. • Must manage investment options in accordance with duties of prudence and diversification.

33. Fiduciary Investment Reviews • Investment 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.

34. 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.

35. 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.

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

37. 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

38. 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

39. 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).

40. 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.

41. Pension Plans: Everything You Need to Know, But Were Afraid to Ask Questions and Answers Marcia S. Wagner, Esq. A0044475