Fathoming FICA: A lifeline for NDCP sponsors and participants

Pizzano-DominickThis blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.

Even if nonqualified deferred compensation plan (NDCP) sponsors and participants successfully navigate safe passage through the compliance complexities of Internal Revenue Code section 409A, they both could still sink in a sea of taxes and penalties if they overlook applicable payroll taxes. High on the IRS’s executive compensation enforcement initiatives is increased scrutiny of the Federal Insurance Contributions Act (FICA) taxes on NDCP benefits. The resulting penalties for a failure to pay appropriate FICA taxes affect both employers and executives and can be severe: back taxes, interest, fines, and even imprisonment if the misrepresentation or miscalculation of FICA tax amounts is proven to be willful.

Setting bearings straight on FICA taxes
FICA taxes have two components:

• Social Security (old-age, survivors, and disability insurance or OASDI) taxes are currently paid by employers and employees at a rate of 6.2%. These taxes are imposed on the employee’s wages up to the Social Security Taxable Wage Base (SSTWB), which is $118,500 for 2016.

• Medicare (hospital insurance or HI) taxes are paid by employees and employers, both at a rate of 1.45%, on all wages (i.e., no cap) paid to an executive. Beginning in 2013, the rate increased to 2.35% for certain high income individuals (e.g., those filing taxes as a single individual with more than $200,000 in wages) but remained at 1.45% for the employer portion.

Regardless of whether their source is executive deferrals or employer contributions, NDCP benefits are considered wages and thus are subject to FICA taxes. However, while these taxes are imposed immediately on current compensation, separate rules determine when NDCP benefits become subject to FICA taxes and vary depending on whether the NDCP is an “account balance” or a “non-account balance” plan.

Account balance NDCPs
Also known as “defined contribution”-style NDCPs, these are plans in which participant salary deferrals and/or employer contributions are allocated to one or more accounts established on behalf of the participant. Such allocations accumulate over time and are typically adjusted to reflect either deemed or actual investment experience. Nearly all plans of this type provide 100% immediate vesting.

Account balance NDCPs that call for only participant deferrals offer smooth sailing when applying the FICA taxation rules. The NDCP benefits are generally subject to FICA taxation only to the extent they are vested (i.e., participants will not forfeit benefits because they terminate employment). In addition, the calculation and withholding of the tax mirrors that used for 401(k) deferrals: the FICA tax is applied to the participants’ total gross compensation prior to any reductions made as the result of a deferral. Like 401(k) deferrals, the FICA withholding for NDCP deferrals takes place at the payroll level.

The immediate application of the FICA tax to the NDCP deferrals also enables participants to take advantage of a “non-duplication” FICA tax rule. Under this rule, once a NDCP deferral is taxed for FICA purposes, neither that amount nor any earnings attributable to that amount is ever again treated as wages subject to FICA taxes. Accordingly, when the participant eventually receives a distribution from the NDCP, no FICA taxes apply to the entire account balance (i.e., sum of all deferrals plus investment growth).

However, for NDCPs that credit participants’ accounts with a flat interest rate or a rate attributable to deemed (instead of actual) investment experience, this favorable tax treatment is only available if such crediting rate does not exceed what the IRS considers a “reasonable rate of interest.” While not providing a specific definition of this term, IRS guidance offers acceptable alternatives and contains several ironclad restrictions that prevent “creative” plan designs intended to produce artificially inflated levels of return on participants’ accounts. To the extent that a NDCP credits such excess returns, the portion that is considered excess will not qualify under the non-duplication rule and thus be FICA taxed as additional deferrals.

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GASB 74/75: Calculation specifics on individual entry age normal

With Governmental Accounting Standards Board (GASB) Statements 73, 74, and 75, new accounting rules for public postretirement benefit plans in the United States are set to take effect soon. Successful implementation of the new rules will require an understanding of a variety of technical concepts regarding the various newly required calculations. In this PERiScope article, Milliman’s Michael Caparoso discusses the individual entry age actuarial cost method for the valuation of Other Postemployment Benefits (OPEB).

Implementation of a single-employer defined benefit plan spin-off

Kamenir-JeffA spin-off of a single-employer defined benefit (DB) pension plan is a complicated transaction, with an end result of one plan split into two or more DB plans. The objective of federal rules governing spin-offs is that participants should be no worse off with respect to the security of their accrued benefits immediately following the spin-off, compared with benefits that would have been received if the plan had been terminated immediately prior to the spin-off.

A change in business circumstances might be one reason a plan sponsor would consider a spin-off. For example, if a portion of the participants in a single-employer DB plan are sold to another company, the buyer and seller might agree that the assets and liabilities of the affected DB plan participants be spun-off into a new plan that becomes the responsibility of the buyer.

Another reason a plan sponsor might consider a spin-off would be for risk management purposes. Many plan sponsors today are interested in transferring the responsibility for pension liabilities to either participants by a lump-sum distribution or to an insurance carrier by an annuity purchase. That interest is due to various uncertainties that will affect the ultimate cost of the pension liabilities (e.g., investment performance, liability interest rates, participant mortality, legislative changes, pension insurance premium charges). A plan sponsor in an ongoing pension plan is generally not allowed to transfer the responsibilities for the liabilities of active participants unless the plan is being terminated. If the assets and liabilities related to active participants are spun off into a new separate plan, that plan can then be terminated with the liability responsibility transferred as described above.

The Pension Benefit Guarantee Corporation (PBGC) is the federal agency responsible for the insurance of unfunded pension liabilities. In the case of an underfunded pension plan termination, the amount of the shortfall covered by the PBGC is dependent on the PBGC’s rules on how liabilities are categorized, with certain lower-priority liabilities not insured by the PBGC. If 3% or more of plan assets are spun-off into a new plan, a complicated actuarial calculation must be done to determine the assets allocated to each plan, based on PBGC liability categorization rules for underfunded plan terminations. Also, a Form 5310-A must be filed with the Internal Revenue Service (IRS) at least 30 days prior to the effective date of the spin-off.

If less than 3% of plan assets are spun off into a new plan, the Form 5310-A filing is not required. Also, the actuarial calculation becomes much simpler because the assets allocated to the smaller plan are just equal to the present value of its liabilities rather than determined by the above rules for larger spin-offs.

In summary, given the complexities of the requirements for implementing a single-employer DB plan spin-off, a plan sponsor may wish to discuss the proposed spin-off with the plan actuary and legal counsel before proceeding.

Regulatory roundup

More retirement-related regulatory news for plan sponsors, including links to detailed information.

DOL releases final overtime rule
The Department of Labor (DOL) issued its final overtime rule. The rule focuses primarily on updating the salary and compensation levels needed for executive, administrative and professional workers to be exempt. Specifically, the final rule:

1. Sets the standard salary level at the 40th percentile of earnings of full-time salaried workers in the lowest-wage census region, currently the south ($913 per week; $47,476 annually for a full-year worker);

2. Sets the total annual compensation requirement for highly compensated employees (HCE) subject to a minimal duties test to the annual equivalent of the 90th percentile of full-time salaried workers nationally ($134,004); and

3. Establishes a mechanism for automatically updating the salary and compensation levels every three years to maintain the levels at the above percentiles and to ensure that they continue to provide useful and effective tests for exemption.

Additionally, the rule amends the salary basis test to allow employers to use nondiscretionary bonuses and incentive payments, including commissions, to satisfy up to 10 percent of the new standard salary level.

To read the entire rule, click here.

IRS publishes final rule related to Roth accounts
The Internal Revenue Service (IRS) released a final rule eliminating the requirement that each disbursement from a designated Roth account that is directly rolled over to an eligible retirement plan be treated as a separate distribution from any amount paid directly to the employee, and therefore, separately subject to the rule in section 72(e)(2) of the Internal Revenue Code (the Code) allocating pretax and after-tax amounts to each distribution.

As a result of this change, if disbursements are made from a taxpayer’s designated Roth account to the taxpayer and also to the taxpayer’s Roth IRA or designated Roth account in a direct rollover, then pretax amounts will be allocated first to the direct rollover, rather than being allocated pro rata to each destination.

To read the entire final rule, click here.

Basic fiduciary duties: Loyalty, prudence, diversification, follow the plan document

Woodman-PaulineWhile the basic duties sound easy enough, a plethora of recent cases demonstrates the prudence of constant review of the retirement plan decision-making process. The recent U.S. Department of Labor (DOL) rule on fiduciary conflicts of interest expands the duty of a fiduciary detailed in ERISA 401(a)(1) to act solely in the interests of participants and beneficiaries. Similarly, rulings on the fiduciary duty of prudence centered on breaches that were due to failure to monitor.

In Tibble v. Edison, the lower courts found that the trustees offered no credible explanation for offering high-price mutual funds. While this was a breach of fiduciary duty, part of the case was dismissed because of a six-year statute of limitations. The Supreme Court found that the fiduciary duty to select a prudent investment does not end once that decision is made: “ERISA’s fiduciary duty is derived from the common law of trusts. As such, a trustee has a continuing duty … to monitor, and remove imprudent, trust investments.” Therefore, the six-year statute was only a starting point for the ongoing duty to monitor any fiduciary decision. This case was remanded back to the lower courts for review.

Enact procedural prudence. In each of the ERISA fiduciary cases, courts focused on “how” a decision was made. Did the fiduciaries document their decision and how they arrived at it? Deciding not to act is a decision. Document both decisions and the progression to an eventual decision. Did the fiduciaries seek expert advice when warranted? The courts are not looking for the right answer using the benefit of hindsight. They are looking for an answer that a prudent person familiar with the situation could have arrived at. When fiduciaries document a prudent decision-making process, unfavorable legal decisions should not become an issue.

Communicating a defined benefit plan conversion

Milliman consultants assisted one particular multiemployer defined benefit plan’s transition to a stabilized Milliman Sustainable Income Plan™ (SIP), formerly known as the variable annuity pension plan (VAPP). The conversion required a communication strategy conveying the new plan’s design to participants. In this article, Jessica Gonchar describes how the firm implemented an employee communications campaign explaining the basic principles of a SIP and how it differs from the prior plan.

Regulatory roundup

More retirement-related regulatory news for plan sponsors, including links to detailed information.

PBGC issues interim final rule on adjustment of civil penalties
The Pension Benefit Guaranty Corporation (PBGC) is amending its regulations to adjust the penalties provided for in sections 4071 and 4302 of the Employee Retirement Income Security Act of 1974 (ERISA). This interim final rule adjusts the maximum civil penalties that PBGC may assess under sections 4071 and 4302 of ERISA. The new maximum amounts are $2,063 for section 4071 penalties and $275 for section 4302 penalties.

The amendments are effective August 1, 2016. The increases in the civil monetary penalties under sections 4071 and 4302 provided for in this rule apply on and after August 1, 2016.

To read the entire rule, click here.

FAF releases updated print editions of FASB and GASB accounting standards codifications
The Financial Accounting Foundation (FAF) has released updated print editions of the Financial Accounting Standards Board’s FASB Accounting Standards Codification® and the Governmental Accounting Standards Board’s (GASB) Codification of Governmental Accounting and Financial Reporting Standards.

The FASB codification is the single, authoritative source of generally accepted accounting principles (GAAP) for public and private companies and not-for-profit organizations. For more information, click here.

The GASB codification is the single, authoritative source of GAAP for state and local governments. For more information, click here.

Milliman Hangout: Milliman Actuarial Retirement Calculator™ (MARC™)

The Milliman Actuarial Retirement Calculator (MARC) is a pension administration and communication tool for pension plan sponsors. The system offers data storage, benefit calculation, correspondence management, a participant website, and more.

In this video, Milliman’s Kevin Hicks explains some of MARC’s benefits. He also showcases MARC’s participant website.

To learn more about MARC, click here.

DOL issues final rule on fiduciary/conflicts of interest

The Department of Labor (DOL) has released a final rule redefining “fiduciary” under ERISA, focusing on individuals who provide investment advice or recommendations to retirement plan savers for a fee. The rule requires investment advisers to adhere to a fiduciary standard – that is, they must act in a client’s best interest – when advising retirement plan participants, such as on whether to rollover funds from an employer-sponsored 401(k) plan or on what funds to invest in for individual retirement accounts (IRAs). The agency concurrently published related guidance to exempt certain activities from the conflict-of-interest rule, allowing advisers to continue to receive fees or compensation if they comply with the fiduciary standard. The final rule generally applies beginning Apr. 10, 2017, although portions become effective Jan. 1, 2018.

The package of the final rule and related guidance on class exemptions and prohibited transaction exemption amendments is lengthy and complex; this Client Action Bulletin highlights the key areas covered for retirement plan sponsors. The rule applies to tax-qualified plans under ERISA; it does not affect 457 governmental plans or 403(b) tax-sheltered annuities under a governmental plan or a nonelecting church plan.

Central States ruling highlights the importance of communication

tenBroek_HeidiOn May 6, the U.S. Department of the Treasury denied the Central States, Southeast and Southwest Areas Pension Plan’s (Central States) application for benefit suspensions. According to Treasury, the plan’s proposal was fundamentally flawed in three ways. The first two reasons Treasury gave were that the proposed benefit suspensions were “not reasonably estimated to allow the plan to avoid insolvency” and were “not equitably distributed” (the plan did not explain to Treasury’s satisfaction the variations in the treatment of different classes of participants).

Poor communication is the third way the plan’s proposal failed to satisfy the requirements. According to Treasury, the plan’s notices to participants were “not written in a manner so as to be understood by the average plan participant.” Treasury explains:

• “The notices extensively use technical language without adequate explanation
• Critical terms used in the notices are not defined in the notices but only by cross-reference to other documents (e.g., the plan document and the rehabilitation plan document); and
• The cross-referenced definitions in those other documents are not understandable to the average plan participant.”

Few pension plans are getting the kind of attention that’s being paid to Central States. But many plans looking to the possibility of benefit suspensions in the future can take this opportunity to learn from Treasury’s issues with Central States’ application. Remember that good participant communications need to be included in your calculations.

For more perspective, read Tim Connor’s article “Central States Pension Plan and the Multiemployer Pension Reform Act.”