Category Archives: Defined contribution

Linking NDCPs with 401(k) requires a “contingency” plan for compliance

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.

Last month’s blog discussed similarities and differences between the rules governing participant deferrals made under a nonqualified deferred compensation plan (NDCP) versus those contributed to a qualified 401(k) plan. This month’s entry will again turn to the NDCP-401(k) connection; however, this time it will show that when NDCP sponsors choose to link their NDCP’s benefits with their 401(k) plan’s, they must be aware of and comply with not only Internal Revenue Code Section 409A’s restrictions but also Section 401(k)’s “contingent benefit rule” (CBR). While such compliance does not directly affect the NDCP, it is a qualification requirement for the 401(K) plan.

In general, an employer may not directly or indirectly condition another employer benefit (other than matching contributions) upon an employee’s election to make or not make elective contributions. If the employer conditions any such other employer benefit upon elective contributions, it is a qualification defect. The purpose of this rule is to prevent employers from encouraging employees to make or not make elective contributions by linking valuable benefits to their contribution or lack of a contribution. These other benefits include but are not limited to the following:

• Benefits under a defined benefit plan
• Non-elective employer contributions to a defined contribution plan
• The right to make after-tax employee contributions
• The right to health and life insurance
• The right to employment
• Benefits under a NDCP

Because NDCP benefits are included among the items for which 401(k) contingency is prohibited, NDCP sponsors must guard against including provisions in their NDCPs under which participants may receive additional deferred compensation under the NDCP depending on whether they make or do not make 401(k) elective contributions. Each of the following three examples illustrates provisions that would create such a contingent benefit and thus a violation of the CBR:

Example 1: Employer T maintains a 401(k) plan for all of its employees and a NDCP for two highly paid executives, Employees R and C. Under the terms of the NDCP, R and C are eligible to participate only if they do not make elective contributions under the 401(k) plan. Participation in the NDCP is a contingent benefit because R’s and C’s participation is conditioned on their electing not to make elective contributions under the 401(k) plan.

Example 2: Assume the same fact pattern as Example 1 except that this time under the terms of the NDCP, Employees R and C may defer a maximum of 15% of their compensation and may allocate their deferral between the 401(k) plan and the NDCP in any way they choose (subject to the overall 15% maximum). Because the maximum deferral available under the NDCP depends on the elective deferrals made under the 401(k) plan, the right to participate in the NDCP is a contingent benefit.

Example 3: Employer S maintains three plans: a 401(k) plan, a qualified DB plan, and a defined benefit NDCP. Under the terms of the NDCP, each participant’s NDCP benefit is offset not only by the qualified DB plan benefit but also by the total account balance under the 401(k) plan. Because the amount a participant elects to defer or not defer under the 401(k) will directly affect the amount of the offset and thus the resulting NDCP benefit, the offset is a contingent benefit.

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Avoiding poverty in a DC-only world

Bradley_JeffIn a defined contribution (DC) world, retirees are forced to make critical decisions, often with little or no assistance. Most of these individuals choose to take a single sum distribution either immediately or soon after they terminate employment.

This paper from the Center for Retirement Research at Boston College asserts that distribution provisions in DC plans are critical factors in evaluating the risk of falling into poverty in old age.

Specifically, the paper states that reliance on non-annuitized DC benefits with fairly easy access to lump-sum distributions puts elderly households at risk of not having sufficient income (or assets) to sustain themselves or, if they are not already in poverty at retirement, falling into poverty as the household members age or die off.

As workers continue to age, this will become a greater problem as those covered by defined benefit plans retire from the workforce and are replaced by those covered only by DC plans. So what can plan sponsors do to minimize the probability of their retirees falling into poverty?

Extrapolating from thoughts in the paper, the conclusion is that plan sponsors should encourage the following behaviors:

• Not taking lump-sum distributions before retirement
• Annuitizing some or all DC benefits when possible
• Choosing joint-and-survivor options when available

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Milliman launches enhanced defined contribution participant website

Milliman today announced the launch of its latest in a series of website enhancements for its defined contribution clients and their plan participants.

New features on MillimanBenefits.com include an interactive “It’s Your Move” dashboard with tools that support successful retirement behaviors, such as saving enough to get the company match, diversifying investments, and utilizing automatic increase and automatic rebalance features – all with a refreshed look and feel. The site enhancements build on Milliman’s robust PlanAhead for Retirement® projection tool, educational Financial Resources Center, and award-winning mobile application.

“Our consultants are excited to offer these new features to our clients. More than ever, our clients understand that it’s important to encourage constructive behavior in this age when too many people are not saving enough for retirement,” says Jeff Budin, Milliman’s global employee benefits practice leader. “From a behavioral finance perspective, it’s helpful to participants to see a list of items they are doing well next to some additional actions they could take to strengthen their account with the simple click of a mouse.”

To learn more about Milliman’s independent, conflict-free approach to recordkeeping in the defined contribution industry, click here.

409A deferral election results: A mixed bag

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.

The process of deferring a portion of a participant’s pay under a nonqualified deferred compensation plan (NDCP) can, at first glance, appear quite similar to how such deferral would be handled under a 401(k) plan. Participants designate a specified dollar amount or percentage of their pay they wish to defer under the plan. The plan sponsor then arranges for such amounts to be deducted from the participants’ pay and allocated to an account maintained on their behalf under the plan. However, upon delving deeper, we see stark differences that must be observed by NDCP participants and sponsors in order to comply with Internal Revenue Code Section 409A. As with many of 409A’s rules, the restrictions on deferral elections require tight timing. This blog will highlight the differences between permissible 401(k) and NDCP deferral elections while also describing some of the plan design options available to provide participants with at least some flexibility when making their NDCP deferral elections with respect to salary and bonuses. While 409A also contains specific rules governing other types of deferrals (e.g., short-term deferrals, commission, etc.), analysis of such rules is beyond the scope of this series.

NDCP deferrals: Generally “Election Day” comes just once a year
Typically, 401(k) plans permit participants to make deferral elections as soon as their first payroll periods coincident with or next following the date on which they meet the plan’s eligibility requirements. If any participant fails to defer when first eligible, a 401(k) plan could allow them to begin deferring as of any subsequent payroll period. Similarly, a 401(k) plan can generally permit participants to increase, decrease, or discontinue their rates of deferrals as of any subsequent payroll period. In contrast, while a participant’s initial deferral opportunities under an NDCP are somewhat similar to the 401(k) plan, once the first deferral chance passes, there is considerably less flexibility.

Under an NDCP, in the case of the first year in which a participant becomes eligible to participate in the plan (whether it is a brand new plan or an existing plan for which the individual has just become eligible), participants have until 30 days after they first become eligible to make their salary deferral elections. Such elections must only apply to compensation (whether in the form of salary or bonus) paid for services to be performed beginning with the first payroll period after the election. If participants pass on this initial deferral option, they will not have another deferral opportunity until January 1 of the next calendar year. Similarly, for those participants who do elect to defer a portion of their salaries when first eligible, no changes to such initial elections can be made until January 1 of the next calendar year.

Because all NDCP deferral elections (including elections not to defer) are “locked in” for the calendar year in which they are made, plan sponsors need to be sure that their corporate cultures and populations are the right fit and that they have effectively provided the appropriate caveats before deciding to offer participants “evergreen elections.” Under such elections participants have the ability to make an NDCP deferral election and then have that election automatically roll over from year to year unless they specify otherwise before the applicable January 1. Without such a fit and/or without any proactive measures in place, such a design runs the risk of participants forgetting to get decrease or discontinuance requests to sponsors on time and then being stuck for the coming year with deferral rates that they do not want, or worse, may not be able to afford, given their anticipated cash flow and expenses for such year. In order to prevent this predicament, the NDCP sponsor can instead require that the participants reenroll each year by making a new salary election prior to January 1 of each year. This design is particularly effective in decreasing potential participant complaints if combined with a strong annual communications campaign during an open enrollment period that begins as early as October and ends on whichever day in December is the last day that the plan administrator is able to accept the election in order to process it for the first payroll period in January, during which the participant earns pay attributable to services performed in the new year. (Note: any “carry-over” pay from the previous year, i.e., pay earned in the previous year but not payable until January of the current year, will be subject to the previous year’s deferral rate.)

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Quantifying retirement programs competitiveness

In this case study, Milliman’s John Wukitsch and Neil Hagin explain how a “peer group” analysis helped one large employer gauge the competitiveness of its retirement benefits program. The analysis provided a comparison of five competing programs, demonstrating to the employer that it needed to offer more generous retirement benefits to keep employees satisfied and retain key talent.

A “Sign O’ the Times” for 401(k) plans?

Laursen DarleneTimes have changed since 401(k) plans were started back in the ’80s, just like hair styles and rock bands. Where most 401(k) plans only offered a lump-sum distribution option, the new trend in retirement plans may have you facing a decision. Could additional options, such as installments and ad hoc distributions, be the new featured value to plan participants? Could a lack of more distribution options be affecting participants’ distribution behaviors? Let’s look at the options and effects for the participants.

A 401(k) retirement plan that offers only a lump-sum distribution option requires participants to move the full account balance before they can even access one dollar from their accounts. While this may seem like no big deal, let’s turn this soup can around and read more about this lump sum on the label. It may provide greater insight into the lump-sum option.

If the need for cash at retirement is immediate, a participant may be forced to distribute the full account balance when the investment market is down. Participants would be locking in the investment loss on their entire account. This effect of the lump-sum distribution option affects participants whether rolling over their account or taking a distribution in cash.

These same lump-sum distributions can also adversely affect the plan as a whole. You may be scratching your head at this point and asking what do you mean? How can only having the lump-sum distribution option adversely affect the plan? Consider the scenario of a large population of plan participants retiring or terminating within a similar time period and possibly carrying away the larger balances in the plan. A tsunami of lump-sum distributions may trigger a significant drop in the total plan assets. This drop in assets may adversely affect the asset pricing structure for the remaining population of participants in the plan, creating a higher asset expense. Not to be a downer on lump-sum distributions, as they certainly have their place in retirement plans, but it may be time to consider offering additional options.

Installment payments can be a second option for a retirement plan. I like to call them the “Pac-Man” of the payment structures. This stream of same bite-size payments works like the Pac-Man arcade game. Pac-Man just kept munching his way around the board, eating until every bite was gone. The upside to installment payments is that participants can have a steady stream of income from the retirement plan and still remain invested. The participant continues to glean the benefit of lower investment pricing by remaining a participant in the plan. What participants should be considering, however, is the effect of these steady Pac-Man installment payments, which continue to happen in a downward investment market. Those installment payments can result in a larger reduction or faster depletion of a participant’s account than planned. For plan sponsors who offer the installment payment option, it is one way of potentially slowing down abrupt changes to the assets in the plan.

The third option, ad hoc distributions, may be considered the most flexible option in retirement plans. Let’s unpack how the ad hoc option can provide an ongoing investment benefit as well as distribution flexibility through retirement. Participants can leave their retirement accounts in the plan and remain invested in the plan’s institutional fund options. The ability to request a distribution when needed, or at the peak of a market upswing, can provide the ability to manage retirement drawdown. For participants who can afford to retire on other sources of income but may incur an unexpected medical cost during retirement, the ad hoc option provides a financial source to tap into only when needed.

Each distribution option has something to offer plan participants. Is it time to offer all three?

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 executive compensation enforcement initiatives of the Internal Revenue Service (IRS) 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 (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 the 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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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.

Honor thy 409A grandfather

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.

Section 409A certainly has set forth more than its fair share of commandments; however, “Honor thy 409A grandfather” has to rank very close to the top of the “most need to follow” list. While Section 409A’s regulatory reach has been described as overwhelmingly widespread, there is still one 409A-free safe haven for NDCP sponsors and participants—the past. Because the 409A rules generally are effective only for amounts deferred after December 31, 2004, benefits attributable to the period prior to January 1, 2005, can avoid 409A coverage provided that they are correctly calculated under and maintained in accordance with the grandfather rules. This blog will review these rules in an effort to provide NDCP sponsors with a reminder of the importance of preserving their grandfathers and a guide to assisting them with such maintenance.

Correct creation and identification of the grandfather
As briefly indicated above, this topic only affects those NDCPs that were in effect prior to January 1, 2005 (i.e., the date that 409A officially became effective). Furthermore, even if an NDCP was in effect prior to that date, the grandfather treatment is only available if the NDCP sponsor made a timely decision to elect grandfathering and met the required documentation and administrative conditions to effect such treatment. To meet the documentation requirement, the sponsor would have had to adopt an amendment to the plan clearly stating that the applicable amounts would be grandfathered and that only the benefits accrued on and after January 1, 2005, would be subject to the 409A rules. The administrative requirement is a bit trickier. First, the plan sponsor had to correctly identify and calculate the permissible amount to be grandfathered. The general rule is that grandfathered treatment is available for any amounts that were both earned and vested as of December 31, 2005. The specific calculation of the applicable amounts depends on whether the NDCP under consideration is a defined contribution (DC) or defined benefit (DB) style plan:

DC style
The permissible grandfather amount equals the sum of (1) the vested portion of the participant’s account balance as of December 31, 2004, plus (2) any future contributions to the account, the right to which was earned and vested as of December 31, 2004, to the extent such contributions were actually made, plus (3) any future earnings (whether actual or notional) on such amounts.

DB style
As one might imagine, the calculation of the permissible grandfathered amount under DB style is considerably more complex. It equals the present value of the amount to which the participant would have been entitled under the plan if such participant (1) voluntarily terminated services without cause on December 31, 2004, (2) received a payment of the benefits available from the plan on the earliest possible date allowed under the plan to receive a payment of benefits following the termination of services, and (3) received the benefits in the form with the maximum value. There are various ways that this amount may increase over time without violating the grandfather rules; however, an increase in the potential benefits under a DB NDCP that is due to, for example, an application of an increase in compensation after December 31, 2004, to a final average pay plan, or to subsequent eligibility for an early retirement subsidy, would not constitute earnings on the amounts deferred under the plan before January 1, 2005, and thus are not permissible reasons to increase the grandfathered amount. A complete description of how such increases can occur without violating the grandfather rules is beyond the scope of this blog. The calculation of any such increases should be made by the sponsor only after consultation with its actuary and legal counsel to ensure that they are completed in a permissible manner. The 409A rules indicate that when performing such calculations, “reasonable” actuarial assumptions and methods must be used. While no exact definition of “reasonable” is offered, the rules do provide two pieces of guidance to assist with this process:

(1) Whether assumptions and methods are reasonable for this purpose is determined as of each date the benefit is valued for purposes of determining the grandfathered benefit, provided that any reasonable actuarial assumptions and methods that were used by the plan sponsor with respect to such benefit as of December 31, 2004, will continue to be treated as reasonable assumptions and methods for purposes of calculating the grandfathered benefit.

(2) Actuarial assumptions and methods will be presumed reasonable if they are the same as those used to value benefits under the qualified plan maintained by the NDCP, provided that such qualified plan’s benefits are part of the benefit formula, or otherwise affect the amount of benefits, under the NDCP.

Accordingly, sponsors need to have not only correctly calculated their plan’s original grandfathered amounts, but also to have established and continue to maintain administrative systems that accurately track such amounts (along with any applicable future earnings attributable to such amounts) separately from any non-grandfathered amounts that may exist under their plans.

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Top hat plans are not one size fits all

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.

“Nonqualified deferred compensation plan” (NDCP) is a widely used term and has even been set in statutory stone by its inclusion as a definition in the final 409A regulations.  However, while 409A defines what constitutes such a plan and creates numerous rules governing these arrangements, one area it does not address is which employees of the plan sponsor are permitted to participate in an NDCP.  Nevertheless, accurately capturing the correct covered group is an essential first step and ongoing process for NDCP sponsors.  So who exactly can be included in an NDCP? Well, due to the lack of any specific, official government guidance on this topic, the process of determining the answer to that question is really more of an art than a science.  In order to attempt to paint a proper picture of permissible NDCP participation, we must first look to the Employee Retirement Income Security Act (ERISA).

Sizing NDCPs for an ERISA’s “top hat”
ERISA imposes a number of substantive and procedural requirements on qualified plans.  Similarly, the Internal Revenue Code (IRC) creates additional restrictions through its various limitations on compensation and benefit amounts. However, ERISA includes an exemption for plans that are unfunded and “maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.”  Plans that fit this standard are exempt from many ERISA and IRC requirements and are commonly referred to as “top hat” plans.  However, given that to date the only official ERISA definition of which employees can be included in such plans consists solely of the above general description, the identification process, like art, is very much subject to interpretation.

While the IRC has its own definition of “highly compensated employee,” this definition is not the standard for “top hat plan” purposes. The U.S. Department of Labor (DOL) has the authority to impose ERISA penalties and thus it is the DOL definition that must be met. Generally, the IRC definition is much less restrictive than the DOL definition. In fact, the DOL has indicated that the IRC definition of highly compensated employee (generally earning at least $120,000 for 2016 limit as indexed) is not appropriate for this purpose. The DOL would presumably focus on a more restrictive group of employees as it issued a past ERISA advisory opinion that warned employers to restrict eligibility for top hat plans to only those individuals who, by virtue of their position in the company, have the ability to negotiate the terms of their employment and thus influence the design and operation of the plan. This rule would be very limiting and, as several commentators have noted, would exclude some people who in the past clearly have been considered “top hat” individuals. The DOL, however, has never issued regulations formalizing its position on this matter. 

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