Category Archives: Defined benefit

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.

Investment gains and favorable interest rate movement power improvement in pension funded status

Wadia_ZorastMilliman today released the results of its latest Pension Funding Index (PFI), which analyzes the 100 largest U.S. corporate pension plans. In May, these pension plans experienced a $10 billion increase in funded status due to increases in pension asset values and decreases in in pension liabilities. The funded status for these pensions increased from 77.0% to 77.5%.


For the first time this year we saw positive interest rate movement. Declining discount rates have increased pension liabilities by more than $100 billion for the year. Last month’s modest $7 billion decrease in liabilities is a move in the right direction.

Looking forward, under an optimistic forecast with rising interest rates (reaching 4.03% by the end of 2016 and 4.63% by the end of 2017) and asset gains (11.2% annual returns), the funded ratio would climb to 84% by the end of 2016 and 96% by the end of 2017. Under a pessimistic forecast (3.33% discount rate at the end of 2016 and 2.73% by the end of 2017 and 3.2% annual returns), the funded ratio would decline to 73% by the end of 2016 and 67% by the end of 2017.

Spot rate methodology: Plans are making the switch

Moliterno-MariaIn April, Milliman released its 2016 Pension Funding Study. The study looks at the 2015 year end GAAP accounting results for the 100 largest defined benefit corporate pension plan sponsors. A surprising feature of this year’s study is that 37 of the 100 companies in the study disclosed on their Form 10-K financial statements their intentions to value their 2016 net periodic pension cost results using an alternative spot rate method.

Under the standard method typically used for determining pension expense, the yield curve is used to first determine the present value of plan liability. A single equivalent discount rate is determined that produces the same liability. This equivalent discount rate is then used for all purposes in the expense calculation that requires interest adjustments, including calculation of interest and service costs.

The spot rate method is an alternative method to calculate interest and service costs. Calculating the plan’s liability under the spot rate method is similar to the standard method, as the yield curve is used to determine the liability as the present value of payout streams. However, under the spot rate method, costs are developed using the individual spot rates of the yield curve for each year of expected costs. The interest cost for the year is developed by applying each individual spot rate under the yield curve to each corresponding cash flow discounted to the beginning of the year. Because the current shape of the yield curve has low interest rates in the early years and higher rates over time, payouts expected in the next few years are valued at lower rates than in the future. For example, the December 31, 2015, Citigroup Yield Curve has a rate of 1.34% for year 1 and 4.54% for year 20.

With 37 of the 100 pension plan sponsors analyzed planning on adopting the spot rate methodology in 2016 for some or all of their plans, the change is expected to result in savings in the 2016 pension expense for them. According to the 2016 Pension Funding Study, if all 100 companies adopted the spot rate methodology for all of their plans, the 2016 pension expense savings is estimated to be $14 billion (assuming a 20% reduction in the interest cost for a typical company).

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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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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.

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.

Corporate pension funded status drops by $25 billion in April

Wadia_ZorastMilliman today released the results of its latest Pension Funding Index (PFI), which analyzes the 100 largest U.S. corporate pension plans. In April, these pension plans experienced a $25 billion decrease in funded status due to a $4 billion increase in asset values and a $29 billion increase in pension liabilities. The funded status for these pensions decreased from 78.1% to 77.1%.


For the year these pensions have now declined more than $100 billion in funded status, despite a $6 billion increase in asset values. As we’ve seen so many times, interest rates are driving funded status for these 100 pensions. The discount rate of 3.65% is the second lowest in the history of this study.

Looking forward, under an optimistic forecast with rising interest rates (reaching 4.05% by the end of 2016 and 4.65% by the end of 2017) and asset gains (11.2% annual returns), the funded ratio would climb to 84% by the end of 2016 and 96% by the end of 2017. Under a pessimistic forecast (3.25% discount rate at the end of 2016 and 2.65% by the end of 2017 and 3.2% annual returns), the funded ratio would decline to 72% by the end of 2016 and 66% by the end of 2017.

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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Communicating lump-sum windows

Lump-sum windows are common ways for defined benefit (DB) plan sponsors to shed pension liabilities. According to Milliman consultant David Benbow, effective communication is essential when employers consider offering of a lump-sum window. He offers his perspective in a recent Money Management Intelligence article.

Here is an excerpt:

Three things are necessary to make a lump-sum window successful: communication, communication, communication. In addition to the required legal notices informing participants of their rights, you should do your best to create a package that is eye-catching (not many people read their mail after it goes in the trash) and easy to read (if it reads like stereo instructions, people will jump to the election forms and make up their own rules). The communication should spell out the pros and cons of taking a lump sum so that the participant can make an informed decision. The last thing anyone wants is for a well-intended offer to turn into a class action because participants were misled.

It takes time to create a good communication package, and usually there will be several people who wants to take a whack at the piñata, including legal counsel. Just know that clear communication up front will reduce the number of questions and follow-up on the back end.

For more Milliman perspective on lump-sum distributions, click here.