Category Archives: Defined benefit

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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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%.

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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.

Funded status deficit increases to $390 billion after rates fall below 4%

Wadia_ZorastMilliman today released the results of its latest Pension Funding Index (PFI), which analyzes the 100 largest U.S. corporate pension plans. In March, these pension plans experienced a $20 billion decrease in funded status, which was due to a $30 billion increase in asset values and a $50 billion increase in pension liabilities. The funded status for these pensions decreased from 78.4% to 77.9%.

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These pensions lost $83 billion in the first quarter. We saw impressive asset performance last month, but with rates slipping back below 4% for the first time since May 2015, we have an even deeper pension funding hole. Hopefully this trip below 4% is brief—the prior visit to record-low territory lasted seven months.

This edition of the PFI reflects the annual update of the Milliman 2016 Pension Funded Study, which was released on April 7.

Looking forward, under an optimistic forecast with rising interest rates (reaching 4.23% by the end of 2016 and 4.83% by the end of 2017) and asset gains (11.2% annual returns), the funded ratio would climb to 86% by the end of 2016 and 98% 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 66% by the end of 2017.

Milliman Hangout: 2016 Pension Funding Study

The 100 largest U.S. corporate pension plans experienced a minuscule funding improvement of 0.1% in 2015, according to the Milliman 2016 Pension Funding Study (PFS). The aggregate funded ratio increased from 81.7% to 81.8% based on a $75.8 billion decrease in the market value of plan assets and a $94.5 billion decrease in the projected benefit obligation (PBO). This resulted in an $18.7 billion improvement in funded status.

In this Milliman Hangout, PFS coauthor Zorast Wadia discusses the results of the study with Amy Resnick, editor of Pensions & Investments.

To read the entire study, click here.

The 100 largest U.S. corporate pension plans’ funded status improved by only 0.1% in 2015

Wadia_ZorastMilliman today released the results of its 2016 Corporate Pension Funding Study, which analyzes the 100 largest U.S. corporate pension plans. In 2015, these pension plans experienced a relatively small funding improvement of 0.1%, as the aggregate funded ratio increased from 81.7% to 81.8% based on a $75.8 billion decrease in the market value of plan assets and a $94.5 billion decrease in the projected benefit obligation (PBO). This resulted in an $18.7 billion increase in funded status. The minuscule improvement belies the fierce dynamics facing these pensions last year.

FIGURE 1: HIGHLIGHTS (FIGURES IN $ BILLION)
FISCAL YEAR ENDING
2014 2015 CHANGE
MARKET VALUE OF ASSETS $1,453.6 $1,377.8 ($75.8)
PROJECTED BENEFIT OBLIGATION $1,779.7 $1,685.2 ($94.5)
FUNDED STATUS ($326.1) ($307.4) ($18.7)
FUNDED PERCENTAGE 81.7% 81.8% 0.1%
NET PENSION INCOME/(COST) ($37.3) ($33.7) $3.6
EMPLOYER CONTRIBUTIONS $39.7 $30.7 ($9.0)
DISCOUNT RATE 4.00% 4.25% 0.25%
ACTUAL RATE OF RETURN 10.8% 0.9% -9.9%
Note: Numbers may not add up precisely, which is due to rounding.

What a strange year for these 100 pension plans. These pensions weathered volatile markets, unpredictable discount rate movements, adjusted mortality assumptions, pension risk transfers, and an industry-wide decline in cash contributions…and yet they still finished the year almost exactly where they began. Given all that transpired in 2015, plan sponsors may be relieved that plans did not experience funded status erosion like that of the prior year. But that doesn’t change the fact of a pension funded deficit in excess of $300 billion.

Study highlights include:

Surprising move toward spot rates. Thirty-seven of the largest 100 plan sponsor companies will record fiscal year 2016 pension expense using an accounting method change linked to the spot interest rates derived from yield curves of high quality corporate bonds. The move to spot rates will result in pension expense savings.

Actual returns well below expectations. Actual plan returns were 0.9% for the year—just a fraction of the expected 7.2%.

Impact of updated mortality assumptions. Pension obligations at the end of 2015 were further reduced to reflect refinements in mortality assumptions. While we are unable to collect specific detail regarding the reduction in PBO, a 1% to 2% decrease has been anecdotally reported. Additional revisions to mortality assumptions may be published in the fourth quarter of 2016.

Cash contributions reduced by almost $9 billion. Approximately $40 billion was contributed in 2014, with that number falling to $31 billion in 2015. The likely cause of the decline: the continuation of interest rate stabilization (funding relief) courtesy of the Bipartisan Budget Act of 2015.

Pension Risk Transfers continue. The estimated amount of pension risk transfers collected from the accounting disclosures was nominally higher in 2015 ($11.6 billion) compared with 2014 ($11.4 billion). It seems likely these transactions may increase in 2016, spurred by the significant increases during 2015 in premiums payable to the Pension Benefit Guaranty Corporation (PBGC); the extension of these premium rate increases was also courtesy of the Bipartisan Budget Act of 2015.

Equity allocations reach a record low. By the end of 2015, equity allocations had dropped to 36.8%, the lowest in the 16-year history of this study. In recent years, the companies in the study generally shifted toward fixed income investments. However, unlike 2014—when plans with higher allocations to fixed income outperformed plans with lower allocations—2015 saw plans with higher allocations to fixed income experience the same rate of return as those with lower allocations.

Under the radar. The 2016 Pension Funding Study also reports on the funded status of Other Postemployment Benefits (OPEB) Plans.

To download the study, click here.

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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