ERISA Section 408(b)(2) Fee Disclosures: Impact on Broker

Pension Plans: Everything You Need
to Know, But Were Afraid to Ask
Marcia S. Wagner, Esq.
Overview of ERISA
Tax-Qualified Retirement Plans
IRA Plans and IRAs
Nonqualified Retirement Plans
Fiduciary Responsibilities Under ERISA
Which Type of Retirement Plan is Right for
I. Overview of ERISA
Employee Retirement Income Security Act of
1974 (ERISA)
◦ Federal law governing private retirement plans.
ERISA is divided into four titles.
◦ Title I – U.S. Department of Labor (DOL) and
fiduciary rules
◦ Title II – Internal Revenue Service (IRS) and
tax-qualification rules under Internal Rev. Code (IRC)
◦ Title III – Coordination of federal agencies
◦ Title IV – Pension Benefit Guaranty Corporation
(PBGC) and pension plan termination insurance
II. Tax-Qualified Retirement Plans
◦ “Pension plan” which also meets the qualification
requirements under IRC Section 401(a).
◦ Private employers may adopt tax-qualified plan.
Advantages of tax-qualified retirement plans.
◦ Immediate deduction for employer contributions.
◦ Employees are not taxed currently.
◦ Earnings on plan trust assets are tax-exempt.
◦ Tax on distributions can be deferred with rollovers.
◦ Plan assets protected from employer and creditors.
◦ PBGC insurance for benefits under certain plans.
Defined Benefit Plans (DB Plans)
DB plan provides stated pension benefit
beginning at retirement.
◦ Normally stated in form of life annuity.
◦ Employer contributions are determined actuarially.
Types of DB plans
◦ Fixed Benefit Plan: fixed $ amount payable annually.
◦ Flat Benefit Plan: % of pay payable annually.
◦ Unit Benefit Plan: benefit formula is based on years
of service (e.g., 1% of pay for each year).
◦ Cash Balance Plan: benefit stated in the form of a
hypothetical account.
Defined Benefit Plans (cont’d)
Methods for calculating pay
◦ Final Average Pay – pension is based on average
compensation during defined period.
◦ Career Average Pay – pension is based on pay earned
during employee’s entire service period.
IRS limits on pay
◦ Plan may not consider more than $250,000 (2012) of
pay per year.
Integration with Social Security
◦ Plan can be designed to provide pension reduced for
portion of participant’s Social Security benefits.
Summary of Characteristics of DB Plans
Employer considerations
◦ Commitment to contribute to plan.
◦ Fully financed by employer.
◦ Investment risk is borne by employer.
Benefit considerations
◦ DB plan can recognize past service.
◦ Easier to provide cost of living adjustments (COLA).
◦ May pay disability and death benefits.
◦ Generally may not pay layoff or medical benefits.
◦ No in-service distributions generally.
◦ PBGC guarantee financed by employer premiums.
Defined Contribution Plans (DC Plans)
 DC plans maintain separate accounts for each
covered employee.
Types of DC plans
◦ Money Purchase Pension Plan: Fixed rate of employer
contributions (e.g., target benefit plan).
◦ Profit Sharing Plan: Employer contributions made at
discretion of employer.
◦ 401(k) Plan: Covered employees may elect to defer
compensation, and employer may provide match.
◦ Stock Bonus Plan: Contributions invested and benefit
payable in employer stock (e.g., ESOP).
Summary of Characteristics of DC Plans
Employer considerations
◦ Flexibility in contribution commitment.
◦ Lower administrative costs and no actuary required.
◦ Permit employer/employee cost sharing.
◦ No PBGC premiums.
Benefit considerations
◦ Terms and structure easily communicated.
◦ Generally favor younger employees.
◦ Investment risk is on employees.
◦ In-service distributions often permitted.
◦ Investments may be participant-directed.
Basic Rules for Tax-Qualified Plans
ERISA and IRC impose comprehensive set of
rules for tax-qualified retirement plans.
Philosophy of tax-qualification plan rules
◦ To receive tax benefits, plan sponsor must help
advance government’s social policies.
◦ For example, plan must help secure retirement of
“rank and file” employees as well as management.
Eligibility and Participation Rules
Minimum age and service conditions.
◦ Must not exclude on account of age beyond age 21.
◦ May require service minimum of up to 1 year
(limited exception for 2-year minimum).
No maximum age condition permitted.
“1,000 hour” rule applies to minimum service.
Plan entry may be delayed up to 6 months.
DB plan must benefit lesser of 50 employees
or 40% of workforce.
Coverage and Nondiscrimination Rules
 Minimum coverage rules
◦ Opportunity for Non-Highly Compensated Employees
(NHCs) to participate in plan must be similar to HCEs.
◦ Must satisfy one of following:
(1) Percentage Test: Plan covers at least 70% of NHCs
(2) Ratio Test: Ratio of percentage of NHCs covered to
percentage of HCEs covered is at least 70%
(3) Average Benefit Percentage Test: 2-prong test.
Nondiscrimination rules
◦ General Test compares actual benefit accruals of NHCs
against actual benefit accruals of HCEs.
◦ 401(k) plans are subject to ADP Test (and subject to
additional ACP Test if plan has a match).
Minimum Vesting Standards
 DB benefits must fully vest in 5 years or:
Years of Service
Less than 3
At least 3, 4, 5 or 6
7 or more
Vesting Percentage
20%, 40%, 60% or 80%
DC benefit must fully vest in 3 years or:
Years of Service
Less than 2
At least 2, 3, 4 or 5
6 or more
Vesting Percentage
20%, 40%, 60% or 80%
Must vest upon Normal Retirement Age.
Year of service based on “1,000 hour” rule.
Top-Heavy Rules
◦ Participants who are NHCs must receive minimum
benefit or contribution if plan becomes Top Heavy.
Definition of “Top-Heavy” plan.
◦ Disproportionate amount of plan’s accrued benefits
are for the benefit of key employees.
◦ Key employees generally include officers earning
more than $165,000 (2012) and 1% owners.
If plan is top-heavy for any year, NHCs must
receive minimum benefit/contribution.
◦ Separate minimum vesting schedule also applies.
Special Accrual and
Funding Rules for DB Plans
 Benefit accrual rule for DB plans
◦ Plan must not provide “backloaded” benefit accruals.
◦ Benefit must accrue ratably over employee’s career.
Minimum funding standard for DB plans
◦ Designed to ensure plans are able to pay benefits
when they become due.
◦ Requirements backed by 10% excise tax (and 100%
excise tax if deficiency is not corrected).
◦ Funding rules do not apply to Profit Sharing Plans
and Stock Bonus Plans.
Limitations on Contributions and Benefits
Annual contribution limit for each DC plan
◦ Lesser of 100% of pay, or $50,000 (2012).
Maximum annual benefit under DB plan
◦ Lesser of 100% of average pay, or $200,000 (2012).
Maximum deduction for plan contributions
◦ DC plan – 25% of participants’ pay for year.
◦ DB plan – linked to funding standards
(minimum required contributions always deductible).
IRS and Plan Document Rules
Written plan requirement
◦ Tax-qualified plan must have written plan document.
◦ Plan document must be timely updated.
IRS determination letter program
◦ Gives employer ability to obtain IRS’s blessing of plan.
◦ Plan should be submitted to IRS every 5 years.
◦ Good faith interim amendments must be adopted
whenever law change requires it.
Prototype and IRS pre-approved plans
◦ Plans are pre-approved by IRS but should be reviewed
by counsel.
III. IRA Plans and IRAs
General Rules for IRAs
Individual retirement accounts (IRAs)
◦ Trust or custodial account maintained by bank or
other qualified person.
◦ Contributions in cash subject to annual limit.
◦ No life insurance permitted.
◦ Account balance must be fully vested at all times.
◦ IRA must be established by written document.
IRA annuity is subject to similar rules.
 Simplified Employee Pension Plan (SEP)
◦ Each eligible employee owns and controls a SEP IRA.
All eligible employees must participate in SEP.
◦ Eligible if (a) age 21, (b) worked 3 out of 5 preceding
years, and (c) earned $550 in current year.
Requirements for SEP
◦ Employer contributes to eligible employee’s SEP IRA.
◦ Allocation formula must be nondiscriminatory.
◦ Annual limit is lesser of 25% of pay, or $50,000.
◦ Subject to Top-Heavy Rules.
◦ Annual notice required for eligible employees.
Savings Incentive Match Plan for Employees
(SIMPLE) for small employers only.
All eligible employees must participate in SIMPLE.
◦ Eligible if received at least $5,000 during any 2 prior
years and expected to earn $5,000 in current year.
Features of SEP
◦ Ability to defer up to $11,500 (or $14,000 if age 50).
◦ Employer must provide 100% match up to 3% of pay,
or non-elective contribution equal to 2% of pay.
◦ Contributions must be fully vested, but not subject to
Top-Heavy Rules or ADP/ACP Tests.
Traditional and Roth IRAs
Traditional IRAs
◦ If employee and spouse are not covered by plan,
Traditional IRA contributions are fully deductible.
◦ Contribution limit is $5,000 (or $6,000 if age 50), but
deduction is subject to phase-out if covered by plan.
◦ Earnings accumulate on tax-deferred basis.
Roth IRAs
◦ Contribution limit is $5,000 (or $6,000 if age 50), but
contribution is subject to phase-out based on AGI.
◦ Contributions are not deductible.
◦ Qualified distributions are tax-free.
IV. Nonqualified Retirement Plans
Types of Nonqualified Plans Under ERISA
Two types of nonqualified plans
◦ Excess Benefit Plan: provides benefits in excess of IRC
limitations on contributions and benefits.
◦ Top Hat Plan: covers select group of management or
HCEs only.
Both types of plans are unfunded.
◦ Plans need not satisfy tax-qualification plan rules.
◦ Discriminate in favor of HCEs by design.
◦ May be informally funded by rabbi trust, where assets
remain subject to claims of employer’s creditors.
Qualified Plans v. Nonqualified Plans
Tax-Qualified Plans
Nonqualified Plans
◦ Qualification rules
prohibit discrimination.
◦ Nondiscrimination rules do
not apply.
◦ ERISA minimum
standards apply.
(e.g., eligibility, vesting)
◦ ERISA minimum standards
do not apply.
◦ Plans must be funded.
◦ Plans must be unfunded.
◦ Employee not taxed until ◦ Employee taxed at payment
or constructive receipt.
IRC Section 409A and
Voluntary Deferred Compensation
 Key concepts under IRC Section 409A
◦ Regulates deferral and payment elections under
nonqualified plans.
Deferral elections must be made prior to year
in which pay is earned, except that:
◦ Newly eligible participants can elect within 30 days.
◦ Election to defer performance-based pay can be made
6 months prior to end of performance period.
◦ Can defer ad hoc bonus within 30 days if subject to
forfeiture for at least 1 year after election.
◦ Special rule if newly eligible in excess plan.
Requirements Under 409A (cont’d)
Payment elections
◦ Must elect payment time/form with deferral election.
◦ No earlier than separation, disability/death, change of
control, unforeseeable emergency, or fixed date.
Anti-acceleration rule
Beneficiary payment election
◦ Payment election for death benefits must be made
with Payment Election (but can change beneficiary).
Payment deferral election
◦ At least 12 months prior to deferred payment date,
can elect to defer again for minimum of 5 years.
V. Fiduciary Responsibilities
Scope of Title I of ERISA
Title I imposes fiduciary requirements on
“employee benefit plans” only.
◦ Includes any tax-qualified retirement plan sponsored
by employer with one ore more employees.
Does not apply to tax-qualified plans without
employees (e.g., plan for sole proprietor).
IRA plans are technically subject to Title I, but
exempt from most requirements.
Nonqualified plans are technically subject to Title
I, but exempt from substantive requirements.
Definition of “Fiduciary”
An ERISA plan must have at least 1 fiduciary.
◦ Person with discretionary authority/control over
management of plan or disposition of plan assets.
◦ Advisors who provide “investment advice”.
Person is not a fiduciary if such individual or
entity only performs ministerial functions.
Fiduciary status is determined under a
functional test.
◦ If you act or “function” like a fiduciary, you are.
Fiduciary Responsibilities
Fiduciary standard of care under ERISA.
◦ Exclusive purpose of providing benefits - must
discharge duties solely in interest of plan participants.
◦ Carrying out duties prudently – must manage plan
assets with skill and diligence of prudent person
familiar with plan investment matters.
◦ Following terms of plan document – must obey
written terms of plan unless inconsistent with ERISA.
◦ Diversifying plan investments – must diversify plan’s
investments in order to minimize risk of large losses.
Fiduciary Protection Under ERISA
Liability protection under ERISA Section 404(c)
◦ Plan sponsor is responsible for participant-directed
investments unless plan complies with ERISA 404(c).
Conditions of ERISA Section 404(c)
◦ Participant must exercise independent control, and
have enough info to make informed decisions.
◦ Plan menu must have broad range of inv. options.
If plan satisfies ERISA 404(c), plan sponsor
only remains responsible for plan’s menu.
◦ Must manage investment options in accordance with
duties of prudence and diversification.
Fiduciary Investment Reviews
 Investment Policy Statement (IPS)
◦ IPS can help plan fiduciary’s review process.
Continuous monitoring
◦ Ideally, investments should be reviewed annually.
Replace funds that don’t meet criteria.
Documentation of fiduciary reviews.
Utilize independent investment expert.
Evaluate expense ratio/fees.
◦ Plan fiduciaries must ensure fees are reasonable.
Reporting and Disclosure Requirements
Summary Plan Description (SPD)
◦ Must provide non-technical summary to participants.
Summary of Material Modifications (SMM)
◦ Written summary of material modifications to plan.
Annual Reports
◦ Form 5500 must be filed annually with DOL.
Summary Annual Report (SAR)
◦ Summary of financial info in Form 5500 filing must be
distributed to participants annually.
Purchasing a Fidelity Bond
 ERISA bond required for every person who
“handles” plan funds.
Coverage amount for ERISA fidelity bond
◦ Must cover 10% of plan assets handled.
◦ Minimum amount of $1,000 and maximum amount of
$500,000 ($1M if plan holds employer securities).
ERISA fidelity bond is not fiduciary liability
◦ ERISA bond protects plan.
◦ Fiduciary liability insurance protects fiduciary.
VI. Which Type of Retirement Plan Is Right for
Considerations for
Employer and Employees
Nature of employer and its business goals
◦ How is business organized? How long in existence?
◦ Benefits provided by employer’s competitors?
◦ Age, years of service, and pay of employees
◦ Employer’s past and projected financial condition
◦ Will benefit costs be shared with employees?
Needs of employees
◦ Owners
◦ Key employees
◦ Rank and file employees
Advantages and Disadvantages of
Tax-Qualified Retirement Plans
 Advantages
◦ Tax benefits, including immediate deductions.
◦ Numerous requirements and restrictions.
Examples of plans meeting business needs
◦ To maximally benefit owners or management
◦ To provide benefits at minimal cost to employer
◦ To encourage long-term employment
◦ For contribution flexibility
◦ To provide fixed contributions with certainty
Advantages and Disadvantages
of IRA Plans
 SEP and SEP IRAs
◦ Advantages: similar to tax-qualified plan benefits but
fewer requirements must be satisfied.
◦ Disadvantages: employer must contribute to SEP IRAs
of all eligible employees.
◦ Advantages: similar to 401(k) plans but fewer
requirements must be satisfied.
◦ Disadvantages: for small employers only, and
employer must provide 100% match
(or non-elective contribution equal to 2% of pay).
Advantages and Disadvantages of Nonqualified
Retirement Plans
◦ Best way to provide benefits favoring exclusive group
of HCEs.
◦ Not subject to tax-qualification rules.
◦ Can be designed as a DB plan or DC plan.
◦ Can not be funded.
◦ No immediate contributions to plan, so no immediate
tax deductions are available.
◦ Generally cannot include any rank and file employees.
Pension Plans: Everything You Need
to Know, But Were Afraid to Ask
Questions and Answers
Marcia S. Wagner, Esq.
99 Summer Street, 13th Floor
Boston, MA 02110
Tel: (617) 357-5200 Fax: (617) 357-5250
[email protected]
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