Benefit Plan Blog

A recent survey conducted by Opinion Research Corporation for the Consumer Federation of America and the Financial Planning Association, reported in a recent MarketWatch article, that 21 percent of the respondents believe the lottery is a practical way to save for retirement.

In addition to the long odds of winning, the Tax Foundation, in FISCAL FACTS, their on-line publication, asserts that contrary to many people’s beliefs—and to state governments’ claims—the money that states raise from lotteries is tax revenue; and that lotteries explify poor tax policy.

In an earlier posting I wrote about the value of defined benefit pension plans.

I mentioned that for some closely-held companies it's not necesarily a question of either/or. It can be both a defined benefit plan and a defined contribution plan (profit sharing or 401k) for those business owners "hearing footsteps", i.e., getting closer to retirement with not enough retirement savings - the qualified plan rules being satisfied, of course.

Several individuals who read the posting contacted me regarding the feasibility of their companies adopting a defined contribution plan to supplement their existing defined benefit plans. While every company’s situation is different, following are some general concepts I provided them which you might find helpful.

Deductibility Issues

The first step would be to determine the extent to which an employer could contribute and deduct contributions to both a defined benefit pension plan and a defined contribution plan. The general rule is that while a company can contribute/deduct the amount necessary to meet minimum funding requirements to a stand-alone defined benefit plan, contributions/deductions are limited to a maximum of 25% of compensation if both types of plans are maintained.

Please note, however, that a 2001 law change allows 401(k) contributions to be disregarded for purposes of deductibility. Thus, we have several clients with defined benefit plans that have adopted 401(k) plans to which only employees contribute. Caveat: The 401(k) plan must pass the 401(k) non-discrimination tests.

Plan Design Issues

Does that mean that if combined contributions would exceed the 25% limit, a defined contribution plan funded by the employer could not be adopted? Not necessarily! The 25% limit applies only if the same individuals are participants in both plans. We have clients that maintain a defined benefit plan for one group of individuals and a defined contribution plan, i.e., profit sharing/401(k) plan for another group. The deduction limits in this situation are minimum funding requirements for the defined benefit plan and 25% of participants’ compensation in the defined contribution plan. Thus, the overall 25% limit is not applicable. Please note, however, that a separate set of qualified retirement plan non-discrimination tests must be met in such situation.

To the extent to which such a combined retirement plans scenario is available is, of course, a matter of facts and circumstances for each employer.

An in-depth analysis (PDF) by Vanguard's Center for Investment Research of more than 500 retirement savings plans indicates that matching contributions have a modest incentive effect on plan participation rates, while loans and investment menu design can also influence employee savings behavior.

In the first comprehensive study of frozen defined benefit pension plans (PDF), the Pension Benefit Guaranty Corporation found that 9.4 percent of plans had halted participants’ benefit accruals as of 2003, the most recent year for which complete data are available.

To date, the principal source of data on frozen defined benefit pension plans has come from client surveys conducted by benefits consulting firms. The PBGC study is the first to examine the Form 5500 annual reports that administrators of qualified pension plans must file with the federal government. The 2003 data indicated that while 9.4 percent of all plans were frozen, only 2.5 percent of participants were affected because most frozen plans were small.

Breaking out the survey data by plan size, the PBGC found that 10.1 percent of small plans (those with fewer than 100 participants) were frozen, affecting 12.5 percent of the participants in these plans. At the other end of the spectrum, 2.2 percent of large plans (with more than 5,000 participants) were frozen, affecting only 1 percent of their participants.

The Form 5500 data for 2003 also showed that, on average, frozen plans are not as well funded as non-frozen plans. Half of frozen plans were less than 80 percent funded on a current liability basis, versus one-third of non-frozen plans. Industries more likely to have frozen plans included fabricated metals, apparel and textiles, rubber and plastics, primary metals, and retail trade. Plan freezes were less likely in the public utility, motor vehicle, and the finance, insurance and real estate industries.

The impact of plan freezes on the PBGC’s financial condition is likely to be mixed, the study says. On the one hand, to the extent that frozen plans are more likely to be terminated by employers, the number of participants in the system would decline and the PBGC’s flat-rate premium would be reduced. On the other, to the extent that frozen plans become better funded as a result of the cap on new benefit accruals, claims against the pension insurance program are likely to be smaller.

On December 30, 2005, Treasury and the Internal Revenue Service released the much awaited Roth 401(k) Final Regulations. These regulations, effective January 1, 2006, provide guidance concerning the requirements for designated Roth contributions under a qualified cash or deferred arrangement (CODA), or what is more popularly referred to as a 401(k) plan.

Under a Roth 401(k) option, a participant in a 401(k) can have his or her salary reduction contributions made out of after-tax pay. The funds would accumulate in the 401(k) tax free, and not be subject to taxation upon distribution (assuming certain conditions are met). The Roth 401(k) rules are generally subject to the same rules as regular pre-tax 401(k) contributions. A participant can not contribute more than the annual limits ($15,000 plus $5,000 catch-up in 2006), but can divide up his contributions among the two types.

While designated Roth contributions bear some similarity to Roth IRA contributions, there are many differences between the types of arrangements, including:

• Designated Roth contributions are not limited by income.
• Pre-tax elective contributions under a CODA may not be converted to a designated Roth account.
• Designated Roth contributions do not have the specific ordering rules for distributions that are imposed on Roth IRAs.

Similar rules will apply to designated Roth contributions available under 403(b) plans sponsored by tax-exempt organizations and public schools.

The Roth option could be beneficial for an employee who would be in a higher tax bracket when he or she receives the funds. It could also be beneficial for an older employee from a Social Security tax or estate planning standpoint.

The IRS also published some helpful FAQs.

In a prior posting, I indicated that there were several important due dates for employee benefit plans between now and year end. One of which is the December 1 due date for calendar year plans to distribute safe harbor notices for 2006.

A safe harbor plan can be an effective tax planning technique for closely-held companies. For the price of a safe harbor employer contribution, the discrimination tests that apply to employee deferrals (ADP) and matching contributions (ACP) are deemed satisfied and, thus, the Highly Compensated Employees (HCEs) may make the maximum allowable deferral of compensation without the need for the plan to pass the discrimination tests. In 2006, the maximum deferral to a 401(k) plan will be $15,000. In addition, if the participant is over age 50, or will attain age 50 during 2006, a catch-up contribution of $5,000 may also be made.

An employer may satisfy the safe-harbor by making a contribution of at least 3% or more of compensation. Generally, the 3% NEC must be provided to all employees eligible to make elective deferrals to the plan.

Alternatively, an employer may make one of two types of a safe harbor matching contribution. The first is a 100% match on the first 3% of compensation deferred and a 50% match on deferrals between 3% and 5%. Alternatively, the employer may choose an enhanced matching formula equal to at least the amount of the basic match; for example, 100% of the first 4% deferred. The enhanced matching contribution rate may not increase as the percentage of deferrals goes up, and the rate of match for the HCE group may not exceed the rate of match for the nonhighly compensated employee group (Non-HCEs).

Here are a few key points about safe harbor contributions:

• No Allocation Requirements may be imposed, such as, a 1,000 hour or last-day requirement.
• The contributions must be 100% vested.
• The 3% contribution can be used to satisfy Top Heavy minimum contribution and can be used towards satisfying cross-testing gateway.
• The matching contribution can used to satisfy a Top Heavy minimum contribution.

Safe harbor plans are not for every employer. The decision to use the safe harbor technique should be based on the employer's goals, plan design, contribution sources and demographics.

The Financial Accounting Standards Board (FASB), a non-governmental panel that reviews and establishes general accounting standards, on Thursday approved a project to begin overhauling the standards for pension plans and other post-retirement benefits. For the time being, however, the FASB won't do away with any of the widely criticized "smoothing" mechanisms that allow companies to obscure the values of their financial obligations and mask volatility in their earnings.

In a unanimous vote, the FASB approved a recommendation by its staff to split the project into two parts, including an initial set of revisions by the end of 2006. Among the staff's suggested, initial revisions: Companies would be required to include an asset or liability on their balance sheets, to reflect the amounts by which their pension and other post-retirement benefits plans are overfunded or underfunded. Essentially, the board would take numbers that now are relegated to obscure footnote disclosures and move them onto companies' balance sheets.

Source: TwinCities.com Pioneer Press

As the year is rapidly drawing to a close, there are several key deadlines that benefit plan sponsors must meet:

• November 15, 2005 - Creditable Coverage Notice regarding new Medicare Part D prescription drug coverage to all active and retirees covered under the medical plan.
• December 1, 2005 - Safe Harbor Notice for calendar year 401(k) plans to avoid discrimination testing.
• December 31, 2005 - Plan amendment for calendar year retirement plans to implement automatic IRA rollovers for terminated participants with “small accounts”.
• January 1, 2006 - Availability of qualified Roth accounts in 401(k) and 403(b) plans.
• January 1, 2006 - Availability of prescription drug benefits under Medicare Part D.
• January 1, 2006 - Effective date of Treasury and IRS Final 401(k) Regulations.

I will be posting separate, detailed explanations of each as the respective deadlines get closer.

The IRS has recently added a comprehensive Examination Process Guide to its website. The Guide clarifies the various steps in the examination process and provides direction to resources that are available on the Retirement Plans Community website.

If you save more, you can have more in the end. That's not a surprise, but what is surprising is just how big a difference small increases in contributions to a defined contribution plan can mean to retirement wealth. Equally unexpected is the relatively small difference between investing in a top-performing mutual fund versus a poor performer.

A study conducted by Putnam Investments compared three components of defined contribution savings over a 15-year period: mutual fund performance, asset allocation and contribution level. Mutual fund performance had the least impact.

According to the study, if investors had a crystal ball and were able to know in advance which mutual funds would perform in the top quartile and then invested in them, their retirement wealth would only be 6% more over the 15-year period than if they had selected bottom-quartile funds. Changing the allocation from a conservative to a more aggressive portfolio increased results by over 20%.

Increasing contribution rates had the most impact. A 2% point increase (from 2% to 4% of salary, e.g.), which doubled retirement wealth, had 90 times the impact of changing from bottom-quartile to top-quartile funds after 15 years. The study covered the 15-year period of January 1, 1990 to December 31, 2004, and is based on data provided by Lipper, which ranks funds based on total returns and without sales charges, according to similar investment styles or objectives in a given fund category.

"The conclusion of this study is simple, but too often ignored. Saving more is the most powerful way to end up with more. Searching for the perfect mutual fund or allocation is a far less effective approach," said David Tyrie, Director of Retirement Services at Putnam Investments. "Fortunately, many employers have recognized the significant correlation between modest deferral increases and substantial increases in retirement wealth. In addition to ongoing educational programs, DC plan sponsors have begun offering automatic plan enrollment and automatic deferral increases to help participants invest more."

Recent rulings by the Internal Revenue Service make it easier for clients who have missed the 60-day tax-free rollover deadline for individual retirement accounts and other tax-advantaged retirement plans to obtain a waiver and successfully complete the rollover.

Generally, there are two conditions under which the IRS may grant a waiver:

• An automatic extension due to error by the financial institution, or
• A private letter ruling request based on taxpayer circumstances.

An article in the September 2005 issue of the Journal of Financial Planning written by by Kenn Beam Tacchino, J.D., LL.M., and Christina Moore provides the details.

New Section 409A of the Internal Revenue Code, which has been in effect since January 1, 2005, affects virtually all employers and the employees, directors, and independent contractors who participate in deferred compensation programs covered by the new law. To this point, the only guidance on 409A was Notice 2005-1, which was issued on December 20, 2004. Now on October 4th, the Treasury Department and the IRS issued over 200 pages of proposed regulations that clarify many of the remaining issues, including the types of plans and arrangements subject to the new rules, deadlines for compliance and plan amendments, and permitted methods of transitioning to the new rules.

Larry Grudzien, an ERISA attorney, with whom I conduct continuing education programs, has written an explanation of the nonqualified deferred compensation provisions of the Act, the clarifications provided by the IRS in Notice 2005-1 and the further detailed operational rules relating to elections and distributions, as well as plan terminations under the proposed regulations. He also compares the major provisions of the Act with the law in effect before 2005 so that the impact of the new law can be better understood. Click here to download a copy of Larry's article.

It's very hard to take an optimistic view of the retirement-savings picture in America. Unless, it turns out, you're an American who's saving for retirement. At least that's what the different surveys say. So what's the reality? Retirement columnist Robert Powell at Market Watch examines this dicotomy found in several recent retirement surveys and tells us why.

An article in the September issue of Watson Wyatt's Insider discusses how defined benefit plans have become increasingly more valuable in the last five years.

Excerpt:

As interest rates have declined over the past five years, sponsoring defined benefit pension plans has become increasingly expensive — as plan sponsors are well aware. Plan participants, on the other hand, often do not fully understand or appreciate how much their defined benefit plans are worth. For most workers who participate in a typical pension plan, the value of their pension benefits has grown at a significantly faster clip than their 401(k) account balances over the past five years.

However, for some closely-held companies it's not necesarily a question of either/or. It can be both a defined benefit plan and a 401(k) plan for those business owners "hearing footsteps", i.e., getting closer to retirement with not enough retirement savings - the qualified plan rules being satisfied, of course.

Employers are often challenged to communicate benefits to a diverse workforce of non-English speaking employees with different cultural beliefs (sometimes negative or erroneous) about the U.S. financial system.

Melissa Burkhart, President of Futuro Solido USA, provides guidance in overcoming these barriers in a recent article (PDF) in the Denver Business Journal via bizwoman.com (registration required). Her advice is focused on Spanish-speaking workers, but her concepts apply across all ethic groups.

In an earlier posting about older employees, I indicated that employers concerned about a shrinking labor pool are trying to keep employees on the job for as long as possible.

Now a recent telephone survey of human resource managers and executives in Illinois, Indiana, Iowa, Wisconsin, and Missouri conducted in the spring of 2005 by the American Association of Retired Persons (AARP) tells us why. The survey was designed to understand employer perceptions of 50-plus workers and identify what, if anything, employers in these states have started to do to attract and retain these workers.

The results of this Midwestern employer survey are largely consistent with findings from AARP's earlier nationwide employer surveys. For example, Midwestern employers, like employers nationally, give older workers high marks in areas such as loyalty and dedication, commitment to doing quality work, dependability in a crisis, and ability to get along well with coworkers. Similarly, both groups rate older workers somewhat lower on issues such as flexibility about doing different tasks and willingness to learn and use technology.

The Department of Labor plans to issue proposed regulations by the end of the year to encourage employers to use automatic enrollment for their 401(k) plans.

One of the reasons many companies have been reluctant to add this feature to their 401(k) plans is a concern about selecting a "default fund". That is, employees would sue if they lost money in the employer-chosen fund. The Labor Department will address this concern in the proposed regulations by providing protection from such law suits if the employer-chosen investment is "reasonable". Ann Combs, Assistant Secretary of the Department's Employee Benefit Security Administration was quoted in USA Today as saying that the proposed regulations would allow employers to "offer balanced investment options with a little more risk but with returns that allow people to save enough for retirement."

Balance investment options include, of course, equity exposure. Click here to see what Vanguard says about it as featured in a prior posting.

As the "Baby Boomers" approach retirement age, the vision of a work-free retirement is giving way to a new idea of a work-filled retirement. This new idea will affect not only older workers, but employees at all stages of their careers as well as employers.

In a recent survey, A Work-Filled Retirement: Workers' Changing Views on Employment and Leisure, approximately 70% of the employees surveyed indicated that they expect to continue working full-time or part-time following retirement from their main job. Only 13% expect to stop working altogether. The survey was conducted by the John J. Heinrich Center for Workforce Development at Rutgers, the State University of New Jersey, and the Center for Survey Research and Analysis at the University of Connecticut.

At the same time, employers concerned about a shrinking labor pool are trying to keep employees on the job for as long as possible. But the law doesn’t make such programs easy. Historically, pension benefits can be legally paid only when a person stops working entirely. But the rules are changing and the Internal Revenue Service has proposed regulations that make phased retirement more plausible in handling retirement plans. The law firm of Feagre & Benson, LLP recently published an article that provides guidance on the proposed phased retirement rules applicable to pension plans, as well as the issues that are likely to arise regarding health and welfare plans and traditional employment law.

To coincide with the 70th anniversary of Social Security, the American Association of Retired Persons (AARP) released a new survey that tracks public perceptions about Social Security over three decades. Not only has public confidence in Social Security increased in recent years according to the poll, but Social Security has also surpassed pensions and savings as the top source of income Americans expect to rely on in retirement. The survey, titled Social Security 70th Anniversary Survey Report: Trends over Time, repeats previous surveys conducted by AARP for the 50th (1985) and 60th (1995) anniversaries of Social Security.

While all the previous surveys demonstrated the high regard that the American public has for Social Security, this latest installment shows that Americans are becoming increasingly informed about the program and are aware of the role it plays for beneficiaries. The survey shows an increase of 8 percentage points among those who consider themselves to be at least fairly well informed between 1995 (70%) and 2005 (78%). This may be a result of the very public debate about the future of Social Security.

Click here to download a copy of the survey.

Close on the heels of Hewitt's study about retirement plan distributions, the subject of a recent posting, comes a Congressional Research Service (CRS) report that expresses concern on the same matter.

The report, Pension Issues: Lump Sum Distributions and Retirement Income Security, pointed out that most recipients of lump sum distributions were more than 20 years away from retirement and warned that:

Lump-sum distributions that are spent rather saved can reduce future retirement income. If the lump-sum distributions received through 2002 that were not rolled over had instead been rolled over into accounts that grew at the same historical rate as the Standard & Poor’s 500 Index, they would have had a median value of $7,214 by 2003. For the typical recipient, if this amount were to remain invested, it would grow to an estimated value of $31,100 by age 65, which would be sufficient to purchase a level, single-life annuity that would pay $225 in monthly income.

Click here for a copy of the report.

Despite the growing need for employees to save for retirement, a significant number of workers participating in 401(k) plans “cash out” of them once they leave their company, according to new research by Hewitt Associates.

The Hewitt study found a direct correlation between age and tenure and employees' decisions to cash out of their 401(k)plans, and not surprisingly, the size of the account balance was also a factor.

If you are a 401(k) plan sponsor, what should be your "default" fund, the investment fund used for those participants who fail to make a choice either for their own or employer contributions?

Conventional wisdom has been to use a fixed income fund such as a money market or the guaranteed fund. Vanguard's Center for Retirement Research now suggests a different approach in its recently released report, Selecting a Default Fund for a Defined Contribution Plan. Vanguard suggests that plan sponsors consider selecting a default fund that has some level of equity exposure.

The 20-page report just issued by the Vanguard Center for Retirement Research:

• provides data on the current default investment options chosen by plan sponsors,
• considers the legal and investment aspects of the default choice, and
• provides a decision making framework for plan fiduciaries when selecting a default, as well as recommendations for policymakers.

Click here for a copy of the report.

As calendar year plan sponsors get closer to Form 5500 filing time, July 31st, it would be helpful to review the fidelity bonding rules.

All retirement plans under Department of Labor regulations are required to have a fidelity bond. A fidelity bond protects the assets in the Plan from misuse or misappropriation by the Plan fiduciaries. Plan fiduciaries include the Plan trustees and any person who has:

• Physical contact with cash, checks or other Plan property.
• Power to transfer or negotiate Plan property for a price.
• Power to disburse funds, sign checks or produce negotiable instruments from the Plan assets.
• Decision making authority over any individual described above.

At the very least, the bond must equal 10% of the value of the total Plan assets, with a minimum bond value of $1,000. For the first year, the bond amount will be based on the estimated amount of assets that will be handled by the Plan for the year.

The Department of Labor is considering issuing a rule that provides employers a "safe harbor" for depositing 401(k) contributions into the plan account reports Thompson Publishing Group. At the Mid-Atlantic Benefits Conference in Philadelphia, Ian Dingwall, chief accountant for the DOL’s Employee Benefit Security Administration, noted the difficulty in writing a "safe harbor" rule and urged employers not to wait for the rule but instead to correct any violations through the voluntary fiduciary correction program.