Summary of Important Guidance

Similar to the prior pronouncements, the new Technical Update:

– Extends the waiver of the requirement to report a missed quarterly contribution for small pension plans under ERISA §4043.25. This waiver is valid as long as the plan (1) has fewer than 25 participants or (2) has between 25 and 100 participants and files a simplified notice with the PBGC. In both cases, the reason for the missed quarterly contribution cannot be due to financial inability.

– Affirms that the assets and liabilities used to calculate the 2011 PBGC variable rate premium should be used to determine reporting requirements for events occurring during the 2012 plan year. This includes determining whether the plan is eligible for reporting waivers, reporting extensions, or is subject to advance reporting requirements.

Technical Update 11-1 also mentions two other small PBGC-related items:

• It acknowledges that the reaction to the proposed 2009 reportable event regulations has been largely negative. So, the PBGC will issue new proposed regulations that “will more effectively target troubled plans and sponsors while reducing burden for those that are financially sound.”

• If the PBGC issues a final rule before the end of 2012, then the guidance in Technical Update 11-1 will be superseded by the final rules.

After three years of temporary reportable event relief, it seems likely that the new proposed regulations will incorporate some of this relief on a permanent basis. We’ll just have to wait and see whether the rules are formalized in 2012 or whether we get another extension as an early Christmas present next year.

Many sponsors want to do all that they can to avoid these benefit restrictions.   Regulations allow four options to do so:

1. Waiving credit balance – If there is any credit balance (carryover balance or prefunding balance) on the valuation date, the easiest way to improve the funding status is to waive the balance.  In fact, this action is required in certain cases.  The trouble is, for most underfunded plans, the credit balance is not big enough to be of much help.  It can also reduce future funding flexibility.
2. Posting security – Sponsors can also post funds in escrow outside of the plan and count it as an asset for purposes of determining if benefit restrictions apply.  This option comes with plenty of strings attached, and would not truly improve the funding status of the plan.
3. Additional current year contribution – A third option is to make an additional contribution for the current year (a “436 contribution”).  A 436 contribution needs to be made before the date the restriction would otherwise start.  This option can avoid restrictions on UCEBs, amendments and accruals, but not limits on lump sums.
4. Additional prior year contribution - The fourth and perhaps most attractive option is to make an additional contribution for the prior year.  Here are a few things plan sponsors considering this solution should know:

• The contribution does not need to be made before the valuation date.  For example, a plan sponsor that is concerned their January 1, 2012 funded status may trigger benefit restrictions would not need to make an additional contribution by December 31, 2011.  This is important because it allows time for the plan’s actuary to measure the preliminary funded status, determine if a contribution is needed to avoid restrictions, and to calculate the amount of such a contribution.
• The January 1, 2012 funded status generally needs to be certified by March 31, 2012.  Ideally, additional contributions would be made by this date because the actuary can not certify the status based on contributions that haven’t already been made.  However, an actuary can issue a “range certification”.  For example, the actuary can certify that once the contribution is made, the funded status will be between 80% and 100%.  This prevents restrictions and allows the sponsor to have until the normal contribution due date (the earlier of September 15, 2012 and the date the 2011 tax return is filed) to fund any additional contribution for 2011.
• The contribution increase may be more affordable than it first appears.  That’s because any additional contribution for the prior plan year is included in the assets for determining the minimum contribution on the next valuation date.   Making an additional 2011 contribution of $1,000,000 may reduce the 2012 minimum contribution by about $160,000.
• WARNING:  If, for any reason, the additional contribution isn’t made so the final funded status is outside of the previously certified range, there are serious consequences.  Potential consequences include retroactive benefit restrictions and plan disqualification.  Therefore, the sponsor needs to be absolutely sure that they will be able to make the contribution prior to requesting a range certification.

Since benefit restrictions can be complicated and costly to implement, it makes sense to avoid them – especially if they can be avoided by paying down unfunded liability that needs to be funded sooner or later.

Background

When retirement plans are top-heavy and/or rely on cross-testing procedures to pass IRS nondiscrimination testing, there are several minimum benefits that must be provided to non-Key employees and non-highly compensated employees (NHCEs). For sponsors of both a DB and a DC plan, these minimum benefits often include:

• 5% DB/DC top-heavy minimum for all participants employed at year-end or who work at least 1,000 hours during the year (note: separate DB and DC options are available instead of the single 5% minimum)

• 7.5% DB/DC minimum “gateway” allocation for cross-testing

What happens when the DB plan is frozen or terminated?

When accruals in the DB plan cease, there are a couple of immediate consequences for the minimum profit sharing allocations.

1. The top-heavy minimum benefit decreases from 5% to 3% of pay. In addition, only participants who are employed at year-end need to receive this allocation. So, you no longer have to provide a top-heavy minimum benefit to employees who terminate during the year. Note: even if the DB plan is terminated and benefits paid out, those DB payments for active employees must still be considered in the remaining plans’ top-heavy determination for up to five years.

2. Since there are no DB plan benefit accruals to test any more, the only cross-testing that may be needed is for the DC plan itself. This means that the “gateway” minimum allocation decreases from 7.5% of pay to 5% of pay.

Plan sponsors generally welcome the reduction in minimum profit sharing benefits that accompany a DB plan freeze or termination. However, there’s at least one important HR consideration: What’s the impact on employee morale when a DB plan freeze/termination is accompanied by a reduction in profit sharing?

This “double-whammy” could make employees very unhappy. An alternative is to keep profit sharing rates unchanged for a while and then decrease them in future years if that fits into the company’s overall benefits strategy. If you’ve frozen or terminated your DB pension plan during 2011, now is the time to explore your options before year-end profit sharing allocations are due!

Changes affecting both DB and DC plans

• HCE compensation threshold increases from $110,000 to $115,000. For calendar year plans, this will first affect 2013 HCE designations because $115,000 will be the threshold for the 2012 “lookback” year.  Slightly fewer participants will meet the HCE compensation criteria, which will have two direct outcomes:

• Plans may see marginally better nondiscrimination testing results (including ADP results) if there are fewer HCEs. It could potentially make a big difference for smaller plans that were very close to failing the tests.

• Fewer HCEs means that there are fewer participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

• Qualified compensation limit increases from $245,000 to $250,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.

DC-specific increases and their significance

• Increase in annual DC 415 limit from $49,000 to $50,000 and 401(k) deferral limit from $16,500 to $17,000. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit isn’t much, but it will allow participants to get a little more “bang” out of their DC plan. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $33,000 from profit sharing ($50K – $17K) if they maximize their DC plan deductions. Previously, their profit sharing limit would have been $32,500 ($49K – $16.5K)

• 401(k) “catch-up” limit remains at $5,500. Participants age 50 or older still only get a $5,500 catch-up opportunity. Combined with the new overall DC limit, they can effectively get a maximum DC deduction of $55,500 ($50K + $5.5K).

• The increase in the 401(k) deferral limit could be of limited value to companies whose 401(k) plans consistently fail the IRS Actual Deferral Percentage (ADP) test. In those situations, HCE deferrals are restricted to an amount below the statutory limit so a limit increase may not matter. One option to remedy the situation (though not without its costs) would be to adopt a safe-harbor plan design.

DB-specific increases and their significance

• DB 415 maximum benefit limit (the “dollar” limit) increases from $195,000 to $200,000. The primary consequence of this change is that individuals who have very large DB benefits (say, shareholders in a professional firm cash balance plan) could see a deduction increase if their benefits were previously constrained by the 415 dollar limit.

Below is a table summarizing the main changes to employer-sponsored retirement plan limits for 2012.

We often hear the question “why should I contribute to a qualified retirement plan if tax rates might go up”?  Good question; here’s why:  you’ll probably end up with more money after tax.  That’s true even if tax rates go up in the future.

How much more you’ll end up with depends on your investment return, the deferral period, and your marginal tax rates at three different times:

• when you contribute the money,
• while it’s invested, and
• when you withdraw it.

The key is that in a taxable account, you lose some of the power of compound interest every time you’re taxed on your contributions and investment earnings.

Let’s start with a simple example, using a 33-1/3% marginal tax rate all the way through.  That’s a bit lower than the 35% top Federal rate, but it makes the math easy.  Suppose you have $3,000 to contribute, and investment earnings average 6%.

Tax deferred account / qualified plan

Contributing your $3,000 to a 401(k) or other qualified plan, you have the whole amount to invest and investment earnings are tax free – but you have to pay tax when you withdraw it.  Leaving it in for, say, 20 years you would have $6,414 after paying your tax:  $3,000 x (1.06 ^ 20) x (1-.3333).

Taxable account

Contributing to a taxable account, you have $2,000 to invest after tax ($3,000 x (1-.3333)) and investment earnings are taxable so your effective investment return is 4% (6% x (1-.3333)).  But then you’re done paying taxes.  After 20 years you would have $4,382:  $2,000 x (1.04 ^ 20).

What if’s:  rising tax rates, capital gains, return, deferral period, Roth

In this simple example, the qualified plan clearly beats the taxable account.  But what if tax rates are higher at withdrawal?  For the $4,382 in the taxable account to beat the qualified plan, the tax rate would have to suddenly jump to 54.5% at withdrawal:  $3,000 x (1.06 ^ 20) x (1-.545) = $4,378.   Any tax increase that happens more gradually would be worse for the taxable account, with no effect on the qualified plan.

What about capital gains?  If the current 15% long term capital gains rate is sustainable and all your investments qualify, your effective return is 5.1% (6% x (1-.15)).  You still start with $2,000 to invest after tax, so after 20 years you would have $5,408:  $2,000 x (1.051 ^ 20).  That’s not bad, but it’s still less than the $6,414 you would have had from a qualified plan.

What about different investment returns and deferral periods?  We’ve used 6% return for 20 years in this simple example, but how does it change for other returns and time periods?  The short answer is that higher investment returns and longer deferral periods favor the qualified plan.  Lower returns and shorter time favor the taxable account.

What about a Roth IRA or 401(k)?  As it turns out, Roth and regular 401(k) results are identical if your marginal tax rates are equal at contribution and withdrawal.  Roth is better if your marginal rate at withdrawal is higher than at contribution time; otherwise a regular 401(k) is better.  And they both blow the taxable account out of the water.

Here’s what it means for plan sponsors:

• The scope of the announcement is relatively narrow and only applies to certain hybrid plan rules and regulations. These rules were spelled out in a combination of proposed and final regulations issued in October 2010.

• Important take-away from the notice: By extending the proposed 2010 hybrid plan regulation effective date, the IRS is hinting that they are still reviewing the definition of “market rate of return” for interest crediting rates. They’ve clearly received lots of comments from plan sponsors and practitioners about what a “fair” market rate of return should be. At this point, it looks like we won’t be getting final regulations about this issue until sometime in 2012.

• Here’s an abbreviated summary of the notice’s relief items:

• Extension of the effective date of the proposed 2010 hybrid plan regulations (which include the definition of market rate of return for interest crediting purposes) to a date no sooner than January 1, 2013 (they were expected to be finalized and effective January 1, 2012). The notice also extends the effective date of the final 2010 hybrid plan regulations from January 1, 2012 to the same date that the 2010 proposed regulations are effective.

• Extension of the deadline for adopting amendments under § 411(a)(13) (other than § 411(a)(13)(A)) and § 411(b)(5)). This includes the 3-year vesting requirement for statutory hybrid plans. Plan sponsors now have until the last day of the year preceding the year that the 2010 proposed hybrid plans become effective to adopt the necessary amendments.

• Additional 411(d)(6) relief for reducing accrued benefits as long as the amendment to reduce/eliminate benefits is done solely to comply with 411(b)(5) [i.e., age discrimination and interest credit rules for hybrid plans]. These amendments also need to be adopted before the last day of the year prior to when the proposed 2010 hybrid plans become effective.

• Additional 204(h) notice timing relief in specific situations related to amendments that changed the interest crediting rate for a statutory hybrid plan.

• The executive’s share of company profits is very small, and
• The executive is willing to shoulder the employer’s credit risk, and
• Providing the benefits through a qualified plan would be too expensive.

But they’re not so great when any of these conditions are missing.  Let’s examine each in turn.

Small share of company profits:  Nonqualified deferred compensation isn’t deductible for the company until it becomes taxable for the executive.  If the executive is a substantial owner in a profitable enterprise, e.g. a law firm or medical group partner, any deferred income boomerangs right back as taxable profit.  In contrast, qualified retirement plan contributions are deductible for the company when they’re made, and not taxable to the employee until they’re received in cash.

Willing to shoulder the employer’s credit risk:  Funding vehicles like rabbi trusts can protect the executive from the employer’s unwillingness to pay, but not against its inability to pay.  In today’s economic environment where even large companies are struggling, this risk may be unacceptable.  Protection from both of these risks – and even from the executive’s personal creditors – is provided by a qualified plan.

Qualified plan too expensive:  This is usually the main reason for setting up a deferred compensation plan.  Qualified plans have many requirements that don’t apply to most nonqualified plans:  coverage, nondiscrimination, government filings etc.  But they’re more flexible than most people realize.  In a cross-tested profit sharing/401(k) plan, top executives can often reach the annual $49,000 defined contribution limit with a 5% staff contribution.  And if that’s not enough, a cash balance or other defined benefit plan can allow much higher deductions:  up to an additional $100k-200k per year.

So, are we biased toward qualified plans?   Oh, absolutely.  Nonqualified plans can be a great choice, but make sure you’ve maximized your qualified plans first.

Note: We’ll be focusing on cross-tested profit sharing plans and cash balance plans. These plans allow owners to make large tax-deferred retirement contributions in exchange for providing a generous employee retirement allocation (usually 5% of pay if there’s only a profit sharing plan, or 7.5% of pay if there’s a cash balance plan too).

• Self-employment “earned income” limit [§404(a)(8)]. For self-employed individuals, a year of low earnings can hinder pension plan deductions. This is because annual retirement plan deductions cannot exceed your “earned income” for the year (net self-employment income with a Social Security tax adjustment).

• Combined DC and DB plan deduction limit of 25% of payroll [§404(a)(7)]. This annual contribution limit has a couple of important adjustments.

• Contributions to a defined benefit plan insured by the PBGC are excluded from the 25% calculations. So, most PBGC-covered pension plans won’t have to worry about the combined limit.

• For defined benefit plans that are not covered by the PBGC, the limit applies only to the extent that employer DC contributions (other than 401(k) deferrals) exceed 6% of payroll. This means that:

1.  The total DB/DC deduction can exceed 25% of payroll if employer DC contributions are 6% or less; and

2. When DC employer contributions exceed 6%, the combined deduction limit is essentially 31% of payroll.

• 401(k) deferral refunds reclassified as catch-up contributions. If your 401(k) plan fails the ADP test, the most common remedy is to refund deferrals to HCEs. Don’t forget, though, that if an eligible HCE has not yet reached the catch-up contribution limit then their refund should be reclassified as a catch-up contribution to the extent possible.

There can be a lot of confusion among sponsors of small- and medium-sized pension plans regarding the different deduction limits. This post aims to clarify some of these issues, but you should consult with a tax professional regarding the details and your specific situation.

1. Add a 401(k) match. If your plan doesn’t already have a 401(k) match, adding one will encourage employees to at least defer a minimal amount into their 401(k) accounts. More NHCE deferrals = better ADP test results.

2. Enhance the current 401(k) match. If your plan already has a match but it isn’t getting NHCEs to defer, then there are a couple of options:

- Increase the match: Maybe that 1% match just isn’t worth it for some folks. A 3% match is about average, and any increase can be factored-in when considering an employee’s total compensation package.

- “Extend” the match: The goal here is to increase the amount of compensation eligible for a match while not increasing employer costs. For example, if you currently match 50% of the first 6% deferred then consider amending the plan to match 40% on the first 7½% deferred. Both formulas have a potential match of 3% of compensation, but the latter encourages employees to save at a higher rate in order to earn the full match.

3. Add an automatic enrollment feature. An Eligible Automatic Contribution Arrangement (EACA) is a feature where new participants are automatically enrolled in the 401(k) plan at a uniform deferral rate, unless they elect to opt out. If your 401(k) plan is suffering the ADP failure blues because few new hires are deferring, then this is a great way to increase your ADP rate and encourage employees to save for retirement. There’s also the Qualified Automatic Contribution Arrangement (QACA) option, which is a safe harbor plan combined with an automatic enrollment feature.

4. Add a “safe harbor” plan design. If you adopt one of these IRS-prescribed benefit formulas, then you get a “free pass” on ADP testing. Safe harbor benefits are 100% vested immediately and you must provide notice of the safe harbor status to participants at least 30 days prior to the start of the plan year. The minimum safe harbor benefit formulas are:

- At least a 3% automatic (i.e., non-matching) employer contribution to each participant’s 401(k) account; or

- An employer match of at least 100% on the first 3% deferral plus a match of at least 50% on the next 2% deferral (i.e., a potential match of 4% of pay).

If you have a cross-tested profit-sharing plan or cash balance plan, then the 3% non-elective option is often the best choice since those benefits count towards the non-discrimination tests whereas the matching formula does not.

Each of the options above has variations and can be combined with the others. Combined with a thorough campaign to educate participants about the changes, they’ll improve your chances of passing the ADP tests next year and avoid having to refund HCE deferrals as taxable income.