Author: jfortenberry@fortenberrylaw.com

The Wall Street Journal has a good editorial today entitled “The Social Security Crisis.” Excerpt:

Back in the 1930s, when the country was shaking off the Great Depression, it became apparent that the elderly were especially suffering — not only had they lost income and assets but there was no time for them to recoup. And so was born FDR’s greatest contribution to the welfare state. The notion was that Social Security would nick a little bit off everybody’s paycheck with a payroll tax and then redistribute that money to anybody over retirement age. The holding pen for this pay-as-you-go transfer was called, brilliantly if dishonestly, a “Trust Fund.”

Demography made the whole arrangement work for a long time. In the 1930s there were 41 workers for every one retiree; the payroll tax could thus be set at a low rate — about 2% for the first $3,000 of earnings. . .

The article goes on to note how the ratio of workers to retirees has fallen over the years–how in 1950, it had dropped to 16 workers to one retiree and now it is just three to one.

The article makes this critical point:

The immediate problem is that payroll taxes during the surplus period that began in the 1980s were not saved in the mythical Trust Fund; instead the taxes were used to finance other government spending. . .

I enjoyed this editorial cartoon from the TaxGuru.

The DOL has posted on its website the “Report of the Working Group on Fee and Related Disclosures to Participants.” The consensus of the working group (which was appointed by the Advisory Council on Employee Welfare and Pension Benefit Plans to study “fee and related disclosures to participants in defined contribution plans”) is for “additional disclosure of fees in defined contribution plans that seek the protections of ERISA section 404(c).” (The Advisory Council was created by ERISA to provide advice to the Secretary of Labor). Brief summary of the recommendations:

(1) “The profile prospectus of each investment option should be delivered to each employee upon eligibility to participate.”

(2) “Participants must be given materials (like a glossary) that explain the meaning of the terms used in the profile prospectus (or other like document) coincident with the delivery of the profile prospectus.” (In other words, a document explaining a document.)

(3) “To the extent that an annual statement is provided by the recordkeeper, the statement must provide the expenses of each investment option expressed as a ratio along with other information provided about the investment options. There must also be an identification of the investment expenses that are paid entirely or in part by the plan sponsor.”

(4) “The DOL should provide a sample model disclosure format that is available on its web site.”

Excerpts from testimony to the working group:

Louis Campagna, Chief, Division of Fiduciary Interpretations, Office of Regulations and Interpretations, US Department of Labor, Washington D.C.:

In choosing the funds menu, the plan fiduciary needs to examine the fees, which must be at a reasonable level given the services and their quality. In the 1997 Advisory Opinion (the “Frost Opinion”), it was stated that compensation to a service provider needs to be reasonable taking into account services provided as well as other compensation the service provider receives such as from asset fees.

Mercer Bullard, President and Founder Fund Democracy, Inc. and Assistant Professor of Law, University of Mississippi:

Professor Bullard speculates that participants do pay higher fees than other investors because fees are less transparent in qualified plans. He also believes that 401(k) participants’ investments perform better than the investments of individuals outside of 401(k) plans. He attributes this to the fact that 401(k) investors trade less often than other investors partially because their objectives are long-term and partially because of inertia.

Bruce Ashton, President, ASPA and partner of Reish, Luftman, Reicher & Cohen:

The current rules relating to the disclosure of plan related fees and expenses only go so far in disclosing to the plan participant what he or she is really paying out. ASPA believes that plan participants should receive full and complete disclosure of all fees and expenses paid out of plan assets that can be reasonably identified. Further, this disclosure should be provided in a meaningful and understandable format. To minimize administrative burdens, the disclosure could be distributed in conjunction with the plan participants regular year-end statement. Although specific disclosure of the amount actually charged to a participant’s account may be preferable, the burden of providing this individualized information is significant, and providing such information could have a chilling effect on the creation and maintenance of such plans.

Norman P. Stein, Professor of Law, University of Alabama:

Clear and understandable disclosure of fees is still important. Uniformity of presentation is necessary so that participants have the same information about all investment options. The disclosure must also provide examples of how fees affect the rate of return and of how fees can make it more expensive to move in and out of investment options. He also points out the DOL does not have expertise in the area of investments. The SEC does, however, have expertise in this area. Therefore, the DOL should consult with the SEC when designing rules for these kinds of disclosures. Nevertheless, the DOL has more expertise in designing the format of such a disclosure than the SEC, so the DOL should prescribe the format.

Regarding the types of disclosure favored by the working group, here is what they had to say:

[T]he working group saw examples of investment statements showing the expense of each investment option expressed as a ratio for each fund in which a participant was invested as of the date of the statement. The working group believes that this is pertinent information that is helpful in making the investment decision. This information can also be presented in an understandable format.

One example was in materials distributed in connection with Russell Ivinjack’s testimony. It consisted of a table having the following information going across the page: fund name, fund type, objective/strategy, risk level and expense ratio. Another example was in materials distributed by Dennis Simmons and Stephen Utkus who were from the Vanguard Group. The sample all-in fee report and the sample fund fact sheet are attached as exhibits to this report. The sample all-in fee report is substantially similar to the DOL Fee Disclosure Form.

U.S. Sen. Mike Enzi, R-Wyo., is expected to be the next chairman of the Health, Education, Labor and Pensions Committee (HELP) and has outlined his priorities for the 109th Congress. He announced plans for “closer scrutiny of the Departments of Health, Education and Labor and the Pension Benefit Guaranty Corporation,” for more affordable and accessible health insurance “by working to simplify and harmonize insurance market standards and regulations”as well as “meaningful Occupational Safety and Health Administration (OSHA) reform and Mine Safety and Health Administration (MSHA) oversight.” In addition, a press release also mentions his plans for pension reform:

Enzi looks forward to a greater role in oversight and reform of our nation’s pension and benefits programs. He anticipates undertaking comprehensive pension reform to stabilize the private pension system to ensure the retirement security of hardworking Americans.

The press release goes on to note that Enzi was one of the authors of the Sarbanes-Oxley Act and that, in the 108th Congress, he introduced the Retirement Security Advice Act of 2003, S. 1698, that would have promoted greater investment advice to workers in managing their retirement income assets.

Imagine the following scenario: A CPA and owner of a public accounting firm is sole trustee of the firm’s 401(k) plan and is responsible for investing, managing, and controlling the plan’s assets. Over a span of three years, the CPA decides that the plan can loan money to a number of companies in which the CPA owns a minority interest. The loans which amount to around $700,000 will bear interest at 12%, and will provide a good return for the plan. Because the CPA does not own 50% or more of the companies to which the plan will be loaning money, the CPA figures he won’t run afoul of the prohibited transaction provisions. (Under Code Sec. 4975 , a tax is imposed on a disqualified person (e.g., a plan fiduciary or a 50% or more owner of the plan sponsor) who participates in a prohibited transaction which includes a loan between a plan and a disqualified person.) Those were the facts in the recent Tax Court case of Joseph R. Rollins, TC Memo 2004-260.

However, the IRS had a different view of the transactions in that case. The IRS pulled out its arsenal of sections 4975(c)(1)(D) and (E) of the Internal Revenue Code and claimed that the CPA had committed prohibited transactions. Under those provisions, the IRS claimed that the “loans were transfers of the [p]lan’s assets that benefited” the CPA under sec. 4975(c)(1)(D) of the Code, and that the the loans were dealings with the plan’s assets in the CPA’s own interest under sec. 4975(c)(1)(E) of the Code. The IRS contended that the CPA was a disqualified person with respect to the plan in two capacities: (a) A fiduciary of the Plan (sec. 4975(e)(2)(A)), and (b) the 100-percent owner of the employer sponsoring the plan. The IRS held that the CPA benefited from the loans in that the loans enabled the borrowers–all entities in which the CPA owned interests–“to operate without having to borrow funds at arm’s length from other sources.”

When the Tax Court reviewed the facts, the court agreed with the IRS that the loans were prohibited transactions under section 4975(c)(1)(D), but held that it was unnecessary to decide whether the the CPA had also violated section 4975(c)(1)(E).

What were the CPA’s excise taxes that he had to pay for the prohibited transactions? Roughly $164,000, a hefty penalty for what in the end looked like a fairly good deal for the plan. The Tax Court reiterated its position that, just because an investment is good for a plan, doesn’t matter when it comes to applying the prohibited transaction rules:

After a review of the statutory framework and legislative history of section 4975 and the case law interpreting ERISA section 406, we conclude that the prohibited transactions contained in section 4975(c)(1) are just that. The fact that the transaction would qualify as a prudent investment when judged under the highest fiduciary standards is of no consequence. Furthermore, the fact that the plan benefits from the transaction is irrelevant. Good intentions and a pure heart are no defense.

Moral of the story: No matter how good an investment looks for a plan, ERISA fiduciaries, trustees, and certain owners and entities should get competent legal advice regarding application of the prohibited transaction rules when entering into transactions with retirement plans, especially in cases where common ownership exists or conflicts of interest issues are present. In the end, the court, in the portion of the opinion where it addressed the issue of whether or not it should impose the additional tax for failure to file an excise tax return, actually seemed to penalize the CPA for not obtaining competent advice:

Relying on his own understanding of the law, petitioner chose to sit “on both sides of the table in each transaction.” . . . Relying on his own understanding of the law, petitioner did not see any need to file section 4975 tax returns to report any of the transactions. . . . Petitioner’s good-faith belief that he was not required to file tax returns does not constitute reasonable cause under section 6651(a)(1) unless bolstered by advice from competent tax counsel who has been informed of all the relevant facts. Stevens Bros. Foundation, Inc. v. Commissioner, 39 T.C. 93, 133 (1962), affd. on this point 324 F.2d 633, 646 (8th Cir. 1963). There is no such evidence in the record in the instant case.

Also, the case is worth reading alone for its detailed discussion of the history behind the prohibited transaction rules.

The HSA Coalition has issued a helpful document explaining many of the rules for setting up and using health savings accounts. The document is entitled “HSA Road Rules for Consumers, Employers, Insurers, Banks, Credit Unions & Administrators.” (Thanks to Roth CPA.com for the pointer.)

It goes without saying that blogs are gaining in popularity, as evidenced recently by the appearance of two new blogs by individuals who have greatly impacted the benefits world. While they will obviously not be blogging about benefits, readers will undoubtedly want to visit now and then:

• Eliot Spitzer has started a blog in conjunction with his announcement that he is running for Governor.
• Seventh Circuit Judge Richard Posner has started a blog here which will “explore current issues of economics, law, and policy in a dialogic format.” In his first post, Posner writes about blogging in general:
  

  Blogging is a major new social, political, and economic phenomenon. It is a fresh and striking exemplification of Friedrich Hayek’s thesis that knowledge is widely distributed among people and that the challenge to society is to create mechanisms for pooling that knowledge. The powerful mechanism that was the focus of Hayek’s work, as as of economists generally, is the price system (the market). The newest mechanism is the “blogosphere.” There are 4 million blogs. The internet enables the instantaneous pooling (and hence correction, refinement, and amplification) of the ideas and opinions, facts and images, reportage and scholarship, generated by bloggers.

If you practice in the executive compensation arena, you need to be reading Broc Romanek who is following developments pertaining to a new wave of executive compensation lawsuits. Read what he has to say here and here. One such lawsuit names the CEO, other executives, directors and the general counsel and “seeks to recover money for the corporation almost solely on the basis that no corporate director could in good faith have allowed executives to have collected the amount of money that was paid” to them. (Quote from a Wall Street Journal article on the Fairchild lawsuit.)

He also writes about the SEC’s keen interest in the timing of option grants as evidenced by this “Legal Proceedings” section of a 10-K filing for a company (filed last week) which states:

We have received notice that the SEC is conducting an inquiry into our granting of stock options over the last five years to officers and directors. We believe that other companies have received similar inquiries. Each year, we grant stock options to a broad base of employees (including officers and directors) and in some years those grants have occurred shortly before our issuance of favorable annual financial results. The SEC has requested information regarding our stock option grants and we intend to cooperate with the SEC. We are unable to predict the outcome of the inquiry.

He also notes this speech by SEC Staffer, Chester Spatt, discussing whether or not there are “adequate safeguards in the setting of executive compensation” so that conflicts are adequately mitigated. Mr. Spatt asks the question: “Should there be additional fiduciary obligations on compensation consultants that advise the board of directors with respect to executive compensation?”

Finally, don’t miss Congressman Barney Frank‘s comments to “250 bank executives, regulators, and politicos gathered for the trade publication American Banker’s annual Banker of the Year Awards” (via the Boston Globe “frank talk from Frank” ):

According to remarks provided from the evening, Frank said: “I mean, do we really have to bribe you to do your jobs? I’m serious. I don’t get it. I don’t get a bonus. Cops don’t get bonuses. . . . And the problem is not just the bonuses. Think what you’re telling the average worker, that you who are the most important people in the system and at the top, that your salary isn’t enough, that you need to be given an extra incentive to do your job.”

As Broc’s title for his post suggests, “Is this a glimpse into the Congressional mindset on executive compensation?”

The following article discussing new rules governing nonqualified deferred compensation plans will be published in the Greater Valley Forge Human Resource Association upcoming newsletter. (I serve as Legislative Chair for the association.) I am publishing the article here as well, since by the time it is published in the newsletter, it will likely need a rewrite due to soon-to-be-released IRS guidance expected in December. If you “google” the subject matter or search via Benefitslink.com, you will see that the internet has already seen a proliferation of law firm articles and publications on the topic. While there is not really anything new to report other than what most have already said about the subject, this article does contain some comments from Bill Sweetnam, Benefits Tax Counsel for the Treasury, made to practitioners at the recent ALI-ABA satellite webcast entitled “Annual Fall Employee Benefits Law and Update.”

The American Jobs Creation Act of 2004 (“AJCA”) made sweeping and dramatic changes to the tax rules relating to nonqualified deferred compensation plans. Such tax rules are the foundation for corporate executive compensation programs. The legislation adds a new section 409A to the Internal Revenue Code, which generally is effective with respect to amounts that are deferred in taxable years beginning on or after January 1, 2005. Noncompliance with the new rules once they become effective will cause all compensation deferred under a plan for the taxable year and all preceding taxable years to be included in an affected participant’s gross income (if not subject to a substantial risk of forfeiture) and subject to interest and an additional penalty tax of 20% of the compensation required to be included in income.

Amounts that are earned and vested before 2005 under a current plan are grandfathered as long as the plan is not materially modified after October 3, 2004. According to the legislative history of AJCA, a “material modification” includes the addition of a new benefits, right or feature, such as a disability benefit or death benefit, as well as acceleration of vesting, but the exercise or reduction of an existing benefit, right or feature does not constitute a “material modification.”

The rules extend to most plans or arrangements that provide for the deferral of compensation including, but not limited to:

• Excess benefit plans
• Supplemental executive retirement plans (SERPs)
• Elective deferrals of salary and/or bonuses
• Section 457(f) plans maintained by tax-exempt and governmental employers
• Stock appreciation rights (SARs)
• Discounted stock options
• Phantom stock

The following types of plans are exempt from the new rules:

• Qualified retirement plans
• Tax-deferred annuities
• Simplified employee plans
• SIMPLEs
• Section 457(b)eligible deferred compensation plans maintained by governmental and tax-exempt employers
• Bona fide vacation leave plans, sick leave, compensatory time, disability pay and death benefit plans
• Code Section 422 incentive stock option plans
• Code Section 423 employee stock purchase plans

Please note that the IRS has indicated informally that deferral provisions in employment agreements or severance plans may be subject to the new rules, and that the IRS will address these types of plans in their upcoming guidance. Also, the conference report makes it clear that plans covering non-employees (e.g. independent contractors, directors) are also covered by the new rules.

Summary of New Rules: Under the new rules, in order for a participant to avoid current taxation of deferred compensation and penalties, the deferred compensation arrangement must satisfy the following requirements:

1. Distributions must be made only upon separation from service, death, disability, change in ownership or effective control of the employer, unforeseeable emergency, or at a specified date. A participant will be considered to be disabled if either (1) the participant is disabled within the meaning of the Social Security Act, or (2) the participant is receiving income replacement benefits for a period of at least three months under an accident and health plan of the employer, by reason of a medically determinable physical or mental impairment which can be expected to result in death or last for a continuous period of at least 12 months. Payments to “key employees” of a publicly traded corporation may not be made in the first six months following the individual’s separation from service. (“Key employees” are officers earning at least $135,000 for 2005 -but not more than the first 50 officers, ranked by current year compensation-and some owners.)

2. The initial deferral election must be made prior to the beginning of the year in which the compensation is earned. However, with respect to “performance-based compensation” based on services performed over a period of at least 12 months, the election may be made no later than six months before the end of the performance period.

3. An election to delay or to change the form of payout is allowed only if:

• Such election does not become effective until at least 12 months after the election is made;
• Such election, if it relates to a distribution at a specified time, must be made not less than 12 months prior to the date of the first scheduled payment; and
• The additional deferral with respect to which the election is made must be for a period of not less than 5 years from the date such payment would otherwise have been made (except in the case of an election related to a payment on account of the participant’s disability, death, or an unforeseeable emergency.)

4. Acceleration of any payout is prohibited. Many existing plans now include provisions that permit participants to elect to receive distributions of their deferred benefits subject to a penalty (referred to as a “haircut provision”). However, the new law would preclude participants from making such an election on or after January 1, 2005. In addition, changes in the form of payment that result in an acceleration of payments, e.g. election options which permit a participant to elect a lump sum over an annuity, would not be permitted.

5. Deferred compensation may not longer be funded using offshore funding arrangements.

6. A financial health trigger that results in a plan becoming funded will result in adverse tax consequences for a participant, even though the assets of the plan are still available to satisfy claims of general creditors.

The Department of Treasury has been directed by the Congress to issue guidance within 60 days after enactment of the law. The guidance will permit employers within a limited time frame to amend plans adopted prior to December 31, 2004 (1) so as to allow individuals to terminate participation in the plan or cancel an outstanding deferral election with respect to amounts deferred after December 31, 2004 or (ii) to comply with the legislation with respect to amounts deferred after December 31, 2004.

What Should Employers Be Doing Now? There are many unanswered questions that will need to be addressed in guidance issued by the Treasury. Until guidance is issued (such guidance is expected in December of this year), employers are being advised by practitioners to be taking inventory of all plans that might be affected. At a recent ALI-ABA conference (November 10, 2004), William F. Sweetnam, Jr., Esquire, Benefits Tax Counsel for the Treasury, stated that the new law will make nonqualified plans look more and more like qualified plans in that there will now be more specific legal requirements for such plans, new document requirements and operational requirements as well. Mr. Sweetnam urged employers not to “panic”, but to be taking inventory of their plans so that when guidance is issued, employers will be ready to take action and make amendments to their plans. He offered assurances that the Treasury will provide a transition period during which employers will be allowed to be bring their nonqualified plans into compliance with the new laws, even though the new rules technically take effect on January 1, 2005.

Also, practitioners are warning that employers who might seek to amend a grandfathered plan now to allow distributions in 2004, and to terminate the plan prior to January 1, 2005 to avoid application of the new rules, might end up actually running afoul of the new rules, since such an amendment would likely result in a “material modification,” meaning that the plan would no longer qualify for the “grandfather” rule.

Please note that the IRS has issued Announcement 2004-96 advising employers about an additional code for use on the 2005 Form W-2. The new code will be used to identify annual deferrals of income under a nonqualified deferred compensation plan covered under new section 409A of the Internal Revenue Code. The deferred amounts will be reported in box 12 of Form W-2, using Code Y.

Bottom Line: All nonqualified deferred compensation plans covered by the new rules will most likely have to be amended. The features of many current plans will no longer be permitted, and many plans will have to be redesigned. Employers will have to communicate these changes to affected participants.