Author: jfortenberry@fortenberrylaw.com

The IRS has issued Notice 2004-78 (from Benefitslink.com), providing guidance with respect to a change to section 415 of the Code which was tucked away in the Pension Funding Equity Act of 2004 (“PFEA”). The change affects all defined benefit plans and has to do with the actuarial assumptions that must be used to adjust a benefit payable in a form other than a straight life annuity.

Prior to its amendment by PFEA, section 415(b)(2)(E))(ii) provided that, for purposes of adjusting any benefit payable in a form that is subject to the minimum present value requirements of section 417(e)(3) of the Code, the interest rate assumption could not be less than the greater of the applicable interest rate (as defined in section 417(e)(3)) or the rate specified in the plan.

PFEA amended section 415(b)(2)(E)(ii) of the Code to provide that the interest rate assumption must not be less than the greater of the applicable interest rate (as defined in section 417(e)(3)) or the rate specified in the plan, except that in the case of plan years beginning in 2004 or 2005, 5.5 % is used in lieu of the applicable interest rate.

The Notice makes it clear that the changes made to section 415 of the Code by PFEA will be effective for plan years beginning on or after January 1, 2004, but that the changes will not apply to plans that terminated prior to April 10, 2004, the date of enactment of PFEA. Also, the Notice provides that a plan won’t violate section 411(d)(6) of the Code or section 204(g) of ERISA if the plan is amended on or before the last day of the first plan year beginning on or after January 1, 2006 and the plan is operated in the meantime as though the amendment were in effect during the period beginning on the date the amendment is effective.

What is the financial effect of this change? The Notice provides as follows:

. . . [W]here a plan’s interest rate is 5%, the applicable interest rate under § 417(e)(3) is 5.25%, and where the plan uses the applicable mortality table for determining actuarial equivalence, the effect of section 101(b)(4) of PFEA ’04 would be to require the conversion of a single-sum distribution paid during the plan year beginning in 2004 to an equivalent straight life annuity using 5.5 % rather than the applicable interest rate of 5.25% as under prior law. In such a case, to satisfy the limitations of section 415 of the Code, the maximum single-sum distribution for a participant who is age 65 in 2004 would be $1,866,645 calculated using 5.5% as required by section 101(b)(4) rather than $1,905,638 calculated using 5.25% as required under prior law.

The Treasury and IRS have issued new 403(b) proposed and temporary regulations as announced here in a press release. Proposed regulations are here and temporary regulations are here. According to the press release, the regulations “provide the first comprehensive guidance on section 403(b) arrangements in over 40 years” and provide guidance on statutory changes that occurred during the 40 years and answer issues that were not previously addressed in formal guidance. The proposed regulations will not go into effect until taxable years beginning after 2005.

(Better make your comments here as to any changes you would like to see. Who knows–an opportunity to comment on 403(b) rules might not come around for another 40 years 🙂

Don’t miss this important decision from the Seventh Circuit written by Circuit Judge Richard Posner which discusses “partial terminations” in the context of when participants must receive 100% vesting: “Matz, et al. v. Household International Tax Reduction Investment Plan.” (An interesting aspect of the case was the fact that the case was in its 9th year of litigation. Many employers automatically vest participants in such transactions in order to avoid the risk of protracted litigation over vesting.) The issue in the case as framed by Judge Posner was this:

The question is the correct approach to deciding whether an ERISA pension plan-in this case a defined-contribution plan in which the employer matched contributions that its employees made by means of payroll deductions to individual retirement accounts-has been partially terminated.

According to the opinion, “as a result of a series of reorganizations of subsidiaries of Household, a total of 2,396 of the 11,955 participants in Household’s plan ceased to be participants.” The issue was whether such reorganizations should result in the participants attaining 100% vesting in the plan. Here’s what Judge Posner had to say:

So where to draw the line? The IRS, which is not famous for encouraging tax windfalls, draws it at 20 percent. As we look back upon the course of this litigation, now in its ninth year and its third interlocutory appeal to this court, we find ourselves drawn back to the IRS’s position. Not because it is entitled to Chevron deference-we adhere to our holding that it is not-but because, having toyed with the alternatives, we think it is the best available and we respect the IRS’s experience in formulating tax rules.

The court provides a table of all of the cases and rulings on the issue of what constitutes a “partial termination” and makes the following statements about the results:

In 20 of the 21 cases and rulings, if 20 percent or more of the participants lose coverage, there is a finding of a partial termination, and if fewer than 20 percent do, a partial termination is not found. The exception is the Sea Ray case, where a 27.9 percent loss of coverage was held not to be a partial termination because the loss was the consequence purely of economic conditions; the employer was not motivated by any desire to obtain a tax benefit or reallocate pension benefits to favored participants in the pension plan.

In an effort to make the law as certain as possible without opening up gaping loopholes, we shall generalize from the cases and the rulings a rebuttable presumption that a 20 percent or greater reduction in plan participants is a partial termination and that a smaller reduction is not. How rebuttable? One can imagine cases in which a somewhat smaller reduction in the percentage of plan participants would be tax-driven and might on that account be thought a “partial” termination, and other cases, like Sea Ray, in which the reduction is perhaps not so far above 20 percent that further inquiry is inappropriate. We assume in other words that there is a band around 20 percent in which consideration of tax motives or consequences can be used to rebut the presumption created by that percentage. A generous band would run from 10 percent to 40 percent. Below 10 percent, the reduction in coverage should be conclusively presumed not to be a partial termination; above 40 percent, it should be conclusively presumed to be a partial termination.

The court then vacated and remanded the case, stating that a remand was necessary for the district court to consider additional “facts and circumstances.” The court noted that it had considered whether or not to “invite the IRS to submit an amicus curiae brief” advising the court of its “current view of the proper approach to determining partial termination” but “decided not to do so because of the great age of the case.” The court went on to emphasize that “should the IRS decide on its own to revisit the issue” the court “would give [the IRS’s] views significant weight” and “therefore the rule we have just formulated for deciding such cases as this should be considered tentative.”

Query: With Judge Posner being the likely author of the appeal in the IBM cash balance plan decision, can we glean anything from this Household opinion which could lead us to believe that Judge Posner might uphold the cash balance plan as being not violative of ERISA in the IBM appeal? (Read about the cash balance plan controversy here in an article from the Journal of Financial Planning as well as in previous posts here and here.) Statements in the opinion like–“[W]e respect the IRS’s experience in formulating tax rules,” the IRS’s views should be accorded “significant weight,” and the emphasis in the opinion on “mak[ing] the law as certain as possible,” coupled with the precedence of 3 out of 4 district court opinions upholding cash balance plans, might lead us to speculate that Judge Posner could provide a reversal.

Some related reading: “What Will Judge Posner Do Next? Balm or Bomb for Cash Balance Plans?” by Alvin D. Lurie (via Benefitslink.com). Lurie makes the following statement regarding Judge Posner and ERISA cases:

Judge Posner, who admits to enjoy(ing) ERISA cases which he finds frequently difficult and fascinating (see Posner, How I Approach the Decision of an ERISA Case, NYU Review of Employee Benefits and Executive Compensation 2002, ch. 14, hereafter “NYU”) waded into this unforgiving terrain with gusto and acumen. . . ”

Also, a personal glimpse of Judge Posner here.

Interesting article here: “Apology a tool to avoid malpractice suits: Doctors shown financial benefits.” Excerpt:

It is a lesson children learn even before their ABCs — say you are sorry when you hurt someone. But it is now being taught in the grown-up world of medicine as a surprisingly powerful way to soothe patients and head off malpractice lawsuits. . .

The hospitals in the University of Michigan Health System have been encouraging doctors since 2002 to apologize for mistakes. The system’s annual attorney fees have since dropped from $3 million to $1 million, and malpractice lawsuits and notices of intent to sue have fallen from 262 filed in 2001 to about 130 per year, said Rick Boothman, a former trial attorney who launched the practice there.

See also this previous post here from David Giacalone who discusses the relevance of the practice for lawyers.

Recently, I ran across the first law-related blog that I know of being written from my former home state of Oklahoma. The blog is named “Phosita” and focuses on intellectual property and patents. I really enjoyed this description of the law firm, Dunlap, Codding & Rogers, P.C., which writes and maintains the blog: “Our offices are located in Oklahoma City and Washington D.C. — one foot firmly in the IP capital of the world while the other foot is grounded in the values and culture of the American heartland.” Thanks to Douglas Sorocco for mentioning Benefitsblog here.

The IRS has announced that, in each issue of its quarterly “Retirement News for Employers,” there will be a column on a “common mistake that happens in retirement plans.” The IRS states that they will “describe the problem, how it happened, how to fix it, and how to lessen the probability of the problem happening again.” The first mistake that is being showcased in its Fall 2004 Issue is the problem of distribution to a participant of a benefit “in a form other than the required Qualified Joint and Survivor Annuity (e.g., a single lump sum) without securing proper consent from the spouse.” For those who might not be familiar with this issue, the article gives a good run-down of the J & S rules:

Many retirement plans are required to distribute benefits to participants in the form of a Qualified Joint and Survivor Annuity (QJSA). A QJSA is an annuity that provides a life annuity to the participant and a survivor annuity for the spouse’s life following the participant’s death. The survivor annuity must be no greater than 100% and no less than 50% of the annuity paid during the participant’s life. . .

If the QJSA rule applies to a participant, a QJSA is mandatory unless the participant elects a different form of payment available under the plan. An election by a married participant to take a different form of payment, even if it is only for a portion of the participant’s benefit, is not effective unless the participant’s spouse also consents to the election. If the lump sum value of the participant’s benefit is $5,000 or less, a lump sum can be paid instead of a QJSA without obtaining the participant’s election or the spouse’s consent.

The article goes on to note that the lack of spousal consent occurs many times because the sponsor’s human resources accounting system incorrectly classifies a participant as not married. However, the error can also occur when the employer doesn’t really know and understand the terms of the plan, or may have inadequate help in administering the plan. Either way, here is the “fix” for the error, as mentioned in the Newsletter and as also required under Revenue Procedure 2004-33 in Appendix A (via Benefitslink.com):

Normally, the correction method under VCP for a failure to obtain spousal consent requires the Plan Sponsor to notify the affected participant and spouse (to whom the participant was married at the time of the distribution) so that the spouse can provide spousal consent to the distribution actually made. If spousal consent to the prior distribution cannot be obtained because the spouse refuses to consent, does not respond to the notice or because the spouse cannot be located, the spouse is entitled to a benefit under the plan equal to the portion of the QJSA that would have been payable to the spouse upon the death of the participant had a qualified joint and survivor annuity been provided to the participant under the plan at his or her retirement. Such spousal benefit must be provided if a claim is made by the spouse.

This means that the fix for this type of error has two unpleasant consequences:

(1) Notifying participants that there has been a mistake, and that there needs to be spousal consent to the distribution; and

(2) Having to pay out some “double” benefits if the plan can’t obtain the spousal consent for some reason (failure to respond, marital difficulties, divorce, etc.). (Unfortunately, the fix might also appear to present some “gaming” opportunities for spouses who happen to understand the rules, i.e. if I don’t consent, I get a benefit? Hmm. . . )

All of this highlights the importance of performing ongoing plan compliance audits to ensure that the plan is being operated in accordance with its written terms, the Internal Revenue Code, and ERISA. Even inadvertent errors can be costly.

Interesting article about the fallout from the Aetna Health Inc. v. Davila case: “Lawsuits against health plans crumble in wake of Supreme Court ruling: Federal appeals courts in New York and Georgia have dismissed cases that they originally said could go forward.” Excerpt:

Two federal appeals courts recently reversed decisions that originally gave subscribers the right to go forward with such cases. The rulings both take into consideration the high court’s June decision that Texas patients could not proceed with their HMO lawsuits. . .

George Parker Young, the Texas attorney who represented the two patients in the case before the Supreme Court this summer, said lawyers have been discussing other claims that could be made against HMOs in state courts.

For example, one Supreme Court justice raised the question of suing under the idea of fiduciary duty.

“It’s going to be an interesting court fight,” Young said.

The IRS has issued proposed regulations pertaining to phased retirement. This is a long-awaited and long-overdue development in the benefits arena. While there will be much more on this later, here is what the IRS has to say in its regulations regarding why it has issued the regulations and its approach to clearing some of the legal hurdles to permit “phased retirement”:

As people are living longer, healthier lives, there is a greater risk that individuals may outlive their retirement savings. In addition, employers have expressed interest in encouraging older, more experienced workers to stay in the workforce. One approach that some employers have implemented is to offer employees the opportunity for “phased retirement’ . . .

The proposed regulations would amend Sec. 1.401(a)-1(b) and add Sec.1.401(a)-3 in order to permit a pro rata share of an employee’s accrued benefit to be paid under a bona fide phased retirement program. The pro rata share is based on the extent to which the employee has reduced hours under the program. Under this pro rata approach, an employee maintains a dual status (i.e., partially retired and partially in service) during the phased retirement period. This pro rata or dual status approach to phased retirement was one of the approaches recommended by commentators. While all approaches suggested by commentators were considered, the pro rata approach is the most consistent with the requirement that benefits be maintained primarily for retirement.

Previous post on the topic here–“Baby Boomers and the Need for Phased Retirement.”

An interesting point to note here is that the proposed regulations contain a link to this NPR broadcast–“Older Workers Turn to ‘Phased’ Retirement.“