Friday, April 19, 2013

Where Bad Law Comes From -- Anatomy of a Bad Proposal

I'm not sure who writes the Administration's budget proposals. I know who is responsible, but the question is who actually writes them.

I ask because of the revenue-raising proposal to limit tax-favored retirement savings. What has been reported is that tax-favored savings will be limited to $3 million. That's a pretty good amount of money. But, the rumor that is circulating among some people in the know is a bit different.

Here is what it seems to be. For an individual, you take all of their tax-favored savings. That would appear to include Roth 401(k) as well as traditional and Roth IRAs, SIMPLE accounts, Keoghs, qualified defined contribution and qualified defined benefits. Then, you express them all as an annuity as Social Security Normal Retirement Age and the sum cannot exceed the 415(b) limit (currently $205,000 per year).

Do I think that is a bad concept? Well, in theory, limiting what people can save for retirement on a tax-favored basis is already done. The old 415(e) combined limit used to do something like this. But, that was from a single employer.

Suppose we start out simply. Adam (I picked Adam because it starts with an A) has only worked for one employer. He is about to reach his Social Security Normal Retirement Age (SSNRA) and he has the following:

  • An accrued benefit in his DB plan of $100,000 per year
  • A 401(k) account balance of $1,000,000
  • An IRA with an account balance of $1,250,000
Whose responsibility is it to calculate the total limit? Is Adam required to tell his employer about his IRA? How are the conversions done? In this simple situation, it's not easy.

Beth, on the other hand, has jumped around from employer to employer. She is 45 years old and has accrued benefits in two DB plans, account balances in three 401(k) plans and an ESOP. She also has an IRA. One of her DB plans gives her an automatic cost of living adjustment (COLA). Who has to administer this? How? Who is responsible for telling whom what? Suppose Beth works two jobs that both provide benefits and she exceeds the limit, which one gets cut back.

Wouldn't you just love to be the people at Treasury and IRS who have to figure out how to regulate this?

The proposal may not be bad in theory, but as I understand the way it is being proposed, it is a disaster.

Stay tuned ...

Friday, April 12, 2013

New Pay Limit for Covered Health Insurance Providers and Maybe a Way Around It

Perhaps you like the Patient Protection and Affordable Care Act (PPACA, ACA, or ObamaCare). Perhaps you don't. You are entitled to your opinion. I think we can all agree that it has its good provisions and it has those that perhaps could have been better thought through. One that falls into the latter category is the [relatively] new Code Section 162(m)(6) dealing with the limit on compensation for Covered Health Insurance Providers (I'll refer to them as CHIPs because it's much easier for me to type). In a nutshell, the section and its new proposed regulations limit the deduction for compensation that can be taken by a CHIP to $500,000 annually with respect to any person.

If you want to read the regulation like I did, you can find it here. If you want a good technical overview with the requisite cynicism, I direct you to Mike Melbinger's blog.

If you would like a solution, read on.

In a nutshell, you are a CHIP if 2% of the gross revenues received by your controlled group are from health insurance premiums. Yes, that means that if you happen to be part of a controlled group that contains a health insurer, you are likely a CHIP. Congratulations!

Most of Code Section 162(m) deals with deduction of compensation (as a reasonable business expense). The parts that limit it generally limit it to $1 million, except for CHIPs. And, for CHIPs, and only for CHIPs, the determination of whether an individual's compensation exceeds $500,000 includes deferred compensation earned, nonqualified plan benefits earned, equity compensation awarded, and severance benefits paid. The calculation is not easy, but this post is not about that. If you'd like to know more about the calculation, contact me and I'll be happy to charm you with its details.

I said I have a solution, and for many companies, I think I do. What was left out? Did you notice that qualified plan contributions and accruals were left out? And, for qualified plans, we have an objective set of nondiscrimination rules.

The solution involves a technique often referred to as a QSERP. What this technique does is to take nonqualified deferred compensation amounts and moves them from a nonqualified plan to a qualified plan. In this case, it has lots of advantages:

  • Frequently immediate tax deductibility
  • Tax-favored buildup
  • More security
  • Pooling with significant other obligations in a large trust
Most often, QSERPs are utilized in a defined benefit context. But, realizing that many companies no longer have defined benefit plans providing for current accruals, QSERPs can be utilized in a defined contribution context as well. 

Again, the explanation is long and has been covered elsewhere, so I'm not going to bore my readers here, but if you'd like a detailed explanation, contact me directly.

I know the cynics among you will say that this deduction limitation is the right thing to do. For you, I will say that you should have asked Congress to craft the law in a way that doesn't leave creative minds the opportunity to find loopholes.

If you're reading this today (it's a Friday) or even if you're not, have a great weekend whenever that may come for you.

Wednesday, April 3, 2013

Does 401(k) Auto-Enrollment Work?

It was hailed as one of the great ideas to come from the Pension Protection Act of 2006 (PPA). Auto-enrollment, technically known as an Automatic Contribution Arrangement (ACA), was supposed to be a revolutionary change to 401(k) plans that would allow participants in this generally non-defined benefit world to someday retire comfortably.

The IRS submitted a Compliance Questionnaire to 1200 401(k) plans that had filed Form 5500. If you are interested, you can read their report for yourself. To me, one of their key findings was around plans that use ACAs. Of participants eligible for ACAs, here is the actual data:

  • 43% defer at the default rate
  • 29% elect a rate higher than the default rate
  • 7% elect a rate lower than the default rate
  • 21% opt out of participation entirely
In my experience, the most common auto-enrollment rate is 3% of pay. If that is truly representative of US companies at large, then 71% of participants are deferring 3% of their annual compensation or less. 

That's not good. Even for participants who defer for quite a long time, annual deferrals of 3% of pay, even with employer matching contributions added to them will not get anyone to a comfortable retirement.

One of the types of ACAs available to plan sponsors is a qualified automatic contribution arrangement (QACA). QACAs generally provide for auto-escalation in default deferrals. Oversimplifying somewhat, a QACA must have a default deferral percentage of at least 6% of pay in the third year following the initial period and cannot increase to a rate above 10% of pay. QACAs are exempt from ADP and ACP testing.

Participants in QACAs who do not opt out of the defaults will often have enough savings to retire comfortably. That's the good news. The other side of the coin is that IRS data shows that only about 5% of all 401(k) plans have ACAs and of those, fewer than 1/4 are QACAs. That means that roughly 1% of all 401(k) plans are QACAs. Many of the rest will have very few participants who will have prepared themselves through saving with sufficient money to retire.

That's not good. 401(k) auto-enrollment is not working as it should.