Thursday, March 28, 2013

409A Bares Its Teeth ... And Bites

Anyone who reads this blog knows what I think of Code Section 409A. Like many other sections added to the Internal Revenue Code in a politically charged environment, it was an overreaction to a financial meltdown. This one was added to the American Jobs Creation Act of 2004 in response to Enron, WorldCom and other failures of that era.

The gist of the section makes sense. Essentially, Congress  (I hope I'm not attributing more logic to them than they deserve) wanted to ensure that participants in nonqualified deferred compensation plans (NQDC) couldn't get treatment preferable to that of the rank and file in qualified retirement plans. For example, there are generally restrictions on when an individual can receive on an unpenalized basis a distribution from a qualified plan. Section 409A seeks to ensure that the deal is no better in the NQDC world.

The tax penalties for failure to comply with 409A are severe. I've discussed them many times. Essentially, a failure is subject to 20% additional income tax (a marginal tax rate of 39.6% becomes 59.6% on that money) plus interest on underpaid taxes at the federal underpayment rate plus 1%. That's pretty severe.

Despite the IRS having announced that they had started an executive compensation audit program, more than a few companies have been cavalier in their efforts to comply with 409A.

They should perhaps reconsider.

I say this in response to a Federal Court ruling in Sutardja v US. Often, I provide my readers with a link to these cases so that they can experience all the excitement in reading the decision that I have, but this time I am refraining. There just wasn't enough excitement. However, here is a synopsis.

  • Dr. Sutardja is the CEO of Marvell Technology Group Limited
  • On 12/10/2003 (note that 409A became law in late 2004), the Board of Marvell approved a grant of not more than 2 million stock options to Dr. Sutardja. The closing stock price that day was $36.19.
  • On 12/16/2003, the Compensation Committee of the Board approved a grant of 1.5 million shares  to Dr. Sutardja at an exercise price of $36.50, the stock price on that day.
  • Said grant was ratified on 1/16/04 when the stock price was $43.64 (Alert: alarm bells go off ... discounted stock option alert).
  • In January 2006, Dr. Sutardja exercised some of his options. He paid an additional amount to make up for the perhaps incorrect grant price.
  • The IRS hit Dr. Sutardja and his wife with a tax bill for a 409A penalty for more than $5 million.
  • After the Court went through a whole lot of technical mumbo jumbo, it ruled in favor of the IRS.
So, what's the point?

Marvell could have handled this more cleanly. 409A wasn't a glimmer in anyone's eyes when they authorized or granted the options. While they didn't use an approved method, Dr. Sutardja and Marvell tried to use what they viewed as good faith to fix the issue. Dr. Sutardja and his wife lost.

The real point is that Congress intended that 409A be a revenue raiser for the United States. The IRS is trying to live up to that intent. Now, there are procedures in place to fix 409A problems. Most companies don't have the expertise to do that internally. Depending on the NQDC plan in question, review of the plan including its administration may appropriately be done by some combination of attorneys, tax experts, compensation experts and retirement plan experts. Often, it should include people from more than one of these categories. 

If you engage such people to conduct a review, one of three things can happen and two may be better than the alternative:
  • They will find no problems because there are no problems.
  • They will find problems and you can use approved correction procedures before the IRS finds the problems.
  • They will not find any problems, but the IRS will (this is the one bad one, but I think it's unlikely if your experts are really experts).
Consider conducting such a review.

Friday, March 22, 2013

SEAL Act Would Help DC Leakage Problems

In 2011, Senators Herb Kohl (D-WI) and Mike Enzi (R-WY) introduced their version of the SEAL Act. Now, two years later, Enzi and Bill Nelson (D-FL) have introduced a nearly identical bill, the Shrinking Emergency Account Losses Act (SEAL Act) into the Senate Health Education Labor and Pensions (HELP) Committee.

Essentially, the bill would accomplish two key purposes:

  • Participants who elect to take hardship withdrawals will not have their rights to defer to a 401(k) plan suspended.
  • Participants who terminate employment while having an outstanding loan balance in a qualified plan will have additional time to repay that loan before having a deemed distribution.
These are both positive steps that would help more participants to be prepared for retirement.

Philosophically, I have an issue with the first provision, however. A participant who has recently taken a hardship withdrawal has bigger issues than saving for retirement. Typically, that person would not be in a position to be taking money out of income for purposes other than keeping up currently.

The second provision makes sense. Currently, many administrative systems would not be equipped to handle such a provision, but certainly this could be fixed.

We'll see if the 2013 SEAL Act fares any better than its namesake did in the last Congress.

Monday, March 18, 2013

New Labor Secretary: Thomas Perez to be Nominated

President Obama has announced that his nomination for the Secretary of Labor replacing Hilda Solis will be Thomas Perez. Mr. Perez is a career government employee who has a history as a civil rights advocate and an advocate for the disabled.

In replacing Ms. Solis who has been hailed by no less than AFL-CIO President Richard Trumka as a wonderful friend to organized labor, Mr. Perez will have the opportunity to continue Ms. Solis's initiatives. Specifically with respect to employee benefit and compensation programs, my view on his most likely direction will be strong advocacy for blue collar workers, the unemployed and the disabled. This would mean that big business including those who work in benefits administration for big businesses might be on the lookout for:

  • Even more enhanced disclosures
  • Re-issuance of ERISA fiduciary regulations
  • Perhaps strengthened guidance under the Fair Labor Standards Act
Assuming he is confirmed (personally, I expect this nomination to fly through the Senate), we will see soon enough what Mr. Perez actually chooses to do.

The Missing Amendment From the Bill of Rights

Suppose the Bill of Rights (in the US Constitution) had contemplated far-reaching things such as benefits policy and tax policy. Just suppose. Now, I know this is far-fetched. Back in the 1780s, there was no income tax (that was a 20th century brainstorm in the US) and generally, people didn't live long enough or save enough to retire. Those who could afford not to work were often so wealthy that savings were not an issue.

Anyway, just suppose. Writing in the spirit and attempting the style of our founding fathers, could this additional amendment have read, "Congress shall make no law intertwining tax policy and benefits policy?"

What do you think? Those founding fathers were pretty wise. That little document that they crafted about 225 years ago has stood the test of time. It's been amended only 27 times thus far and 12 of those occurred in the first years after the Constitution was ratified.

In my opinion, had the founding fathers known the mess that Congress would create, they would have loved my amendment. Using tax policy as an excuse for nearly everything these days is not good governance. But, look at the Internal Revenue Code (I know, you don't want to). Aside from the taxes, virtually everything else in there is an incentive to change the behaviors of groups of individuals and or corporations. In a nutshell, whenever Congress finds something they would like for employers to provide to employees, they give them a tax deduction for it. If they think it's being done too much for executives, they cap it.

And, when they go through this song and dance, the esteemed members of Congress are consistent -- they are always sure to make their legislation as unintelligible as possible. If there are tax [policy] issues embedded in the legislation, they are careful to include a clause saying that the poor souls at the Treasury Department shall figure this stuff out and write regulations.

That's where it gets even worse. Only the Treasury Department appears to have the ability to take a one sentence law and write hundreds of pages to tell us what it means. (For full disclosure, I'm not sure that in many of these cases that if I were charged with regulating these laws that I could make the guidance any shorter.)

Perhaps we should go back to a world of competitive practices. If it is necessary to offer someone health care benefits, for example, in order to employ them, then companies will do so. If it's not, then they won't. If the costs are affordable to companies, they may offer them. If the costs are too high, they may not (see, for example, the retail and restaurant industries and their reaction to PPACA (ObamaCare)). Then, if the markets lose business, they may lower their costs so that companies might in turn reconsider their decisions to not offer benefits.

What is it that they say these days? Just sayin'?

Today, the largest tax expenditure (think tax deductions) for the federal government is the cost of employee benefits. In fact, if you add the deductions for employer-provided health care benefits to the cost of employer-provided retirement benefits, the expenditure for the deduction of mortgage interest looks like a needle in a haystack.

Just think if we hadn't backed ourselves into this corner.

Just sayin'

Friday, March 15, 2013

Tax Reform on the Horizon

The Washington Post reported yesterday that Congress has begun meetings on Tax Reform. And, for the grammarians who are reading this, I capitalized tax reform for emphasis, not because we have anything formal yet.

Could we have tax reform? And, if we do, what might it do to the world of benefits and compensation?

Let's focus on my first question first. Could we have tax reform? Of course we could. The better question is will we? I think it is as likely as not. Although some measures say that it has picked up, the economy, in the opinion of your humble (well, I try to be humble most of the time) correspondent, it is still abysmal. Republicans in Congress want to balance the budget, but without raising tax rates. Democrats in Congress and the White House generally want to get the budget closer to being balanced, but would like to do it without cutting back social programs which would require more revenue. More revenue comes from three places:

  • Growing the tax base (the two parties do not agree on how to do this)
  • Raising tax rates (Republicans say this will not raise revenue and will filibuster such a bill in the Senate and vote it down in the House)
  • Decreasing tax expenditures (regular people refer to this as closing loopholes and cutting back on deductions)
The third one seems to be the way to go. I head similar sentiments way back at the beginning of 1985. And, guess what, that was the first year of a President's second term. He was a President who inherited a terrible economy. And, before the mid-term elections, we had the Tax Reform Act of 1986. What did it do, generally? It decreased marginal tax rates, cut the number of marginal rates from a lot (I don't recall how many) to two and eliminated a tremendous number of deductions.


In fact, suppose we look at the first half of the last few two-term President's second terms (I am going to count Nixon as two-term since he was elected a second time).
  • Nixon -- ERISA was passed and signed into law shortly before the mid-term election of his second term (actually Ford was President by then and if you don't know why, then either you are very young or have been living under a rock).
  • Reagan -- In the first two years of his second term, we got COBRA as well as TRA86, and a plethora of smaller bills. TRA86 as I noted above was signed into law shortly before the mid-term elections.
  • Clinton -- This is the apparent anomaly and perhaps we should note that he is a Democrat who was working with a Republican-controlled Congress. We got some smaller bills, but nothing of the magnitude of TRA86 or ERISA. But, even in what was then a booming economy, the first half of Clinton's second term brought us the Taxpayer Relief Act, the Balanced Budget Act, and the ever-memorable Child Support Performance and Incentive Act.
  • Bush (43) -- Nearly halfway through his second term, we were greeted with the landmark Pension Protection Act of 2006, shortly before Congress recessed to campaign for the mid-term elections.
Do you detect a pattern here? I know that my readers are very observant, so as they say in the math textbooks, the observation of the pattern is left to the reader.

It could happen. And, if it does, what can I tell you about what it will look like?
  • It will be thick. Major legislation that has come out of the Obama White House has been fairly universally thick. Consider that both PPACA and Dodd-Frank weighed in in exess of four full reams of paper apiece. Should we truly get a comprehensive tax reform bill (perhaps it would be called the Comprehensive Reform And Policy ACT ... if you can't work that out, go back to the beginning), I would take the over if five full reams were the betting threshold.
  • It will focus on what the media will call loopholes. This is one thing that the two parties can agree on is that there are too many loopholes in the current Internal Revenue Code. It will attempt to simplify, but once it goes to a Conference Committee and each member appeases his or her favorite special interest, simplicity is not going to happen.
When you hear about loopholes in the media, they tend to focus on two things: deductions for corporations that allow what we know to be highly profitable ones to pay no federal income taxes; and deductions for very high earners that are just not available to the rest of us.  Bearing those two things in mind, consider these potential changes:
  • Reduction in corporate tax deductions for employer-provided health benefits either by simply limiting the deduction, disallowing the deduction for a far tighter definition of discriminatory plans, or not allowing a deduction with respect to all but preventive health benefits for highly compensated employees. This would be somewhat analogous to the limits that were placed on long-term disability benefits about 25 years ago.
  • Reductions in the pay cap and 415 limits (maximum benefits and contributions limits) for qualified retirement plans. Additionally, we could see a reduction in the 402(g) limit, the annual limit on elective deferrals to a 401(k) plan.
  • A tighter definition of what constitutes a nondiscriminatory retirement plan thereby reducing the level of deductions attributable to highly compensated employees.
  • A reduction in the compensation threshold under Code Section 162(m). This would be a significant appeasement to the major labor unions.
  • Tying deductions for executive compensation to the Dodd-Frank Say-on-Pay votes. I went out on a limb on this one, but voting for this would not cost any elected official many votes.
So, that's what I see the style of such a bill to be. Even at Congress's worst, though, that would only fill up 100-200 pages. They would still need almost five reams more for me to be on the winning side of the over-under bet. What's your opinion? If you have one, and I know you do, please comment, be it here, on Twitter, on LinkedIn, or on Facebook. Or, if you don't want to go public, send me an e-mail.

Tuesday, March 5, 2013

DOL Provides Guidance on TDFs

In February 2013, the Department of Labor (DOL) issued a paper entitled “Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries.” Clearly, this is a signal from DOL that this is an issue for plan sponsors and their plan committees to watch. But, there are other fiduciaries as well and some have a vested interest in a plan sponsor’s choice of target date funds (TDFs). In this article, we’ll examine the DOL paper and some of its implications, but first we provide some background for those who don’t live in this world on a daily basis.

In 1993, Barclay’s Global Investors introduced the first TDF. While there had been some dabbling in risk-based funds, this was the initial plunge into developing a fund targeted at an individual’s intended retirement date. The evolution of TDFs moved along fairly slowly for the next ten years or so, but in 2006, Congress passed and President Bush signed into law the Pension Protection Act (PPA) starting a veritable explosion in TDF usage in 401(k) and other defined contribution (DC) plans.

The impetus was a provision in PPA establishing the qualified default investment alternative (QDIA), the investment that a plan sponsor uses as a default for moneys in participants’ accounts not otherwise designated for investment. The law and its guidance established that QDIAs should be one of these:
  •  A fund that takes the participant’s age or retirement date into account
  •   An investment service (managed account) that takes the participant’s age or retirement date into account
  • A balanced fund
  • A money market fund, but this can only be used for the first 120 days

According to the 2012 Janus/Plan Sponsor survey, approximately 75% of all defined contribution plans have chosen target date funds as their QDIAs.

Today, there exist a wealth of TDFs of many shapes and sizes. Virtually all of them have in their name a year (multiple of five) that is intended to represent a participant’s expected retirement age. Often, that is where the similarities end. There are “to” funds and “through” funds so named because they are either intended to take a participant to retirement (the participant is expected to take a distribution when he or she retires) or through retirement (the participant is expected to keep his or her money in the plan and draw it down gradually through retirement). There are proprietary funds (those which are essentially a fund of funds run by the asset management institution that manages the TDF) and there are open-architecture (often custom) TDFs composed of those funds that the asset manager thinks are most appropriate for the fund regardless of the manager of the constituent funds. There are TDFs that are composed largely of actively managed funds (these usually have higher underlying expenses) and TDFs that are composed primarily of passively managed funds (usually having lower underlying expenses).

The DOL paper suggests factors that a plan sponsor should consider in its fiduciary decision to choose a family of target date funds, often as the QDIA. Specifically, the paper points out investment strategies, glide paths (this is the move from a more aggressive equity-heavy strategy far from retirement to a more conservative strategy closer to retirement), and investment-related fees.

Plan sponsors should consider this DOL guidance carefully. While there is nothing in the paper that suggests that a plan sponsor must follow the DOL’s suggested steps, one would certainly think that plan sponsors that do so may relatively well shield themselves from costly losses in litigation. No strategy is foolproof, but if I were on a jury or if I were a judge and I heard that a plan sponsor did exactly what the Department of Labor suggested, such evidence would often compel me.

The paper spells out these eight steps:
  • ·         Establish a process to compare and select TDFs
  • ·         Establish a process for periodic review
  • ·         Understand the fund’s investments and how they will change over time
  • ·         Review the fund’s fees and investment expenses
  • ·         Ask about the availability and appropriateness of non-proprietary TDFs
  • ·         Communicate with your employees
  • ·         Use all available sources of information in evaluating and selecting your TDFs
  • ·         Document the process

I am going to add two more items to this list. First, a number of defined contribution recordkeepers are affiliated with or owned by asset management firms. Some of them will only take on a new client if their own proprietary TDFs are used as the plan’s QDIA. It may be acceptable to begin by using these proprietary TDFs as the plan’s QDIA, but when you use recordkeepers of this sort, you will certainly have a contract for services for several years. The contract will offer you financial disincentives to change TDFs to those provided by another vendor. It aligns well with the DOL’s advice to not engage in such a contract. Doing so could put you in a poorly-performing family of funds that you cannot switch out of without incurring significant fees (usually passed on to the participants) or in a very expensive family of funds that are subsidizing hidden fees or both.

Second, the DOL’s final piece of advice (of the eight) is to document the process. Documentation of processes is an excellent idea. It’s especially an excellent idea if you follow your own processes. However, a number of companies (see for example, Tussey v ABB) have lost or settled litigation when they did not follow their own documented processes. Not having a documented process is bad, but documenting what you should and will be doing and then doing something else is probably much worse.

Several points that the DOL makes are particularly noteworthy. Consider, for example, a proprietary family of TDFs composed of high-expense actively-managed proprietary funds. While not all TDFs are set up this way, the following is a possible scenario:
  • ·         Family of TDFs is composed of high-expense, actively-managed proprietary funds
  • ·         The TDFs come with an underlying investment expense
  • ·         Each of the underlying funds in the TDF provide a return net of expenses

In this case, the TDF is essentially double-charging the plan participants. Each of the underlying funds has a significant investment expense and, at the same time, the overall fund comes with an additional investment expense. The DOL paper points out how an account balance of $25,000 compounded at 7% per year for 35 years will accumulate to approximately 40% more than the same account balance compounded for 35 years at 6% per year. Put into more practical terms, for a younger employee, the 40% implicit cost of much higher investment fees may be insurmountable.

Finally, the paper points out the importance of defined benefit (DB) plans in selection of TDFs. While it is true that far fewer employees are covered by DB plans than were 25 years ago, a significant number still are. While the paper doesn’t use these words, it makes clear that plan sponsors that also provide broad-based DB plans might consider those defined benefit amounts as a fixed income investment for participants. In such cases, using a more aggressive TDF is likely appropriate.

The DOL paper is not formal guidance. It’s not part of a regulation on fiduciaries. Following the DOL’s advice in this case is not, per se, required. But, a word to the wise: other such pieces of informal guidance have been considered safe harbors by courts. Plan sponsors and their consultants might wish to consider this publication that way as well.