IRS Withdraws Troubling Provision of Proposed Nondiscrimination Regulations

Yesterday, the IRS released Announcement 2016-16 withdrawing parts of the nondiscrimination regulations it proposed at the end of January. Those proposed regulations had troubled many in the defined benefit industry since their proposal for a number of reasons (more below). From the standpoint of the IRS, the troubling part of the proposal addressed some serious abuses by practitioners and the sponsors they consult to. From the standpoint of practitioners, the proposed regulations took an objective test that has been around for quite a while and essentially changed the rules of the game.

I'm going to have to get a little bit technical here before I bring you back to reality. What the proposed regulations would have done was to make retirement plans with multiple formulas show that each formula applied to reasonable business classifications of employees or to pass a more difficult test.

Under regulations that were finalized in 1993 and then amended for cross-tested plans in the late 90s, a rate group in the testing population must have a coverage ratio at least equal to either

• 70% if the plan uses the Ratio Percentage Test to pass minimum coverage tests or
• The midpoint of the safe harbor and unsafe harbor (the midpoint is typically in the 25% to 40% range, but is determined through a somewhat convoluted formula) if the plan uses the Average Benefit Test to satisfy minimum coverage

It is far easier for a rate group to satisfy a lower minimum coverage ratio than a higher one. And, many plans had been designed around satisfying the lower threshold. While the preamble to the proposed regulation said that it was targeting QSERPs, practitioners found that they also were potentially problematic for many plans of small businesses and plans of professional service firms. 

Why would this be troubling? Certainly, among larger corporations, the prevalence of ongoing defined benefit plans has dropped precipitously, but many small businesses and professional service firms have adopted new defined benefit plans (DB) over the last 15 years or so and many of these plans would have found it more difficult or perhaps impossible to pass these proposed rules.

This doesn't mean that DB plans of this sort are out of the woods yet, so to speak. Clearly, the current Treasury Department views that plans of this sort may be abusive in their application of the nondiscrimination regulations, so we could see another effort from the IRS to make the regulations a bit less QSERP-friendly. 

In the meantime, there are some great DB designs that exist for companies that wish to provide meaningful retirement benefits to their rank and file employees. You can learn more about them here.

DOL Suggests Rules on Lifetime Income Illustrations

Earlier this week, the Employee Benefit Security Administration (EBSA) of the Department of Labor (DOL) released three items related lifetime income illustrations for benefit statements for defined contribution plan participants. I know, that's a mouthful. Here's what we got from them:

• An advance notice of proposed rulemaking (ANPR) under Section 105 of ERISA that gives us an idea of what future regulations might look like and to seek comments
• A "fact sheet" discussing briefly what they have done
• A lifetime income calculator using the methodology expressed as a safe harbor in the notice

For background, the Pension Protection Act of 2006 (PPA) established a requirement for annual benefit statements from qualified retirement plans. All these years later, we don't know how to do the required lifetime income illustrations.

The ANPR tells us that any set up of assumptions that we use that employ generally accepted investment theory will probably be considered reasonable. EBSA also gave us safe harbor assumptions. When push comes to shove, we expect that most sponsors (or their vendors), once the regulations become effective, will opt for simplicity and use the DOL's safe harbor assumptions.

What are they, you ask?

• Contributions continue to normal retirement age at the current (dollar amount), increased by 3% per year
• Investments return 7% per year
• Discount rate of 3%
• To convert account balances to annuities, use the interest rate on Constant Maturity 10-year T-bills
• Use a 417(e)(3) mortality assumption (for those who don't keep their noses mired in the Internal Revenue Code, this means that the mortality assumption is to be the one currently used for most pension purposes under the law)
• If you're married, you and your spouse were born on the same day ... even if you weren't
• For purposes of converting the current account balance to a lifetime income stream, payments begin immediately and you are assumed to be your current age or normal retirement age, whichever is older

To me, some of these assumptions are not bad and some are ... well, they're not not bad. Let's start at the top. For people who stay in the workforce continuously until retirement, the 3% annual increase in contributions is probably as reasonable as anything else. But, very few people stay in the workforce continuously anymore. There are all of maternity leave, paternity leave, layoffs, reductions-in-force, and then there are the companies that freeze pay or cut benefits making the 3% annual increase assumption a bit lofty.

How about investment returns of 7% per year combined with a 3% discount rate? That's a 4% real rate of return, net of expenses. Did anyone watch the Frontline special on PBS telling you how your account balances are eroded by expenses? If you did, I bet you don't think a 4% real rate of return is reasonable.

What a participant is to receive in his or her statement are four numbers:

• Current account balance on the effective date of the statement
• Projected account balance on the later of the effective date of the statement or normal retirement date
• The amount of lifetime income that could be received on the current account balance over the lifetime of the participant or joint lifetime of the participant and spouse if married
• The amount of lifetime income that could be received on the projected account balance over the lifetime of the participant or joint lifetime of the participant and spouse if married

I see several outcomes from this exercise.

• Participants will have an overly rosy view of their defined contribution plans
• Despite that, they will suddenly think that their 401(k)-only retirement program isn't very good
• Most participants will not achieve the lifetime income projections that the illustrations suggest

So, what happens?

• Just as they do with Summary Annual Reports, participants find the nearest trash can or recycling bin and insert these statements, or
• Participants read the statements and ask their generally unknowledgeable friends what they mean
• Participants go to HR and ask HR what it means
• When participants start to understand, they learn that a 401(k)-only retirement program is generally not very lucrative unless they defer far more than they are currently which they probably don't they can afford

Some will complain. Some will jump ship.

What can an employer do? An employer can say that this result is fine and move on as if nothing happened. Or, an employer can decide paternalistically that it has some responsibility here and revisit retirement design. Perhaps the answer is that old dinosaur, defined benefit. Perhaps the answer is another old dinosaur, profit sharing. Either way, both have far more flexibility in design than do 401(k) plans.

The DOL needs intelligent comments on this one. I hope it gets them.

The Election Happened, Now What?

As the politicians like to say, the people have spoken. Now what?

There are lots of things I could say here about the policies of either side and what I think is right, wrong, or beyond comprehension, but that would be as worthless as much of the blather that occurs inside the Beltway.

What we have now is the same President that we have had for the past four years, roughly the same makeup of the Senate, albeit very slightly more left-leaning it appears and the same House of Representatives although perhaps slightly more right-leaning in its ideology. What we also have is an Administration which no longer needs to be in campaign mode. This means that policies and regulatory agendas which perhaps were on hold for political or non-political reasons may move forward.

Before moving forward, I caution you that what I am about to write is nobody's opinion but my own and that it is only my opinion on the morning of November 7, 2012. It may be different this afternoon, tomorrow, or some other day, but I hope that it doesn't change too much.

PPACA (health care reform or ObamaCare if you prefer) remains the law and it will remain. Whether they like the law or not, companies must prepare for 2014 when many of the key provisions of the law will take full effect. As an American, I hope that most employers do not make the decision to convert many employees from full-time to less than 30 hours for the sole purpose of excluding those employees from semi-mandatory coverage, but that is a decision that some will make.

The President is a strong believer in nationalized benefits programs (see, for example, ObamaCare). Look for his Administration to put forth a proposal for mandatory employer-provided retirement coverage with the option being contributing to a national retirement exchange. Retirement plans will look much more portable in this proposal. And, more coverage means more tax expenditures which must be paid for. Look for them to be paid for with tax savings generated from reductions in 415 limits and 402(g) limits. In other words, the highest earners will not be able to save as large a percentage of their incomes for retirement.

Historically, the Democrat Party has favored defined benefit (DB) plans more than the Republican Party. Republicans as a group have viewed that such plans are not representative of individuals taking responsibility for themselves. However, unless Congress really seeks the assistance of outside experts, do not look for any sort of resurgence in the DB world. Every effort from Washington to promote DB plans has been fraught with agency intrusion that moves employers away from DB.

At the same time, look for the President to leave Ben Bernanke in charge of the Federal Reserve and Tim Geithner in charge of Treasury. This will likely mean continuing low interest rates in an effort to spur the economy. The pension funding stabilization provisions of MAP-21 have, in the short run, allowed companies to not have exorbitant expenditures to fund their DB liabilities, but accounting disclosure often attached to loan covenants and credit-worthiness of companies that sponsor the plans will be unaffected by funding rules. In fact, companies that choose to make the MAP-21 minimum required contributions will have their accounting disclosures look worse.

President Obama has made it clear that he plans to raise taxes on high earners. We've previously written here about the FICA tax increases under ObamaCare as well as the 2013 combination of tax increases sometimes referred to as Taxmageddon. When marginal tax rates increase, deferred compensation becomes more valuable. Look for more companies to focus on nonqualified deferred compensation plans for their executives.

Similarly, the estate tax, or death tax, if you prefer, is due to return with a 55% top rate. Individuals who have accumulated significant wealth will be looking for ways to transfer that wealth to their heirs. Privately-owned companies will frequently look to ESOPs perhaps through so-called 1042 exchanges to plan for wealth succession.

Executive compensation is going to be a huge issue. As tax rates increase and the limitations in qualified plans likely decrease, deferred compensation will be become a bigger issue. With increases in deferred compensation come larger risks both for the executive and the employer. Funding such plans has become increasingly difficult while failure to fund them leaves unmitigated risk for both parties.

Dodd-Frank was one of the hallmark laws of the first Obama Administration. Seven key executive compensation provisions remain unregulated, but look for all of them to be regulated soon. Particularly critical among them are:

• Policy on erroneously awarded compensation
• Disclosure of pay versus performance
• Pay ratio disclosure

Look for the Administration to consider policies that would cut the million dollar pay limit under Code Section 162(m). While the original 162(m) codification probably backfired, most Americans would not consider it particularly controversial to limit the amount of compensation that is not performance-based that top executives receive.

Finally, in all areas, look for increases in required disclosures. Thus far, regulatory guidance in this arena has gone to levels under the Obama Administration not seen before. For employers, this means additional administrative burden. For employees, unless disclosures can be more useful, this will mean more stacks of paper for the trash bin.

And, look for gridlock once again as each side blames the other. Who will blink first? I'll report on the first blinkage here.