Pozek On Pension

Donald Trump, Elves and 401(k) Plans – Part 2

In Part 1 of this post, I discussed some of the DOL rules that can make real estate not all it’s cracked up to be as a 401(k) investment.  Here in Part 2, we will take look at some IRS wrenches that get thrown into the works.

Nondiscrimination

More often than not, real estate holdings in a qualified plan are limited to one or several of the highly compensated employees.  There might be any number of seemingly valid reasons for this limitation. Nonetheless, the option to invest in a particular type of asset is generally considered to be a benefit, right or feature subject to nondiscrimination testing.  That means if HCEs invest in real estate, the plan must offer the opportunity to a sufficient percentage of NHCEs.  It is not enough to simply say, "Well, I would have let them if they expressed an interest."  Offering the opportunity means communicating it to them.

Unrelated Business Taxable Income

A qualified plan is normally exempt from income tax.  However, if a plan derives income from carrying on a trade or business, that income is unrelated to the primary purpose of the plan.  So-called Unrelated Business Taxable Income or UBTI may be subject to tax even though the plan is otherwise tax-exempt.  Certain forms of income, e.g. rental income, are generally exempt from the UBTI rules, but other forms are not.  If the plan is in the business of buying and selling real estate, the proceeds of the sales may trigger taxation.  If a limited partnership is involved, the plan may be required to look through to the activities of that partnership to determine the applicability of UBTI.  These rules can become extremely complex, so it is often necessary to seek the advice of an accountant or tax attorney specializing in this area.

Distributions on Plan Termination

This really crosses both agencies in that it raises qualification and fiduciary issues.  While maybe not as big of a problem in fully participant-directed plans, real estate in a plan with pooled accounts can create significant challenges in a plan termination.  Basically, the property must be liquidated to cash so that distributions can be paid; however, it is not always possible to find a buyer.

One solution that is frequently proposed is to liquidate all other assets to cover distributions to employees, leaving the owner(s) with the real estate.  Although that may sound plausible, the problem is that every participant in the pooled account “owns” a piece of each investment.  That means that no participant, including the owner, can claim the real estate as belonging only to him or herself no matter how noble their intentions may be.

Another option that is sometimes suggested is for the owner to use outside assets to purchase the real estate from the plan.  Since transactions between the plan and an interested party are generally prohibited, this solution might not work either.  In limited circumstances, plan fiduciaries can use the DOL’s Voluntary Fiduciary Correction Program to request permission for the owner to purchase illiquid real estate, but the fees associated with going through this process can easily reach five figures.

One of the only remaining options is to have the plan distribute the real estate to a liquidating trust, established so that the plan termination process can be completed.  Each participant receives a proportionate share of the trust.  Of course, someone must recordkeep the trust accounts until such time as the real estate can ultimately be liquidated and the cash proceeds paid.

The esteemed Mr. Trump may be wise to love real estate, and it may be an extremely profitable investment...outside of a qualified plan.  However, when a plan is doing the investing, the cost of complying (and probably correcting) the issues raised by both DOL and IRS may make any excess investment returns as elusive as Mr. Vonnegut’s elves and pixies.

 

Donald Trump, Elves and 401(k) Plans – Part 1

“Real estate doesn't interest me. It's no doubt a great flaw in my personality, but I can't think in terms of boundaries. Those imaginary lines are as unreal to me as elves and pixies.”  -- Kurt Vonnegut, Jr.

When it comes to real estate in 401(k) plans, unfortunately, not everyone shares Mr. Vonnegut’s disinterest.  Rather, some subscribe to the Donald’s statement, “It’s tangible; it’s solid; it’s beautiful.  It’s artistic, from my standpoint, and I just love real estate.”

Regardless of one’s beliefs about the prudence of real estate investment, when the location, location, location is inside a qualified plan, life gets very complicated very quickly.  ERISA’s fiduciary rules and the requirements that plan assets be presented at fair market value do not always play well with real estate.  The IRS also has a few rules that create unintended consequences as well.  My experience has been that those who advocate using plan assets to purchase real estate are very much unaware of these complications.

We’ll take a look at some of DOL’s concerns in this post and then address some IRS issues in Part 2.

Appraisal

The financial schedules to the Form 5500 require assets to be reflected at fair market value as of the reporting date.  For publicly traded instruments such as mutual funds, this is no big deal.  Not so much with real estate.  The plan must engage an independent appraiser to establish the fair market value, and the DOL is serious when it comes to the qualification and independence of the appraiser.  That means a letter from the trustee’s real estate buddy won’t cut it.  The reason might best be explained by a quote from Will Rogers, “In a real estate man's eye, the most expensive part of the city is where he has a house to sell.”  According to this letter from the DOL, failure to properly obtain and report fair market value of plan-held real estate constitutes a fiduciary breach.

Real estate held through limited partnerships doesn’t make things any easier.  As explained in another DOL letter (see bottom of page 3), “A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”

Annual Audit

Plans with more than 100 participants on the first day of a plan year are required to be audited by an independent CPA.  Smaller plans are exempt from the audit requirement unless more than 5% of total assets are so-called non-qualifying assets.  You guessed it…real estate (including LPs) is a non-qualifying asset.  The fact that it’s held in someone’s individually directed account doesn’t change things.  A plan can avoid the audit by securing an increased fidelity bond covering 100% of the value of the non-qualifying assets and by providing additional disclosure in the Summary Annual Report for the year.  However, in many cases, the real estate holdings are not “discovered” by someone who understands these requirements until it’s too late.  I have been involved in examinations in which the DOL has required the employer to obtain CPA audits for historical years, so this is not one of those “no harm, no foul” issues.  With audits easily running into five figures per year for a qualified CPA, the cost can be significant.

Prohibited Transactions

Real estate is not always the most liquid of assets, and there can challenges in acquiring and disposing of it.  Sometimes, it seems to make sense for a participant to use his or her plan account to purchase property s/he owns outside the plan.  The problem is that it lands in prohibited transaction territory.  Generally speaking, transactions between the plan and parties related to the plan, including participants, are not permitted.  This can be particularly problematic if, upon realization of the audit requirement, a sponsor wants to get the real estate out of the plan but doesn't want to sell it to an unrelated third party.  In limited circumstances the DOL’s Voluntary Fiduciary Correction Program does permit a plan to sell the real estate to a related party but only if the proposed transaction if submitted to DOL for review and approval.

In the next installment, we will take a look some IRS requirements that might make Mr. Vonnegut's personality look less flawed.

Your Tax-Exempt Status Has Just Been Revoked!

It’s funny how the human brain (or maybe it’s just my brain) forms associations with words or phrases.  Whenever I hear the word “revoked,” I immediately think of a scene from one of the Lethal Weapon movies.  The bad guy had been using his diplomatic immunity to get away with all sorts of nefarious deeds.  At the end of the movie as he lay clinging to life after being on the wrong end of a shoot-out, Danny Glover’s character says rather pithily, “Your diplomatic immunity has just been REVOKED.”

The Pension Protection Act of 2006 created a new filing requirement for small not-for-profit organizations (“NFPs”).  The IRS is required by statute to revoke the tax-exempt status of any NFPs that fail to satisfy the new filing requirement for three consecutive years.  A Guidestar whitepaper on the subject is available here (free registration required), and the IRS has an FAQ on its site.

When I first heard the time had come and the first round of revocations are imminent, I had visions of Danny Glover and Mel Gibson kicking down doors of local NFPs and shouting, “Your tax-exempt status has just been REVOKED.”

What does all of this have to do with retirement plans?  If you are or work with an NFP that maintains a 403(b) plan and is the unfortunate recipient of one of these revocation letters, quite a bit.

Only 501(c)(3) NFPs and certain educational institutions can sponsor 403(b) plans.  That means a 501(c)(3) with a 403(b) that has its tax-exempt status pulled is no longer eligible to make contributions to the plan, nor can any of the participants.  This is referred to as an Employer Eligibility Failure that must be corrected under the IRS Voluntary Correction Program as described here.  In short, all contributions must cease, and the plan must be maintained as a frozen plan until each participant has a distributable event, e.g. termination of employment, death, disability, etc.

One of the fundamental requirements of VCP is that a plan must make full correction.  Therefore, NFPs finding themselves in this situation would be well served to conduct a full review of their plans to determine if there are any other “skeletons in the closet” that must be addressed prior to the VCP submission.

While an NFP that loses its tax-exempt status may believe it has more pressing issues, the 403(b) plan is equally worthy of attention.  Otherwise, Mel and Danny may be kicking down the door to make the same exclamation about the plan also.

Are You Kidding? The Fall Will Probably Kill You!

My good friend and benefits attorney Ilene Ferenczy sends out an e-newsletter from time-to-time.  The Ferenczy Flash always includes timely, practical information for plan sponsors and service providers.  The edition she sent earlier this week highlights a very important point that often gets lost in the 401(k) shuffle - while all of the fiduciary rules are important, it is failing to comply with the Tax Code that is more likely to land most plan sponsors in hot water.

The text of the March 23rd Ferenczy Flash is posted below with permission from Ilene.

Are You Kidding?  The Fall Will Probably Kill You!

In a recent Ferenczy Flash, we outlined our thoughts about the flood of advice being published by practitioners nationwide in relation to ERISA’s fiduciary rules.  Certainly, fulfilling your fiduciary responsibilities is really important and failure to do so can subject you to lawsuits and penalties.
 
However, concentrating so hard on the fiduciary issues can in some respects be like the Sundance Kid worrying that he would drown after jumping off a cliff into a river because he couldn’t swim.  As Butch Cassidy reminded him, the jump into the river itself would probably be fatal.  Similarly, while worrying about fiduciary issues has value, placing all of your concentration there may be missing the point.  In our experience, it is much more common for sponsors of small-to-medium-size retirement plans to be subject to an IRS examination than it is for them to undergo investigation by the Department of Labor.  And, the chances that there are problems with the plan from a tax perspective are much greater than that there are significant fiduciary liabilities – particularly for plan sponsors that are diligent about making their 401(k) deferral deposits on a timely basis.
 
In truth, the IRS enforces the Code rules very strictly and a failure to follow those rules can put the plan sponsor and the participants at risk for significant taxes and penalties.  What is worse, it is easy for these very technical rules to be broken without the plan sponsor ever knowing it.
 
There are common plan problems that we see and need to address daily for clients who think they’re doing everything by the book.  We thought it would be helpful to outline a few of these problems and to give you our tips on how to avoid them.
 
Big Problem No. 1:  Plan Documentation
 
The IRS is absolutely obsessed with proper plan documentation.  Commonly, the documents have all been prepared, but no one has signed and dated the copies of that documentation.  This is particularly problematic for clients who have changed service providers over the years.

What You Need to Do:

• Contact whoever is responsible for your plan documentation and get a copy of every plan document, amendment, board resolution adopting documentation, employee notice, and summary plan description that they have.
• Make sure you have a signed and dated copy of each document.
• Put it all in a plan binder and keep it up to date.
• Make sure your service providers have up-to-date copies of your documentation so that they are administering your plan properly.

Big Problem No. 2:  Who’s on First
 
You would be amazed at how much needs to be done to keep a plan in compliance!  It is very possible that you, as the plan sponsor, have duties that you don’t even know exist.  The IRS will seek to make sure that everything required to be done is actually accomplished.

What You Need to Do:

• Have someone assess the tasks that need to be done to keep your plan in compliance and determine who is responsible for each task.  (We have a worksheet you can use for 401(k) plans. Just drop us a line and we’ll give you a copy.)
• If you know everything that must be done and who’s doing what, you can determine whether there are unmet needs, or whether you are paying twice for the same service.
• Plug the holes, and get rid of the duplications.

Big Problem No. 3:  Consider a Plan Health Check-Up

Only professionals can really review your plan to make sure that you are in compliance with the law.  If you have a large enough plan, your independent auditors will be reviewing some areas of compliance in their plan examination.  But your auditors don’t claim to be plan compliance experts, and they focus their attention on the financial operations of the plan.  So you might want to invest in a compliance review – that is, an examination by a professional that is not unlike an IRS audit, to see what the IRS would turn up if it examined your plan.  The IRS has correction programs that permit you to fix errors before an audit is a glimmer in the IRS’s eye – and by coming forward voluntarily to the IRS, you pay much lower fees or penalties to the IRS (often only in the hundreds of dollars) than you would pay if you got caught being noncompliant by an IRS examiner. You also accomplish this with considerably less wear and tear on you.  It’s somewhat like catching a disease in the early and curable stages.

What You Need to Do:

Consider hiring someone independent to review your plan for compliance with IRS rules.  If problems are found, work with a professional advisor (perhaps your favorite ERISA law firm!) to resolve the problems before they become deadly.

Werewolves of Pension

I was recently asked to write an article on ERISA Section 404(c).  As I contemplated how to approach the article, I recalled many situations in which I have heard 404(c) pitched as the mythical silver bullet to save plan fiduciaries from the specter of liability associated with participant-directed investments.

Despite the heading for the post, this is more a 401(k) issue than a pension issue; but “silver bullet” led me to werewolves which led me to this classic song from the late Warren Zevon.  Werewolves of 401(k) just didn’t have the same ring to it.  But, I digress.

In short, 404(c) provides a safe harbor for fiduciaries who prudently select and monitor the menu of funds offered to participants.  Fiduciaries who jump through 404(c)’s 20+ hoops are entitled to claim an affirmative defense against claims from participants who suffer losses due to their investment decisions.

Unfortunately, there is a great deal of misinformation about what 404(c) does.  I have witnessed many sales presentations in which 404(c) was touted as the way to guarantee fiduciaries won’t get sued.  Or, in reverse, I have heard, “If you are not 404(c) compliant, you are guaranteed to get sued.”  Both ends of the spectrum are absolutely false.

Compliance with 404(c) is not mandatory; it is one option plan fiduciaries may pursue to minimize their liability.  Nonetheless, they can still be sued.  If they are, it’s not as simple as waving the 404(c) “get out of jail free” card.  The accused fiduciaries must still go to court to actually prove they jumped through all the hoops at the time the alleged breach took place.

Therein lies one of the challenges of 404(c)…it is all or nothing.  Miss a single hoop and the defense is out the window.  Another challenge is that some fiduciaries mistake the safe harbor as a “set it and forget about it” arrangement.  However, 404(c) relief is predicated on the fund menu having been prudently selected in the first place and monitored on an ongoing basis.

The good news is that losing reliance on 404(c) is not the end of the world.  No one has a crystal ball, and ERISA does not require plan fiduciaries to make perfect decisions every time.  Rather, one of the over-arching themes of ERISA’s fiduciary rules is that plan fiduciaries must follow a prudent process to arrive at decisions.

Instead of taking the silver bullet approach, plan fiduciaries would be well-served to focus on creating, following and documenting a prudent process.  404(c) may be a part of that process, but it shouldn't be the only part.  By making prudence the primary concern and jumping through hoops secondary, missing a hoop isn’t quite as detrimental.

Anyone know where the nearest Trader Vic’s is?  I could really go for a pina colada.  Ah-oooo.

 

DOMA, Worry? Got To.

The public discourse concerning same-gender marriage continues to be very heated with passionate advocates from one end of the spectrum to the other.  Some argue it is a question of fundamental civil rights, while others believe the final decision should be driven by certain religious beliefs.

To date, ten states have permitted or recognized same-gender marriage; however, when it comes to employee benefit plans, we must look to federal law for direction.  The Defense of Marriage Act (DOMA) was signed into law by President Bill Clinton in 1996.  Although the Obama Administration recently indicated it would no longer defend DOMA in court, it remains the law of the land until Congress changes it or the Supreme Court overrules it.

Why do we care about DOMA?  Because, it defines marriage as “a legal union between one man and one woman as husband and wife” and requires that this definition be used “[i]n determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States.”

Qualified plans are governed by ERISA and the Internal Revenue Code, both of which are acts of Congress, and two agencies of the federal government – the IRS and DOL – have primary jurisdiction to enforce those laws.  As a result, those responsible for administering retirement plans must apply the one man/one woman definition of marriage, regardless of their personal position on the debate or the laws in their particular states.

Although it is nearly seven years old, this article provides some examples of some of the plan issues and benefit determinations that may be impacted, including QDROs, beneficiary designations and spousal consents.

The plan document may be drafted to recognize an alternate definition of spouse for certain purposes, and many pre-approved plan documents now provide employers with this option.  Examples include a definition tied to state law or one that specifically recognizes same-gender relationships such as civil unions or domestic partnerships.

The language must be included in the document in order to act upon it, so it is important to understand what the plan requires.  If you are unsure what your plan says, it is worth a call to your attorney or consultant or plan document provider to confirm.

By the way, the Styx reference in the title was just too tempting pass up.

 

Is It Time To Reinvent The 401(k) Or Our Expectations Of It?

The 401(k) plan has failed.  At least, that’s what an increasing number of articles and pundits would have us believe. 

It seems to me that unreasonable and unintended expectations have been placed on the plan that derives its name from the only section of the Tax Code that most people know.  I wrote an article on this topic last year for the Journal of Pension Benefits; but with the emergence of more recent negative press, I couldn’t resist commenting.

By now, it likely comes as no surprise that many U.S. households are projected to fall short of their retirement needs based on current account balances and savings rates.  However, I fail to understand how the 401(k) plan can be blamed.

A couple of quick Google searches led me to the following information on U.S. spending for 2009:

• $165 billion on consumer electronics
• $101 billion for beer
• $7 billion at Starbucks
• $10.5 billion on movie tickets
• $307 billion at casinos (a 57% drop from the prior year)

That’s almost $600 billion in these 5 categories alone in the year following one of the most precipitous economic declines in our history…and somehow, it’s the 401(k) plan’s fault that people don’t save enough?

Before you scramble to hit the comment button, I know these are broad figures that don’t consider variables such as non-U.S. residents spending money in the U.S., wealthier individuals with increased discretionary spending capabilities, etc., but this still paints an interesting picture.

The 401(k) plan, from its inception, was intended to a savings plan used to supplement other retirement plans, not a retirement plan in itself.  According to the ICI, 401(k) plans held nearly $3 trillion in assets as of September 30, 2010, and statistics from the Employee Benefits Research Institute continue to show that individuals covered by a workplace retirement plan are nearly 20 times more likely to save than if they do not have access to a plan.  Sounds pretty successful to me.

Yes, the average American needs to accumulate more retirement assets to achieve a comfortable retirement, but to somehow scapegoat the plan that has been so successful in getting people to save at all just seems short-sighted.

 

As If You Don't Already Have Enough To Read

I have had several inquiries regarding previous articles I have written, so I decided to post a few of them for the perusal of anyone who cares.  Click here or the link at the top of the page to see a sampling of some of the Articles I've Authored.

Reasonableness Requirement Is Not New

An article appeared yesterday on CFO.com entitled “New 401(k) Obligations Heaped on CFOs” and it carried a tagline stating “New disclosure rules abound, but pay close attention or you could be sued by plan participants.”

The article goes on to describe that, among other things, plan fiduciaries have a duty to “pay only reasonable plan expenses.”  While this is certainly correct, it is not a new requirement.

For many years, the law has imposed a duty on plan fiduciaries to ensure that any fees paid by the plan are reasonable in light of the services provided.  Just as this rule is not new, the specter of participant-driven litigation is not new either.  There have been plenty of excessive fee cases in the past few years to prove it.  However, in addition to the litigation risk associated with unreasonable fees, they can also result in Prohibited Transactions subject to DOL/IRS sanctions.

The challenge has been that while fiduciaries have been required to know and understand the fees (both pre-requisites for determining reasonableness), service-providers have not been required to provide that information.  As a result, even the most knowledgeable and diligent fiduciaries could face significant roadblocks to satisfying their obligations.  The Department of Labor’s new fee disclosure regulations change that. Originically slated to take effect this summer, the DOL recently annouced the postponement of the effective date until January 1, 2012.

The regulations are far too detailed to cover here, but the gist is that in order for fees to be considered reasonable, the service-provider who will receive those fees from the plan must disclose them to fiduciaries in advance.  Obviously, the amount of the fees must be in line based on the services provided, but fees that are otherwise reasonable in amount are deemed unreasonable in the absence of proper disclosure.  A plan fiduciary that allows a plan to pay fees in the absence of the requisite disclosure commits a Prohibited Transaction.

While the new fee disclosure regulations are certainly drawing much attention, it is important for fiduciaries to understand that the reaonsableness requirement is not new.  If there is concern that a plan has paid or is paying excessive fees, don't wait until 2012 to start asking questions.

What’s The Problem With PTINs?

I must confess that I have been very surprised by the vocal opposition to the new Preparer Tax Identification Number (PTIN) requirements.

As a brief background for any readers who may be scratching their heads, the IRS announced a new initiative designed to ensure that those who are paid to prepare tax returns meet certain minimum standards related to expertise and accountability.  In general, preparers must pass a competency exam, complete specified continuing education hours each year, comply with the ethical standards in IRS Circular 230 and obtain a PTIN.

Many in the qualified plan arena have been less than pleased at the prospect of being subject to these requirements.  Although the Form 5500 is now exempt, preparers of Form 5330 must still have PTINs.  Since the Form 5330 covers excise taxes related to ADP/ACP test failures, contributions exceeding the deduction limit and the delinquent deposit of 401(k) deferrals, it would appear many plan administrators should have PTINs.  Though, there are some very knowledgeable people who disagree on this point.

Since the IRS dropped the initial exam and CPE requirements for those who prepare 5330s, the cost for a PTIN is only $64.25 per person per year…not really cost-prohibitive.  Despite this fact, there continues to be significant opposition, and I just don’t get it.

For years, I have heard many retirement plan administrators and consultants lament the fact that despite having expertise in a very complicated area, we are often not treated with the same professional respect and deference as other professionals such as attorneys and CPAs.  However, at the first sign of the IRS seeking to apply the same standards of professionalism, these same lamenters have been some of the most vocal objectors.

It seems to me that rather than object, we should embrace and support this initiative.  Yes, it might require that we spend a little more time and money ensuring we have and maintain the requisite expertise to serve our clients.  Yes, it might mean that as knowledge increases we have to pay our employees a little bit more.  But, it would also mean that plan sponsors would consistently receive the level of service and expertise they should be able to expect.  How can that be a bad thing?