IRS Guidance on Governmental DROP Plans and Code Section 415(c)

A recent IRS memorandum addresses the application of Internal Revenue Code section 415(c) contribution limits to DROP plans. http://www.irs.gov/pub/foia/ig/spder/TEGE-07-1114-0029%5b1%5d.pdf. The IRS memo is a welcome development because it reaches conclusions that generally do not disrupt the operation of DROPs, and it allows the IRS to process determination letter requests for DROP plans that have been pending for over six years in some cases.

A “DROP” is a feature of a defined benefit plan that allows an employee who is eligible to retire and receive a pension to continue working, while the pension payments the employee would receive if retired accumulate for future payment from the “DROP” account. Because the DROP creates an account within a defined benefit plan, it raises the question: are contributions to the DROP account subject to the contribution limits of Internal Revenue Code section 415(c)? Before this new memo, some IRS reviewers refused to issue favorable determination letters to governmental pension plans unless the plans were amended to state that all contributions to the DROP account are subject to the limits of Code section 415(c). This posed a serious problem for plans that credit a DROP account with annual defined benefit pension amounts exceeding the 415(c) limit. For example, a plan could not credit a DROP account with a participant’s defined benefit pension of more than $52,000 in 2014, because that amount would exceed the 415(c) limit for 2014.

The IRS memo instructs IRS employees reviewing governmental DROP plans not to apply the limits of Code section 415(c) to a participant’s defined benefit pension amounts that are credited to the DROP.

The IRS memo also explains how 415(c) limits apply to amounts other than a participant’s defined benefit pension that may be credited to a DROP, such as employer or employee contributions to the DROP. Because employee and employer contributions to a DROP rarely, if ever, approach the limits of Code section 415(c), this aspect of the memo should not present obstacles to the administration of most DROP plans.

Although this recent IRS memo states that it “is not a pronouncement of law,” it offers a workable solution to the complexities of applying Code section 415(c) to governmental pension plan DROP provisions.

Importance of Loan Policies for 403(b) and 457(b) Retirement Plans

The IRS recently released a “403(b) Fix It Guide” that includes advice on correcting many common errors in 403(b) plan operations. On the topic of plan loans, the Guide (Item 9) advises employers to: “Make sure that there are loan procedures in place.” This is an important warning for all employers who offer loans from their retirement plans, but it deserves extra attention from employers who allow employees to borrow from 403(b) and 457(b) plans. As the IRS Fix-It Guide notes, 403(b) plans are especially vulnerable to plan loan errors because they often allow multiple companies (vendors) to administer plan loans. The IRS Fix-It Guide also warns that employers often incorrectly think they can pass legal responsibility for 403(b) loan compliance to the plan vendors. In the words of the IRS:

Plan sponsors are responsible for determining that each participant loan meets the requirements of the loan program and for enforcing loan repayments. “Hold harmless” agreements between a plan sponsor and its vendors don’t lessen the plan sponsor’s responsibility.

These warnings are important not only for employers that sponsor 403(b) plans, but also for employers that sponsor 457(b) plans. Like 403(b) plans, employers may think of 457(b) plans as “extra” retirement savings vehicles that do not require significant attention because they are administered by multiple vendors who “take responsibility” for the details. This overlooks the requirement that loans among all plans of the employer must be coordinated in order to satisfy tax law limits. Vendors cannot coordinate plans they do not administer. Therefore, the employer must adopt a loan policy that coordinates loans among all plans the employer sponsors.

Importance of Coordinating Retirement Plan Fiduciary Insurance and Indemnification

Fiduciary liability insurance offers important protections for retirement plan fiduciaries. In addition to purchasing fiduciary liability insurance, many retirement plan sponsors also agree to indemnify plan fiduciaries against liability for fiduciary acts. A simple rationale for using both fiduciary liability insurance and indemnification may be that “more is better,” and that it helps fiduciaries to have both types of protection against fiduciary liability. The intended result of this “doubling up” on protection is to assure fiduciaries that they will not face unwanted legal exposure for taking on fiduciary duties.

This approach may backfire for the plan sponsor if the terms of the fiduciary liability policy and the indemnification are not carefully reviewed.  Fiduciary liability insurance policies often contain subrogation provisions, which give the insurer the right to pursue and collect other sources of reimbursement available to the fiduciary.  If the subrogation provision gives the insurer the right to pursue indemnification the fiduciary receives from the plan sponsor, the result is not what the plan sponsor intended.  Instead of “extra” protection, the indemnification and subrogation provisions may combine to make the fiduciary liability policy worthless to the plan sponsor.

In my experience, this bad result may be easily overlooked because the insurance broker is not aware of the plan sponsor’s indemnification provision, and the plan sponsor does not understand the details of the insurance policy. To avoid the possibility of this problem, plan sponsors should insist on clearly understanding how fiduciary indemnification provisions and fiduciary liability insurance interact.

“Anti-Cuback” Rule May Prevent Decrease in ERISA Pension Plan Benefits Due to Change in Plan Interpretation

The “anti-cutback” rule of Internal Revenue Code section 411(d)(6) prohibits reductions in protected benefits of an ERISA pension plan. This rule typically applies to reductions caused by a formal amendment to the terms of a pension plan. A recent court decision illustrates how this rule may also apply to a less formal change in the interpretation of the meaning of pension plan terms.

Cottillion v. United Refining (W.D. Pa. 4/8/13) involved a dispute over calculation of early retirement pensions. The employer interpreted ambiguous pension plan amendments to cause an increase in the calculation of early retirement benefits. Later, the employer concluded this interpretation was wrong. The employer received IRS approval to correct the error and recoup past overpayments of benefits from participants. The affected participants sued, claiming the “correction” in plan interpretation was a benefit cutback prohibited by Internal Revenue Code section 411(d)(6). The court agreed with the participants.

This court decision means that ERISA pension plan sponsors may not avoid the “anti-cutback” rule of Internal Revenue Code section 411(d)(6) by writing ambiguous pension plan terms that are open to varying interpretations. An interpretation of ambiguous plan terms may create benefit rights that are protected from cutback under Internal Revenue Code section 411(d)(6).

(Note: Internal Revenue Code section 411(d)(6) does not apply to governmental pension plans.)

Effect of Colorado Civil Union Act and Windsor Decision on Colorado Retirement Plans

Significant changes in laws affecting same sex couples result from the Colorado Civil Union Act (CRS 14-15-101 et seq.), which took effect May 1, 2013, and the U.S. Supreme Court’s June 26, 2013 decision in United States v. Windsor.  

The new Colorado law grants individuals in a civil union “the rights, benefits …and other incidents under law as are granted to spouses, whether those rights are derived from statute, administrative or court rule, policy, common law or any other source of law.” The Act addresses retirement plans only once, stating that the spousal rights it creates include “survivor benefits under local government firefighter and police pensions.” (CRS 14-15-118)

The U.S. Supreme Court decision in Windsor requires federal law to follow state law in defining “marriage” and “spouse.”   

These developments raise the following preliminary questions and possible answers: 

• Are parties to a Colorado civil union entitled to benefits that a Colorado governmental retirement plan provides to a “spouse”?

Preliminary answer is: “yes” for retirement plans sponsored by Colorado governmental employers, if the retirement plan is a “law.” The Civil Union Act defines a “law” to include a “policy…or any other source of law.” It is possible that a retirement plan meets this definition of “law” even if it is not enacted into an ordinance or statute, if the retirement plan is a “policy” adopted by a Colorado governmental entity.

• Do federal tax law definitions of “spouse” include parties to a Colorado civil union, with the result that all tax law benefits for a “spouse” apply to parties to a civil union?

Preliminary answer:  The IRS is expected to issue guidance soon. If the IRS determines that a “spouse” includes parties to a Colorado civil union, ERISA retirement plans (sponsored by nongovernmental employers) will be required to offer parties to Colorado civil unions the same spousal protections as the plan offers to married spouses, e.g., surviving spouse benefit protections.

Retirement plan sponsors should keep informed of pending legal developments in this area.

Poor Defined Benefit Pension Plan Investments: May Plan Participants Sue?

Fiduciaries of defined benefit pension plans should not to be lulled into comfort by a recent federal court decision that participants could not sue the fiduciaries of a defined benefit plan for a claim of poor investments and excessive investment fees. In David v. Alphin, (4th Cir. January 14, 2013), participants in a Bank of America pension plan sued plan committee members for breach of fiduciary duty and prohibited transactions caused by selecting and retaining Bank-affiliated mutual funds as plan investments. The participants alleged that many better investment options were available, and that most of the Bank’s affiliated mutual funds offered participants poor performance and high fees, causing multimillion dollar losses to the plan.

The court found that the participants lacked standing to sue because the defined benefit pension plan was overfunded and the plan would retain any surplus plan assets. The court concluded this was unlike a defined contribution plan, where excessive fees cause direct harm to participant accounts, because “the risk that … benefits will at some point in the future be adversely affected as a result of the alleged ERISA violations is too speculative.” For support, the court cited a U.S. Supreme Court decision, stating that “misconduct by the administrators of a defined benefit plan will not affect an individual’s entitlement to a defined benefit unless it creates or enhances a risk of default by the entire plan.” La Rue v. DeWolff, Boberg & Associates, Inc., 552 U.S. 248, 255 (2008).

For the following reasons, defined benefit pension plan fiduciaries should not assume that the David decision protects them from potential liability for poor investment management or excessive investment fees:

• This decision addressed a plan that was overfunded when the claim was filed.  Very few defined benefit plans are currently overfunded.
• The court acknowledged that the U.S. Department of Labor (DOL) would have standing to sue for a breach of ERISA, even if the participants would not. ERISA section 408(b)(2) fee disclosure and review requirements could provide basis for DOL enforcement action in this type of case.
• This decision did not consider a plan where funding more directly affects participant costs or benefits, such as (a) a contributory pension, where excessive plan expenses may lead to an increase in required employee contributions, or (b) a pension COLA or other benefit that is directly related to plan funding.

One-Time Irrevocable Elections Under Code Section 403(b) Plans—Error in 2007 Regulations Should be Corrected

Tax regulations must follow the terms of the Internal Revenue Code and must be internally consistent. These rules were violated in 2007 tax regulations defining a “one-time irrevocable election” for purposes of 403(b) plans. The 2007 regulations require an employee to make the election “on or before … first becoming eligible to participate under the employer’s plans.” This wording is more restrictive than the Internal Revenue Code and previously issued regulations, which allow an employee to make an irrevocable 403(b) election “at the time of initial eligibility to participate in the agreement.” The IRS should address this error in the 2007 regulations as part of the guidance the IRS is expected to provide for 403(b) plans in 2013. The following paragraphs explain the issue in more detail.

Use of the “One-Time Irrevocable Election” Definition. The “one-time irrevocable election” offers a useful option in retirement plan design. It allows an employee to commit to making employee pre-tax contributions to a retirement plan without regard to complex rules and limits that apply to “elective” 403(b) or 401(k) contributions. A “one-time irrevocable election” under a 403(b) plan may be a particularly attractive option for government 403(b) plans, where contributions are not subject to discrimination testing. Defining a “one-time irrevocable election” is critical to the use of this approach to 403(b) plan contributions.

Code Section 402(g) and Regulations Clearly Defined a “One-Time Irrevocable Election” for 403(b) Plans Before the 2007 Regulations. Internal Revenue Code section 402(g)(3) includes the following definition of a “one-time irrevocable election” for 403(b) plans:

…[a contribution to a 403(b) plan] shall not be treated as an elective deferral…if under the salary reduction agreement such contribution is made pursuant to a one-time irrevocable election made by the employee at the time of initial eligibility to participate in the agreement [emphasis added] or is made pursuant to a similar arrangement involving a one-time election specified in regulations.

Treasury Regulation section 1.402(g)-1(c) follows the Code provision, stating:

(c) Certain one-time irrevocable elections. An employer contribution is not treated as an elective deferral under paragraph (b) of this section if the contribution is made pursuant to a one-time irrevocable election made by the employee:

(1) In the case of an annuity contract under section 403(b), at the time of initial eligibility to participate in the salary reduction agreement [emphasis added].

2007 Regulations Contradict the Code and Prior Regulations. In contrast to the Code and regulations cited above, 403(b) regulations issued in 2007 redefine a “one-time irrevocable election” under a 403(b) plan. The 2007 regulations state that a “one-time irrevocable election” must be made “on or before the employee’s first becoming eligible to participate under the employer’s plans” [emphasis added]. Treasury Regulation 1.402(g)(3)-1(b). The 2007 regulations incorrectly use the same definition for 403(b) plans as Treasury Regulation 1.401(k)-1(a)(3), which defines a “one-time irrevocable election” for purposes of 401(k) plans. Applying the 401(k) definition to 403(b) plans contradicts the clear terms of Internal Revenue Code section 402(g)(3). Treasury Regulation 1.402(g)(3)-1(b) is invalid and should be corrected to state that a one time irrevocable election must be made “at the time of initial eligibility to participate” in the 403(b) agreement, not before eligibility to participate “under the employer’s plans.”

New IRS Procedures for Correcting 403(b) Plan Errors

New IRS procedures for correcting retirement plan errors add important new correction methods for 403(b) plans. (See Rev. Proc. 2013-12 at http://www.irs.gov/Retirement-Plans/New-Revenue-Procedure-Updates-EPCRS )  This is good news for employers who sponsor 403(b) retirement plans. Here are some key points regarding the application of this correction program (which the IRS calls EPCRS) to 403(b) plans: 

• Failure to Adopt Plan Document by December 31, 2009. If an employer did not adopt a 403(b) plan document by December 31, 2009 (as required by IRS Notice 2009-3), the employer should take advantage of new IRS procedures to correct this error. To encourage employers to make such corrections this year, the IRS offers a 50% discount in filing fees if the 403(b) plan document is filed under the “EPCRS” program by December 31, 2013.
   
• Failure to Follow the Terms of a 403(b) Plan Document. If the operation of an employer’s 403(b) plan document did not follow the terms of the document, the employer may use the new “EPCRS” program to correct the operational error. A checklist of common 403(b) errors appears at:

  http://www.irs.gov/pub/irs-tege/pub4546.pdf  

• Errors in Plan Document. The new “EPCRS” program permits employers to submit corrections for errors in 403(b) plan documents. However, the IRS will also permit corrections of 403(b) plan documents within a “remedial amendment period” to be announced in the future. Because the IRS has not developed a system for reviewing 403(b) plan documents for compliance with all tax law requirements, the IRS allows employers who timely adopted written 403(b) plan documents to wait for future IRS guidance before submitting plan documents for detailed IRS approval. This new “EPCRS” program states that it should be used to correct a 403(b) “plan provision (or the absence of a plan provision) that, on its face, violates the requirements of section 403(b).” For example, a 403(b) plan document that states incorrect limits on contributions or compensation could be corrected under the new “EPCRS” program.

 

Colorado Court Rules That Pension COLAs Are “Limited” Contract Rights

Reversing a lower court decision, the Colorado Court of Appeals recently ruled that “limited” contractual rights apply to cost-of-living benefit adjustments (COLAs) payable from the statewide pension plan (Colorado PERA). The contract rights apply to the COLA in effect when a participant’s benefit becomes “vested.” The Court of Appeals reasoned that the statute unambiguously said the COLAs “shall be” a specified amount, and that frequent past changes to the COLAs did not affect the contract right this wording created. Justus v. State of Colorado, 2012 COA 169. No. 11CA1507 (October 11, 2012).

In response to this decision, the lower court must now answer the following questions in order to determine whether a law passed in 2011 may be applied to reduce COLAs for vested Colorado PERA participants:  (a) Did the law cause only an “insubstantial impairment of” the contract right to a COLA? (The answer to this question is presumably no, because it was the high cost of the COLAs that made them an appealing target for the legislation’s attempt to reduce unfunded pension liabilities); or (b) If the law caused a “substantial impairment,” was that impairment “reasonable and necessary to serve a significant and legitimate public purpose (i.e., actuarial and funding considerations).” (This is the big question: At what point do underfunded public pensions become an unreasonable drag on public finances, so that the contractual promise may be broken?)

This case raises issues of great significance to Colorado and possibly other states (although it the court said its decision is not relevant to cases decided differently in South Dakota and Minnesota.) Both sides have appealed the decision to the Colorado Supreme Court.

Here is a link to a 2008 New York Times article about this case that explains the broad scope of political and economic issues that are involved.

Colorado Government Immunity Act Does Not Protect Plan Trustees

Trustees of Colorado governmental pension and benefit plans should take note of a recent Colorado Court of Appeals decision, which ruled that the Colorado Government Immunity Act does not apply to protect trustees of an employee benefits trust. The Colorado Court of Appeals issued its opinion in Casey v. Colorado Higher Education Insurance Benefits Alliance Trust on August 16, 2012.

In response to this decision, trustees of Colorado governmental pension and benefit plans should review their fiduciary liability protections, including fiduciary liability policies. Trustees should be sure they understand the exact scope and limits of their potential fiduciary liability. Fiduciary liability insurance provisions that expose the trustees to potential liability should be identified, discussed and renegotiated.