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 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.)

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.

American Bar Association Proposals To Simplify Pension Tax Laws

As my previous blog installment explained, major simplification of federal tax laws is universally desired but unlikely in the near future due to political gridlock. Piecemeal simplification of pension laws and regulations appears more feasible. In October, the American Bar Association Tax Section submitted recommendations to Congress that would simplify selected tax laws affecting pension and benefit plans. The ABA recommendations deserve attention because past ABA proposals of this type have convinced Congress to eliminate some very unwieldy pension laws, such as the impossibly complex “combined plan” limit of Code section 415(e). (I worked on the ABA committee that urged Congress to eliminate Code section 415(e).)

The ABA proposes a variety of changes, most significantly:

•  Simplification of the age 70 1/2 required minimum distribution rules to

–  exempt taxpayers whose tax qualified plan benefits are $250,000 or less and whose IRAs have combined values under $250,000, and

–  require post-death distributions within five years after the death of the individual and spouse or, if the beneficiary is a child of the decedent or his or her spouse, the beneficiary’s attainment of age 26.

These changes deserve Congressional approval, because they would allow more flexibility in the timing of distributions from smaller retirement accounts and would streamline post-death distribution rules.

•  Liberalization of pension rules to allow employees to receive pension benefits while continuing to work as early as age 55, rather than the current minimum age 62.

Although this proposal would simplify distribution rules for pension plans, I question the choice of age 55. It adds potential confusion because it does not coordinate with laws prohibiting in service withdrawals from 401(k) and 403(b) plans before age 59 1/2.

Correction of IRS Model 402(f) Notice is Long Overdue

 

It has been three years since the IRS issued its version of the “402(f)” notice that retirement plans must provide before paying a distribution that is eligible for rollover to an IRA. (IRS Notice 2009-68.) Buried in the IRS notice is a description of rollover rules for after-tax money that does not follow Internal Revenue Code section 402(c)(2). The IRS should correct this notice, as it presents unjustified complications for individuals who wish to make a direct IRA rollover of taxable retirement plan money and also receive a distribution of after-tax retirement plan money.

 

Detailed analysis of this error in the IRS notice appears in correspondence to the IRS from interested parties such as the American Benefits Council. See http://www.americanbenefitscouncil.org/documents/followup_letter_re_402c2.pdf

 

The IRS position is particularly illogical because it can be avoided through an indirect rollover. According to the IRS position, a portion of a plan’s after-tax distribution is taxable when paid to a recipient who also makes a direct rollover of a taxable distribution from the plan to an IRA. However, the IRS concedes that the after-tax distribution is not taxable if the recipient takes the extra step of first receiving the entire distribution (including after-tax and pre-tax money and paying 20% withholding tax) and then rolling the taxable money to an IRA within 60 days. It is illogical for the IRS to adopt a policy that gives an indirect rollover more favorable tax treatment than a direct rollover. It is also contrary to the plain wording of Internal Revenue Code section 402(c)(2). The IRS owes the pension community a long overdue correction of this error. A three year delay in taking corrective action is too long, particularly for retirement plan sponsors who struggle to satisfy the many complex deadlines the IRS applies to their tax law compliance.