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.

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.

 

Political Gridlock and Pension Law

The Presidential campaigns rarely mention pension issues, but pension law is shaped by politics. What do current political trends mean for the future of pension law? A recent book by two prominent congressional scholars tells us that the political gridlock in Washington is Even Worse Than It Looks. The authors, Thomas E. Mann and Norman J. Ornstein, explain that the causes for this include:

•  Political parties that are polarized and “vehemently oppositional”;  

•  The “checks and balances” in the U.S. constitutional system, which present “more structural impediments to action than any other major democracy”;

•  Redistricting that allows politicians to run in “safe” districts, not requiring them to respond to diverse political views;

•  Splintered media sources that narrow their ideology to viewers’ preferences, promoting extremism rather than centrism; and

•  Campaign finance laws that allow huge sums of money to buy negative, polarizing ads.

What does this portend for tax simplification proposals that would affect pension laws? It suggests that no comprehensive changes are imminent. In some ways, this is good. It delays the possible disruption that could be caused by major “simplification” of the kind proposed by the Bush administration, which would consolidate various retirement plans (457, 403(b), 401(k)) into a single form called an Employer Retirement Savings Plan. The American Society of Pension Professionals and Actuaries has stated that such reforms would “not be simplification” and “would disrupt saving, and force state and local government and nonprofits to modify their retirement savings plans and procedures.” Gridlock would also forestall proposals to reduce retirement plan tax benefits in order to raise revenue, such as the “20/20” proposal of the National Commission on Fiscal Responsibility and Reform that would limit annual contributions to the lesser of $20,000 or 20% of compensation.

The good news is that vast complexities of pension law could be simplified by administrative action and piecemeal legislation. Progress on simplifying pension law is possible despite a political situation that may remain Even Worse Than It Looks.

Having Your Pension and Working Too—A Strict IRS Ruling Contrasts with New Laws for Federal Employees

A new law (the 2012 Highway Investment Act) allows a phased retirement program for federal employees. In contrast, an IRS private letter ruling severely restricts pension plans from paying benefits to retirees who return to work before age 62. This difference in laws governing federal pensions and other pension plans is illogical.

The new law allows federal employees to work part time at 20% to 80% of their full-time schedule, receive pay and pension credit for that working percentage, and also receive a pension for the other (nonworking) percentage of their full-time schedule. No termination of employment is required to start this combination of work and pension.   

In contrast, tax laws prohibit all other “pension plans” (money purchase pension plans and defined benefit pension plans) from providing benefits to an employee who is under age 62 and has not retired or separated from employment (unless the employee has reached the plan’s “normal retirement age”). Internal Revenue Code section 401(a)(36), Treas. Reg. sections 1.401(a)-1(a)(2) and 1.401-1(b)(1)(i). Because the meaning of key terms such as “retired” and “separated from employment” is open to varying interpretations, the practical impact of these laws has been uncertain. Just how long must an employee be absent from work to make a pension payment permissible before age 62? Under what circumstances may the employee return to work without jeopardizing the tax qualified status of the pension plan?

The IRS letter ruling (201147038) states that an absence from employment for a week or less is not a bona fide separation or retirement. The ruling refers to Treasury Regulations interpreting Code section 409A to define “retirement” and “separation.” (The ruling notes that “although section 409A and its regulations address a nonqualified plan arrangement the definitions regarding termination and separation from service are consistent with” the definitions for purposes of pension plan qualification.) The 409A regulations apply very strict rules. For example, the 409A regulations generally require that the employer and employee reasonably anticipate that after the date of termination the employee will either perform no further services, or services at a level of no more than 20 percent of the average services performed over the immediately preceding 36 month period. The regulations also list other relevant factors, such as whether the employee continues to be eligible for other employee benefit programs, whether the employee is permitted and available to perform service for others in the same line of business and whether a change in business circumstances, such as termination of the employee’s replacement, causes the employee to return to employment.

The result is:  Plans that pay pensions to retirees under age 62 who are rehired after a short absence face possible disqualification if the IRS determines that the retirement was a sham, because the retiree returns to work at more than 20% of his prior work schedule. In contrast, the new law allows federal employees (including IRS employees) to switch to 20% to 80% part-time work and receive federal pensions before age 62 without terminating their employment.

These differences in laws for federal employee pensions and other pensions make no sense.

Pension COLA Reductions—Contract Breach or Justified Flexibility?

Is it legal to reduce pension cost-of living adjustments (COLAs) being paid to retirees? This question is a major issue, because of the value of COLAs for retirees and their high expense for pension plans. Recent reductions in retiree COLAs for several state and local government pension plans have brought legal challenges. The following paragraphs briefly examine how legal protections for COLAs differ in private sector and public sector pension plans. Recent cases offer less protection to public pension COLAs than previous cases, yet public pension COLAs still exist. In contrast, private plan COLAs have are rare, perhaps due to legal restrictions. Is a COLA that may be reduced better than none?

(a) Broad Level of Protection: Past State Court Decisions Protect Governmental Pension COLAs for Past and Future Accruals. Because state laws vary, there is no single “general rule” for public sector pension COLAs. However, some past state court decisions give public sector COLAs surprisingly broad protections. At least one decision prohibits COLA reductions for past and future pension accruals for active employees, e.g., Calabro v. City of Omaha, 247 Neb. 955, 531 N.W.2d 541 (1995). Another decision prohibits COLA reductions for employees who have worked for a “legally significant period of time” Nash v. Boise City Fire Department, 104 Idaho 803, 663 P. 2d 1105 (1983). These decisions protect COLAs not only for current retirees but also for benefits earned in the future by active employees, so that COLAs may only be cut back for newly hired employees or employees who have worked for less than a “legally significant period of time.” These decisions seem almost naïve in the simplicity with which they create potentially huge future COLA liabilities for state and local pension plans.

(b) Medium Level of Protection:  ERISA Protects Private Sector Pension COLAs for Past Accruals. Unlike the COLA rules for public sector plans that were created by state courts, laws affecting private sector COLAs have been studied, written and revised over time by Congress, the IRS and the U.S. Department of Labor as well as federal courts. The resulting laws, which are more exacting than state court decisions, prohibit reductions in COLAs for past benefit accruals (with limited exceptions for very poorly funded plans). This approach allows reductions in COLAs for benefits earned in the future but not the past. Hickey v. Chicago Truck Drivers, 980 F. 2d 465 (7th Cir. 1992). The laws for private sector pensions also address the question:  May a pension plan avoid this prohibition on COLA reductions by adopting a temporary or “ad hoc” COLA, or does that make the benefit too unreliable because it may be renewed (or not) at the discretion of the plan sponsor? Treasury regulations adopted in 2005 allow only limited use of “ad hoc” COLAs, by prohibiting a COLA (or other benefit) reduction if it is part of “a pattern of repeated plan amendments providing for similar benefits in similar situations for substantially consecutive, limited periods of time.” (Treas. Reg. section 1.411(d)-4 Q&A-1(c)(1).) In simpler (but less precise) words, a private sector pension plan may adopt a temporary COLA once or twice, but the COLA becomes a protected, permanent pension benefit after it is renewed several times.

(c) Low Level of Protection: Recent State Court Decisions Allow Public Pension COLA Reductions for Retirees. Recent state court decisions uphold COLA reductions for public sector pensions, reasoning that (1) the governing pension documents do not state that COLAs are protected contractual rights, and (2) the COLAs are not a protected benefit because they have been repeatedly adopted in varying forms over time. Justus v. Colorado (District Court for Denver City and County, 2011) and Swanson v. Minnesota, (Ramsey County District Court, 2011). Could these decisions approving “ad hoc” COLAs create a precedent that undermines the broader security of public sector pension benefits (a concern that tax regulations governing private sector pensions attempt to address with more detailed regulation)? Or do these decisions allow benefit flexibility that is necessary to continue to pay benefits from underfunded public pension plans (applying less stringent rules than apply to private sector pensions)? Which approach serves the interests of pension plan sponsors and participants more fairly and effectively? One thing is certain: future pension law developments will offer more examples of the trade-off between pension viability, flexibility and security.

Supreme Court Justice Roberts’ 1935 Opinion on Pension and Health Care Reform

“Those who cannot remember the past are condemned to repeat it.”

–George Santayana 

This quote came to mind recently while I read Supreme Power by Jeff Shesol. This fascinating book recounts the legal standoff between Franklin Roosevelt and the Supreme Court over the constitutionality of FDR’s “New Deal” legislation. In a key decision, the Supreme Court struck down the Railroad Retirement Act as unconstitutional on May 6, 1935. The author’s explanation of this decision (Railroad Retirement Board v. Alton) initially peaked my interest because it involved pension legislation that, similar to ERISA, was intended to safeguard pensioners in dying industries. The laws mandated employer and employee contributions to pensions for retirees of failing railroads. But the interesting parallels to current legal issues did not end there. The name of the Supreme Court Justice who wrote the 1935 opinion was Roberts (although the 1935 Justice was named Owen Roberts, not John Roberts). Even more striking, the 1935 opinion discussed not only employer‑provided pensions but also employer‑provided medical benefits. Justice Roberts opined that the federal government could not force the railroads to provide pensions because this was not within the federal powers to regulate interstate commerce. As the book explains, Justice Roberts reasoned that if Congress could mandate employer‑provided pensions, then “there was no limit to the field of so-called regulation”: Congress could order employers to provide employees “a hundred other matters” including, “say, free medical care for employees.”  (Emphasis added, Supreme Power, page 118.)

As this illustrates, current legal controversies surrounding employer‑provided pension and medical benefits have occurred in the past. And they will undoubtedly continue into the future (perhaps even with other Justices named Roberts).