By William A. Clemmer and Gary S. Lesser, Esq.
Retirement plans are marvelous vehicles for the accumulation of pre-tax assets that can be used to enhance retirement of employees and their beneficiaries. Only the misguided would fall into the trap of thinking that social security was meant to be the sole provider for retirement. Thus, additional retirement funds can turn barren years into golden years.
Because retirement plans provide specific tax benefits to both the employer and the employee, such plans must follow guidelines set down by Congress and administered by the Internal Revenue Service and the Department of Labor. To review, an employer can take a current business deduction (within limits) for its contribution to a qualified plan. This has the effect of reducing an employer's income and income tax and setting aside funds that accumulate on behalf of the employee without tax until distributed (again within certain limits). Funds within a Plan earn and compound income on a tax-advantaged basis.
Further, a lump-sum distribution meeting certain requirements may be eligible for special forward income averaging (for individuals born before 1936) and/or a 20% long-term capital gains tax treatment (in respect to pre-1974 participation in the qualified plan). If employer securities are distributed in a lump-sum distribution, the net unrealized appreciation in those shares (including shares of a parent or subsidiary corporation) during the time the shares were held in the plan's trust is not taxable until the securities are sold. Although the net unrealized appreciation tax treatment is optional, it does not preclude the use of special averaging.
Sponsors and administrators of retirement funds have wide discretion regarding the investment and administration of such funds. Investing in a growing economy, such as that enjoyed by the United States, has had an additional effect of providing a steady stream of investment dollars to the market and marketplace, building a compounding asset from which benefit the economy, employees and their beneficiaries.
Nevertheless, plans that "qualify" for advantageous tax treatment must satisfy specific requirements regarding participation, vesting, coverage, and the accrual of benefits set forth in Internal Revenue Code Section 401(a).
Even if a retirement plan satisfies the requirements for qualification, there is no assurance that the plan will be operated in accordance with applicable rules, and it may become a trap to the unwary. We'll mention several potential traps. While several of those discussed might well seem obvious, they happen often enough to bear note. All of the cases noted have been the subject of litigation and adjudication.
Administration
It would seem obvious that the administrator of the plan must act efficiently and in accordance with both the law and the plan. Yet, far too often administrators are found to be liable for processing failures or even overstepping.
1. In a case where proceeds of a life insurance policy were paid to a fiduciary in error, the court ruled against the fiduciary for "unjust enrichment."
2. An employer was found to have failed to process a deceased beneficiary's request for a change in beneficiary. Here the charge was "negligence."
3. Unless a plan gives the administrator unrestrained discretionary authority to determine eligibility for benefits or to construe the terms of the plan, the court, according to its ruling, will review such denials of benefits. The standard here is that of "arbitrary and capricious."
Exclusivity
A basic rule in a retirement plan is that the plan must be for the exclusive benefit of all employees. The trustees of a pension plan borrowed against the cash surrender value of a life insurance policy for the benefit of the plan sponsor's primary stockholder. The trustees then loaned the proceeds to this stockholder who, in turn, loaned the proceeds to the corporation at a higher rate of interest.
The court ruled that the loan transaction was a diversion of trust assets for a purpose other than for the exclusive benefits of the employees after noting that the lower rate of interest received by the plan was not in the best interests of the plan trust. The court further noted, "The primary purpose of benefiting employees or their beneficiaries must be maintained with respect to investments of the trust fund as well as with respect to other activities of the trust."
Discrimination
The IRS approved an amendment that allowed a plan to eliminate life insurance for employees over 56 years of age to save money. This, on the face of it, did not discriminate. The plan then eliminated the policies fitting this criterion. However, the court ruled that the plan had in fact discriminated when it was found that there was only one employee over 56 years of age, no notice had been given of the amendment, and that the key employees of the plan tripled their own life insurance coverage. In this case, the court found that just because the IRS had approved the amendment did not mean that the plan had not violated ERISA.
Fiduciary
An insurance consultant was found NOT to be a fiduciary in a case where he recommended the purchase of life insurance policies whose values violated the incidental death benefit rules. Fiduciary authority under ERISA rests on these principals:
1. Discretion or control (especially as it relates to the purchase or sale of property)
2. Investment advice for a fee, or authority or responsibility to do so
3. Discretionary authority or responsibility in the administration of the plan.
The case on which the court ruled provides direction for the role of an insurance consultant. While it was clear that the consultant did, in fact, exercise a degree of discretion and control, it was noted that the trustee did not relinquish his independent discretion to make a final decision. The fact that the consultant exercised some influence over the trustee's investment decision did not make him a fiduciary based on control. In addition, the court found that the consultant did not provide investment-type advice on a regular basis and that there was no agreement that such advice would be the primary basis for the plan's investment decisions.
Investments
At a time when the "mantra" is "self-designed," "individual accounts," "unlimited investment choices" (which are almost always limited in some way), it is easy to forget that there are many plans in which the trustee makes the investment decisions. This is seen to allow the one with the most knowledge to make the "prudent" and "informed" decisions regarding investments. (Few employees have any say as to administration issues.)
The court ruled against an employer/trustee who had complete discretion regarding investments. He maintained the investments in money market instruments for a significant period of time during which the market had a significant increase. To put it another way, the plan assets received a minimum rate of interest while the market generally had very large increases. The court ruled that this was not prudent and required that the employer/trustee contribute the difference between the return actually received and the average rate attained by the general market. While this served to encourage the use of individual accounts and the control of plan assets by individuals, it also points out the need for trustees to utilize professional advisors and consider the need for "prudent" decisions.
Congress has clearly advocated retirement benefits for all--starting with social security and extending into special tax considerations for those employers and employees who will exercise them. Through constant, if not always consistent, legislation, Congress has sought to enhance and protect all who are involved. The regulations are generally clear, allowing retirement plans to be a benefit. Those who push or ignore the limits may find themselves trapped by the IRS, the Department of Labor and the courts. *
The authors
William A. Clemmer and Gary S. Lesser, JD, head up Financial Services Agency Consulting (FSAC), a division of The Rough Notes Company. Clemmer has more than 25 years of financial services industry experience on Wall Street. Lesser writes and lectures widely on retirement planning and taxation issues. He is a member of the board of advisors for the Journal of Taxation of Employee Benefits.