Employee Benefits and Qualified Plan Update Sonya D. Wright, CFP, CEBS, QKA First, a Quiz... There will be prizes! Getting to Know You! Percentage of your business in qualified retirement plans? Securities license? Documents used? 1
What We re Going to Cover Impact of PPA 06 Roth 401(k) s Fee Transparency Qualified Plan Basics Pension Protection Act of 2006 Pension Protection Act of 2006 Signed into law August 17, 2006 Some provisions effective immediately Others 2007 Some for 2008 One for 2010 2
PPA 06: EGTRRA Permanence EGTRRA 2001 Permanent Increased annual additions limit (IRC 415) Increased compensation Favorable deductions Increased portability Catch up contributions Roth 401(k) s Tax Credit for Low Income Savers 50% of first $2,000 contributed to: IRA s 401(k) s 403(b) s 457(b) s Credit, not deduction 3
PPA 06: Automatic Enrollment Automatic Enrollment Safe Harbor Plan Effective 2008 Automatic deferral limits: Year One 3% Year Two 4% Year Three 5% Subsequent Years at least 6% Auto Enrollment Safe Harbor Deemed to satisfy top heavy Deemed to satisfy nondiscrimination Does not have to apply to existing participants or those who have already opted out 4
Auto Enrollment Match 100% of first 1% PLUS 50% of next 5% OR 3% nonelective Fully vested after two years of service Compare Safe Harbor Plans Current Safe Harbor 401(k) 100% up to 3% PLUS 50% between 3% and 5% Maximum 4% for 5% deferral Automatic Enrollment Safe Harbor 100% up to 1% PLUS 50% of next 5% Maximum 3.5% for 6% deferral Why Automatic Enrollment? Increased participation Low savings rate among Americans Forces appropriate behavior 5
Legal Solution PPA preempts state payroll laws that require employee authorization for deductions Notice Requirement How to opt out Default investments How to change deferral rates and investments Employee Opt-Out New employee has 90 days to opt out and withdraw contributions 10% penalty for early withdrawal does not apply 6
Default Investments Applies to auto enrollment plans and regular plans where participant chooses not to elect investments DOL responsible for default investment guidelines Plans which provide notice and have approved default investment qualify as self-directed plans under ERISA Qualified Default Investment Alternatives (QDIAs) ERISA now embraces modern portfolio theory Focus on capital accumulation rather than capital preservation Target dates and asset allocation funds in Stable value investments out Four Types of QDIAs Product with a mix of investments taking into account individual s age or retirement date Life cycle fund Target retirement date fund Professionally managed account taking into account age or retirement date Product with a mix pertinent to the group of employees Balanced fund Capital preservation fund First 120 days of participation 7
Problems with Stable Value Funds Ill-diversified Tend to be more expensive Early withdrawal penalties Not guaranteed Good Things About Stable Value Funds Return of principal plus a stated rate of income A bird in the hand instead of two in the bush Easy to explain to participants Not so easy to explain market fluctuation Taking Sides Mutual fund industry stands to gain significantly from endorsement of target date/asset allocation funds Insurance industry promotes stable value funds 8
Current Trends Matching participant retirement date with investment choice One size fits all solution ERISA requires investment prudence Modern portfolio theory PPA 06: Investment Advice Exemption from Prohibited Transaction Advisor s fees must be unrelated to the choices made by participant OR Advice based on computer model certified by independent third party Applies to: Registered investment companies Banks Insurance companies Registered broker-dealers 9
Computer Model Certified by independent investment expert Who? TBA Must take into account all plan investments Must not be biased in favor of adviser s own investments Detailed Disclosures Before initial advice given and annually thereafter Relationship between the fiduciary adviser and the plan investment options and fees that will be received Past performance of investment options Services provided by the advisor and that he/she is a fiduciary Detailed Disclosures (cont.) Participant is free to engage an independent adviser Other disclosures required by securities laws 10
Investment Advice Arrangements Investment advice arrangement must be authorized by another plan fiduciary (such as plan sponsor) Specific information about arrangement and fees must be provided to participant Investment advisor is a fiduciary under the plan and liable for fiduciary standards Plan Sponsor Responsibility Decision to provide investment advice must be prudent Plan sponsor has no responsibility to monitor specific advice to each participant PPA 06: 401(k) Test Correction 11
401(k) Plan Test Corrections Automatic enrollment test corrections Effective 2008 Refunds can be made within 6 months (not 2½ months) after PYE without 10% excise tax Gap period earnings Effective 2008 Do not need to be calculated for refunds 401(k) Plan Test Corrections Timing of taxation Effective 2008 Refunds made within 2½ months after PYE are taxed in the year of distribution rather than year of contribution Also applies to automatic enrollment plans correcting within 6 months after PYE PPA 06: Miscellaneous Provisions 12
Plans with Employer Stock A plan that permits or requires investment in publicly traded employer stock must provide participants with the right to diversify into other investment options Notice must be given Does not apply to ESOP s Accelerated Vesting 6 yrs 100% 5 yrs 80% 4 yrs 60% 3 yrs 40% 2 yrs 20% 0% 100% 3 years Investment Mapping/ERISA 404(c) PPA provides 404(c) protection if: Participant exercised control before the change Written timely notice is provided comparing old and new investments and outlining how investments will be mapped absent participant instructions 13
Participant Statements Participant directed DC plans Quarterly notice within 45 days of end of quarter Non participant directed DC plans Annual notice DB plans Every three years First one due 2009 DC Quarterly Reports Must reflect assets as of most recent valuation date Some assets are trustee invested and may be hard to value Employer securities 401(k) Rollovers to Non- Spouse Beneficiaries Allows same options for 401(k) plans as for IRA s Withdraw over non-spouse beneficiary s lifetime Previously required withdrawal over five years Plan must elect to allow; if not, encourage participants to rollover to IRA ASAP after retirement Transfer must be made by last day of year after death 14
Plan Document Amendments IRS-approved language not yet available Plans don t need to be amended until after 2008 Must comply operationally Quiz Answers! Who is a Key Employee? Any employee who owns more than 5% of the business Regardless of compensation amount Any employee who owns more than 1% of the business and makes more than $150,000 Not indexed Officer who makes more than $145,000 (indexed) Maximum 50 or 10% of employees but not less than 3 15
Highly Compensated Employees > $100,000 in lookback year More than 5% owner in current or lookback year Family member of more than 5% owner Member of top paid group If elected in plan document Top paid group is the group of HCE s who earned more than $100,000 in the lookback year and in the top 20% of employees as ranked by compensation Highly Compensated Employees If more than 5% owner, HCE regardless of compensation If family member of more than 5% owner, HCE regardless of compensation Compensation limit based on prior year If >$95,000 in 2005, considered HCE in 2006 If >$100,000 in 2006, considered HCE in 2007 Top paid group Elected in plan document Why do we care? Highly Compensated Employees Key Employees 401(k) and 401(m) 401(a)(4) Nondiscrimination 410(b) Coverage Top Heavy Testing 16
401(k) Discrimination Testing Applies to salary deferrals Pre-tax and Roth Average percentage deferred by HCE s cannot exceed 2 percentage points above percentage deferred by NHCE s Top Heavy Testing If key employees account balances exceed 60% of total assets in the plan, it s top heavy Minimum benefits or contributions DB accrued benefit for non-key employees must not be less than 2% times years of service or 20% DC 3% allocation if key employees receive at least 3% Including salary deferrals made by key employees Including forfeitures Salary Deferrals Pre-tax Also called elective contributions IRC 402(g) calendar year limit $15,500 for 2007 and 2008 Catch up contributions Employees age 50 $5,000 Non-calendar year plans 17
Annual Additions Limit IRC 415 100% of participant compensation OR $46,000, whichever is less Compensation Outlined in plan document Limited to $230,000 in 2008 Prizes! 18
Roth 401(k) s Roth 401(k) Early in 2007, 22% of 401(k) plans surveyed offered Roth accounts More plans (61%) considering Roth adoption in the future Anxiety over EGTRRA sunset in 2011 had been a major concern Roth Obstacles Participant education Lack of demand Administrative burden Divided between small and large companies Small lack of demand Large additional education 19
Roth 401(k) Distributions Final regulations released by IRS April 30, 2007 Effective for plan years beginning on or after January 1, 2007 Apply to any 401(k) plan that has or will add a Roth contribution feature Including SIMPLE 401(k) s Final rules for 403(b) Roth yet to be released Roth 401(k) Distributions Qualified Roth distributions Roth contributions to a 401(k) plan made at least 5 years before the distribution Made following a qualifying event Death Disability Attainment of age 59½ NOT termination of employment Taxable Earnings Roth Contributions Total Roth Account Balance X Distribution Amount 20
Distribution Start Date Based on actual year of payment Series of payments prior to 5-year qualifying period Prior to 5 years - partially taxable After 5 years - tax free Five year period begins with the first day of the employee s taxable year for which a Roth contribution is made Reporting Roth Distributions Plan administrator tracks 5 year taxable period and amount of designated Roth contributions Upon direct rollover, plan administrator must furnish statement First year of 5 year taxable year AND Amount of distribution attributable to basis OR Distribution is qualified Behavioral Finance 21
Behavioral Finance Decline of defined benefit plans Individuals responsible for their own retirement Employees may not participate or contribute enough to their 401(k) s Individuals not particularly wise investors Participant Passivity Procrastination Status quo Self-control Hyperbolic discounting Lack of understanding Choice Overload Majority of plans offer between 11 and 20 investment options Participation tends to drop with more investment options 22
Individuals are Loss-Averse People are more sensitive to losses than they are to gains of the same magnitude Losses are felt more than 2x more than gains Retirement savings requires loss to discretionary income Possible Solutions Simplified enrollment process Automatic deferral increases QDIA s Research Findings Among companies offering automatic enrollment Increases participation Participants remain at default contribution rates Even if employer match rewards higher deferral rates 23
Plan Design Critical Plan design drives participant choices and therefore participant retirement security Important to design plan to encourage deferrals at appropriate levels Plan defaults can be perceived by participants as implicit advice Fee Transparency More than anybody would ever want to know about their retirement plan Disclosure and Reporting Disclosure information provided to plan fiduciaries and sponsors before purchasing investments Reporting Form 5500 24
Current Form 5500 Reporting Schedule A, Insurance Information Commissions and expenses Schedule C, Service Provider Information Applies only to plans with >100 eligible participants Reports expenses in excess of $5,000 to providers Schedule C Large Plans Form 5500, expanded Schedule C for 2008 requires explicit reporting of fees paid over $1,000 including: Contract administrator Securities broker Insurance roker Custodian Consultant Investment Advisor Who s Missing from the List? Attorneys 25
Schedule A and C Reporting Identify each fiduciary or service provider who failed or refused to provide the information Can result in investigation and lead to civil and criminal penalties Indirect Compensation Finders fees Placement fees Commissions Transaction-based commissions Sub TA fees 12(b)-1 fees Soft dollar payments Problem Fees both direct and indirect Revenue sharing between TPA s, mutual funds and investment managers Fees not disclosed to plan sponsors or participants Fees not clear 26
Fiduciary Responsibility Prudent standard ERISA allows civil action against fiduciary breach Personal liability Fiduciary responsible for understanding hidden fees Hidden Fees Investment Management Fees % of assets Sales charges/loads/commissions Transaction costs Revenue Sharing Arrangements Compensation to TPA from mutual fund R Shares Hidden Fees Sub-Transfer Agent Fees Payments to third party does fee fairly represent the value of services rendered? 12(b)-1 Fees Could plan sponsor invest in same or similar mutual fund and pay a lower 12(b)-1 fee? 27
Hidden Fees Variable annuity wrap fees Investment management fees Surrender charges Mortality and expense risk charges Administrative fees Is the same underlying mutual fund available at a lower cost outside the variable annuity? Mushy Fees Providers can estimate indirect compensation Include explanation of formula used to calculate payments DOL Best Practices Fiduciaries are not judged so much on the results they achieve but on the processes they follow Processes should not be static but should change with the times Fiduciaries are held to a higher standard today than in 1974 28
DOL Stance Plan sponsors should avoid doing business with vendors who refuse to disclose amount and sources of fees and compensation Providers should provide a detailed written analysis of all direct and indirect compensation (see handout) Plan sponsors should obtain information for each investment option DOL Stance (cont.) Plan sponsors should require annual written statements on compensation, both direct and indirect Plan sponsors should understand that asset-based fees will increase with the size of the plan, regardless of whether additional services are provided by the vendor DOL Stance (cont.) Plan sponsors should calculate the total plan costs annually 29
www.dol.gov/ebsa/publications A Look at 401(k) Plan Fees Targeted to employees 23 pages Understanding Retirement Plan Fees and Expenses Targeted to employers 16 pages DOL Publications (cont.) Meeting Your Fiduciary Responsibilities Targeted to employers 17 pages 401(k) Plan Fee Disclosure Form Targeted to employers 11 pages Purpose Allow plan sponsors to assess reasonableness of service provider s compensation But does it allow apples-to-apples comparison between providers? 30
Problems May be hard to collect this data Some providers say this is impossible to provide Compensation to providers not on a plan by plan basis but as an omnibus payment Pending ERISA 404(c) Change Plan fiduciary not responsible for participant investment decisions when participant receives enough information to make an informed decision Proposed change designed to clarify what fee information must be provided to participants to enable them to easily compare fees among investment options Class Action Lawsuits Against Fortune 100 companies and their service providers Allege that 401(k) plan fees borne by participants were improper, excessive and undisclosed Hidden fees and revenue sharing were undisclosed and therefore violated ERISA 31
In Summary... Interesting Times... PPA 06 Improving participation Automatic enrollment Increasing deferral rates Appropriate default investments Investment advice Employers not mandated to make changes Employees can opt out Fees and Expenses Necessary to pay attention to developments regarding fees and expenses Especially indirect payments Increased reporting and disclosure 32
Questions? swright@mizehouser.com 33