Understanding workplace plans: Diversifying wealth concentration at work Speaker: Title: For broker/dealer or institutional use only. It has not been filed with FINRA and may not be shown, quoted to, or used with, members of the general public. 1792534 (06/17) 7B1F/1822753
Concentrated wealth at work Key Employees, Senior Employees and Executives: The wealth concentration of an individual in one of these categories can be significant. Employees may participate in defined benefit plans, defined contribution plans, deferred compensation plans and various ways of acquiring company stock. Whether a dynamic growing company or an established firm, high concentrations of wealth in one place is a financial risk factor. Establishing a financial plan that integrates the various compensation and retirement programs is an essential need for these employees. 2
Table of contents Defined benefit plans Defined contribution plans Nonqualified deferred compensation Stock purchase and compensation plans 3
Defined benefit plans
Two types of defined benefit plans Traditional Cash balance Required to pay an employee s retirement benefit The plan sponsor, not the individual, is responsible for contributing money and electing investments 1 Benefit is based on length of service and weighted salary Benefit is based on salary ( pay credit ) and interest credit Not portable 2 Portable and lump-sum distribution option 1 Defined benefit plans may allow participant contributions, and cash balance plans may allow salary deferrals to the plan. 2 Approximately 25% of traditional plans do allow for portable lump-sum distributions. Source: Department of Labor 5
Distribution considerations Pros Immediate annuities Investment risks born by the plan or insurance carrier Guaranteed lifetime payment* Fixed income Lump-sum distributions Investment control More growth potential than annuity Withdrawals based on need Lump-sum rollover to IRA allows for beneficiary strategies Cons Inflation can erode purchase power No access to principal Limited ability to transfer wealth to beneficiaries Possible investment losses Could outlive assets * Guarantees based on the claims-paying ability of the insurance company and/or state insurance guaranty coverage for annuities purchased from insurance carrier or the plan s ability to fulfill its obligation and the potential for PBGC coverage. 6
A new trend in private defined benefit plans? Freezes, terminations, de-risking Major employers across many industries, such as: GM and Ford NCR, Verizon, Alcatel-Lucent and Motorola Solutions Many other employers have introduced a new approach in managing pension liabilities. Transfer pension obligations for certain retirees who are receiving monthly annuitized payments to an insurance carrier. In some cases, select retired employees who are receiving payments or separated employees who are not yet receiving payments have a one-time chance to elect a lump sum in lieu of monthly payments. The term generally used in stating this change is de-risking future pension liabilities. Financial advisors should take it upon themselves to help their clients assess the pluses and minuses of continuing (or selecting) an annuity payment stream compared with a lump-sum distribution. 7
Funded status volatility Over the last decade, defined benefit plan sponsors have experienced a roller coaster of funded status volatility. Funded status (%) of Milliman 100 Pension Funding Index Technology bubble and Fed easing policy Average funded level dropped to 82% Financial crisis and Fed easing policy Average funded level dropped below 80% 123 102 82 88 89 91 99 105 79 82 84 79 77 88 81 83 81 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 A strong funded status presents an opportunity for plans to protect funded status gains and reduce future volatility of their funding levels. At a lower funded status, a plan sponsor can implement liability-driven investing to manage interest rate risk and maintain an allocation to risk assets to improve funded status. Source: Milliman Pension Funding Index, as of December 31, 2016 8
De-risking activity continues FedEx (2017) Lump-sum window offered to 73,000 separated, vested employees not yet receiving benefits across 2 plans Boeing (2016) New lump-sum payment option is available for employees who leave Boeing on or after April 1, 2016 Lockheed Martin (2016-2020) Phasing out accruals under the pension plan over the next several years. Lockheed will start making automatic company contributions equal to 2% of salary to 401(k) plan January 1, 2016 US Steel (2015) USS froze the salaried employee pension plan effective December 31, 2015 Two non-qualified plans were frozen as well Alcatel-Lucent (2015) A one-time lump sum window offer to about 75,000 U.S. retirees and former employees receive monthly pension benefit payments Eligible participants could elect to convert those payments into a single, lump-sum payment Freddie Mac (2015) Freddie Mac terminated its defined benefit plan and participants could elect lump sum or an annuity payout Motorola Solutions (2014) Offered a lump sum window to approximately 32,000 former employees who were not yet receiving benefits Purchased a group annuity contract from Prudential to cover 30,000 retirees who were receiving lifetime annuity payments Prudential now pays and administers benefits to those retirees 9
Defined contribution plans
How most clients view a 401(k) plan 401(k) plan My contribution rate (%) Company match (%) Pretax option Designated Roth? 11
XYZ Corporation hypothetical defined contribution plan $18K/$24K (catch up) 402(g) Company match Profit sharing Employee stock ownership plan Pretax Designated Roth After-tax $54K/$60K (catch up) 415 limit Descriptions of benefits provided are for a hypothetical plan and not linked to any specific company plan. 12
Plan contributions Three types of employee contributions: Pretax deferral Designated Roth Employee after-tax Two primary types of employer contributions: Match Profit sharing Example Joe (age 52) Annual compensation: $290,000 2017 Compensation cap: $270,000 Match: 100% up to 5% of compensation Profit sharing: none Hypothetical contributions Employee: $24,000 pretax Employee: None Roth Employer: $13,500 match = $37,500 < $60,000 $22,500 remaining contribution opportunity NOTE: The permitted after-tax contribution amount will vary from plan to plan. 13
Rollover/conversion of after-tax to Roth IRA 401(k) after-tax account In-service/non-hardship withdrawal For an after-tax account often available before age 59½ and regardless of time in plan. Pre- 87 after-tax Post- 86 after-tax Roth IRA Earnings 14
Rollover/conversion of pre-1987 after-tax contribution 401(k) after-tax account Pre-1987 after-tax contributions Eligible for distribution, rollover or conversion without earnings. Results in a non-taxable event. Pre- 87 after-tax Post- 86 after-tax Roth IRA Earnings 15
Rollover/conversion of post-1986 after-tax 401(k) after-tax account Basis recovery rule Post-1986 after-tax must be distributed, rolled-over/converted with earnings. After-tax earnings becomes a taxable event. Pre- 87 after-tax Post- 86 after-tax Roth IRA Earnings 16
Rollover/conversion of post-1986 after-tax Pre- 87 after-tax Post- 86 after-tax Traditional IRA Earnings Roth IRA IRS Notice 2014-54 Recordkeepers are now authorized to process and distribute multiple checks to multiple locations. 17
SEC and FINRA on rollovers FINRA Notice 13-45 addresses firm and advisor responsibility about rollovers from qualified plans to IRAs. A balanced discussion involves educating clients on the four options: Leave assets in plan Roll over to future employer plan Roll over to IRA Cash out FINRA also recommends the following discussion points and comparisons in reaching a decision: Investment options Fees and expenses Services Penalty-free withdrawals Protection from creditors and judgements RMDs Employer stock SEC Retirement Targeted Industry Reviews and Examinations (ReTIRE) program is a focus for branch visits in 2017: Reasonable basis for recommendations Conflicts of interest Supervision and compliance controls Marketing and disclosure 18
Net unrealized appreciation (NUA) Ellie s 401(k) plan invests a portion of her employer contributions in the common stock of her employer, Big Time Co. (BTC) Ellie takes a lump-sum distribution, including $350,000 of BTC stock: Cost basis of BTC stock to the plan = $75,000 Current value of BTC stock = $350,000 Ellie s NUA ($350,000 $75,000) = $275,000 She sells the stock three years later for $400,000 Net unrealized appreciation (NUA) tax treatment At distribution $275,000 $75,000 Cost basis Taxation delayed Taxed as ordinary income NUA At sale $50,000 $275,000 $75,000 Taxed at long-term capital gains rate* Taxed at longterm capital gains rate No additional taxation Earnings post distribution *Gain on stock after distribution from the plan is taxed at long-term capital gains rate upon sale if held for more than 12 months. Taxed at short-term capital gains rate upon sale if held for 12 months or less. 19
Key considerations Ellie s 401(k) plan invests a portion of her plan assets in the common stock of her employer, Big Time Co. (BTC). Several years later, as a result of bankruptcy, the BTC stock becomes worthless. Ellie takes a lump-sum distribution of the worthless BTC stock. Stock value when purchased $75,000 Taxation delayed Stock loss Value when distributed $0 20
Non-qualified deferred compensation plans
Non-qualified deferred compensation plan Deferred compensation is a contractual agreement to pay in the future for services rendered in the present Two types of private sector non-qualified deferred compensation plans (NQDC): Supplemental executive retirement plan (SERP) Contribution is made by the employer There is a set benefit and payout schedule Deferred compensation plan Contribution is made by employee as a percentage of salary and/or bonus Company may match or make contributions Election to participate must be made each year Overall, deferred compensation plans must be unsecured to avoid taxation. Payment depends on the company s ability to pay at the scheduled time of distribution The NQDC plan is not subject to creditor protection in the event of bankruptcy NQDC plans are offered to a limited and select group of employees. 22
Non-qualified deferred compensation plan Deferred compensation plan investment choices: May offer the ability to select investments such as mutual funds or a company stock fund Participants do not actually purchase shares Deferrals are converted into units, which are updated daily with gains, losses and dividends that mirror the actual investments An election must be made each year: The participant must choose the compensation percentage and distribution options Each election requires a year of distribution, example: 2020, and payment option (lump-sum or installment payment from a range, example: 5 15 years) Distribution choices are generally irrevocable, though a plan can offer a one-time opportunity to extend a distribution year out by 5 years At termination, the plan will often distribute assets in the following year A plan may honor the year(s) selected if it s a qualified retirement Installment schedules are generally followed Deferral could affect qualified retirement plan benefits by lowering eligible pay for the purposes of calculating deferrals under a 401(k) plan or qualified pension. 23
Stock purchase and compensation plans
Company stock purchase and compensation programs Stock ownership at work can come in many forms, and an employee may be participating in more than one type of program: Employee stock ownership plan (ESOP) Employee stock purchase plan (ESPP) Qualified and non-qualified stock options Non-qualified stock option (NQSO) Incentive stock options (ISO) Restricted stock awards (RSA) or restricted stock units (RSU) Stock appreciation rights (SARs) Phantom stock Source: Internal Revenue Bulletin 2007-19 25
Stock option exercise methods Cash exercise Cash is used to pay for the exercise Cashless exercise A stock option is exercised with a simultaneous sale of some or all shares to pay the total exercise cost (exercise price and tax withholding) Stock swap Owned company shares are delivered in lieu of cash to pay for the exercise Sell-to-cover exercise Just enough stock is sold to cover the total exercise cost (exercise price and tax withholding) and the remaining stock is held Promissory note Used in private companies, a company loan that covers the total exercise cost (exercise price and taxes) Net options exercise In the money options are tendered back to the company to cover exercise and withholding. Net options are the remaining options that result in net shares received 26
Comparing stock compensation programs Non-qualified stock option Incentive stock options Restricted stock award Restricted stock units Vesting Yes Yes Yes Yes Expiration Yes Yes No No Shareholder If exercised If exercised At grant; risk of forfeiture until vested At distribution, post-vesting Taxable amount and character Compensation income on the spread Long-term capital gain on spread, if holding period met; potential AMT at exercise Compensation income on the fair market value (generally) Compensation/ ordinary income on fair market value When taxed NQSO: Generally at exercise or vesting, if later* Generally at sale of stock; potential AMT at exercise Generally at vesting Generally when shares/cash distributed; FICA at vesting Long-term capital gains on sales of appreciated stock Hold stock for more than one year Entire spread if held more than two years from grant, one year from exercise Hold stock for more than one year Hold stock for more than one year 83(b) Generally not available Only for AMT purposes Possible N/A * In some cases, a plan may permit exercising prior to vesting and receipt of unvested stock subject to forfeiture. Sources: IRS Publication 525 and Internal Revenue Bulletin 2007-19, IRS Revenue Procedure 2012-29 27
Pairing stock compensation and NQDC Client has a restricted stock award (RSA) grant Partial vesting in 2018 Fair market value (FMV) estimated to = $50k FMV of $50k is addition to W2, taxable as wage income An extra $50k will push the client over a new tax threshold Client also has NQDC plan Client elects to defer 25% of $100k cash bonus ($25k) Must make election in 2017 Offset keeps client below a new tax threshold If cash flow is needed or for diversification, the client can sell vested stock Sale creates cash Additional tax obligation, only if there is an increase (capital gain) from the vesting FMV 28
Restricted securities A restricted security should not be confused with restricted stock. The restriction in this case is based on security laws, not based on company plan rules. When is a stock a restricted security? A stock that is not registered with the SEC A stock acquired from an issuer or affiliate in a private sale Rule 144 A set of safe harbor rules governing the sale of restricted securities These rules also apply to affiliated (control) persons who sell registered (control) securities in a public sale The rules cover holding periods, volume limits, manner of sale, SEC filing requirements, and availability of company information Source: http://www.sec.gov/investor/pubs/rule144.htm 29
SEC Rule 10b5-1 and Rule 10b5-1 plans Rule 10b5-1 is an SEC regulation that further defines insider trading, which is prohibited by SEC Rule 10b5 Insiders (officers and directors) who want to sell company stock may face significant limitations due to insider trading concerns A Rule 10b5-1 plan can provide greater certainty to insiders in planning stock transactions A Rule 10b5-1 plan is a written plan for trading securities designed in accordance with Rule 10b5-1(c) Paragraph C allows an affirmative defense to insider trading when the trade is made pursuant to a contract, instructions or a written plan that: Is created before the person has inside information Does not permit subsequent influence over how, when or whether to effect purchases or sales Sources: www.sec.gov/rules/final/33-7881.htm and www.sec.gov/answers/insider.htm 30
Investment considerations Investment products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. Collectively, the entities are known as Columbia Management. This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle Investments does not provide tax or legal advice. Please consult a tax or legal advisor for individual needs. Guest speakers from the Retirement Learning Center or PLAN SPONSOR Institute, third-party industry consultants, are not affiliated with Columbia Management. Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies. Columbia Management Investment Distributors, Inc., 225 Franklin Street, Boston, MA 02110-2804 31