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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?

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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

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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

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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

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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

Maximum 3.5% for 6% deferral

Maximum 4% for 5% deferral

50% of next 5%50% between 3% and 5%

100% up to 1% PLUS100% up to 3% PLUS

Automatic

Enrollment

Safe Harbor

Current

Safe Harbor

401(k)

Why Automatic Enrollment?

� Increased participation

� Low savings rate among Americans

� Forces appropriate behavior

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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

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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

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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

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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

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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

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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

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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

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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

0% 100%

2 yrs – 20%

3 yrs – 40%

4 yrs – 60%

5 yrs – 80%

6 yrs – 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

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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

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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

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Highly Compensated Employees

� > $100,000 in lookback year

� More than 5% owner in current or lookbackyear

� 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 lookbackyear 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

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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

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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!

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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

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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

XDistribution

Amount

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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

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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

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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

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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

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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

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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

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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?

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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

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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

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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?

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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

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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

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Questions?

swright@mizehouser.com