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Economically targeted investing—ERISA considerations

“A number of my clients have asked about economically targeted investing (ETI). Are there any special considerations of which I need to be aware?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from New Jersey is representative of a common inquiry related to selecting plan investments.

Highlights of the Discussion

Plan fiduciaries under the Employee Retirement Income Security Act of 1974 (ERISA) should be aware of the Department of Labor’s (DOL’s) stance and guidance on ETI. First, let’s wrap our heads around what ETI is, and the many names by which it is known.

ETI is a type of investment behavior where an individual or plan committee considers the economic, social and/or corporate governance benefits of an investment, in addition to its propensity for favorable returns, when making investing decisions. Other common names for this behavior include socially responsible investing, sustainable and responsible investing, environmental, social and governance (ESG) investing, green investing and impact investing.

ESG criteria are many and varied. The Forum for Sustainable and Responsible Investment offers the following common examples of ESG criteria, but there are surely others:

Environmental Social Corporate Governance
Water Use & Conservation Workplace Safety Corporate Political Contributions
Sustainable Natural Resources Labor Relations Executive Compensation
Pollution/Toxins Workplace Benefits Board Diversity
Clean Technology Diversity & Anti-Bias Issues Anti-Corruption Policies
Climate change/Carbon Community Development Board Independence
Green Building/Smart Growth Avoidance of Tobacco or Other Harmful Products  
Agriculture Human Rights  

Over the past 35 years, various members of the financial industry have asked the DOL to opine on the use of ESG investments within qualified retirement plans given the constraints of ERISA. ERISA requires plan fiduciaries to make decisions with respect to their plans that are in the best interests of the participants and beneficiaries, with their decisions being held to an expert standard. Selecting and monitoring plan investments is well within this purview.

Through several DOL interpretive bulletins (IBs), culminating with IB 2015-01, the DOL has confirmed its longstanding view that, “… plan fiduciaries may invest in ETIs based, in part, on their collateral benefits so long as the investment is appropriate for the plan and economically and financially equivalent with respect to the plan’s investment objectives, return, risk, and other financial attributes as competing investment choices.” Some have referred to this standard as the “all things being equal” test. Put another way, “Would the investment make the cut as a plan investment using ERISA standards if it were not ESG conscious?”

What about a plan’s investment policy statement (IPS), the written document that provides fiduciaries with general instructions for making investment management decisions? If ESG investing is an objective of the plan, then the DOL deems it appropriate for a plan’s IPS to reference the process and criteria for inclusion of such investments. Moreover, prudence dictates plan fiduciaries maintain records sufficient to demonstrate compliance with ERISA’s evaluation requirements and IPS guidelines.

Conclusion

All things being equal, plan fiduciaries can consider an investment’s ESG criteria as part of an ETI objective as long as the investment otherwise meets ERISA’s best interest and prudent expert standards.

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Deferral limit, multiple plans and excess deferrals

“What is a plan participant’s deferral limit if he or she participates in more than one 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Connecticut is representative of a common inquiry related to contribution limits.

Highlights of the Discussion

The IRC § 402(g) annual limit on employee salary deferrals is an individual taxpayer limit—not a per plan limit. Consequently, an individual under age 50 for 2018 was limited to deferring 100 percent of compensation up to a maximum of $18,500 (or $24,500 if age 50 or more)—regardless of the number of plans in which he or she participated during the year. For 2019, the respective limits are $19,000 and $25,000.

This annual limit is inclusive of employee salary deferrals (pre-tax and designated Roth) an individual makes to all of the following plan types:

  • 401(k),
  • 403(b),
  • Savings incentive match plans for employees (SIMPLE) plans [both SIMPLE IRAs and SIMPLE 401(k) plans[1]] and
  • Salary reduction simplified employee pension (SARSEP) plans.[2]

(Note: A person who participates in a 457(b) plan has a separate deferral limit that includes both employee and employer contributions.)

If a taxpayer exceeds the annual limit—the result is an excess deferral that must be timely corrected. The IRS could disqualify a plan for violating the elective deferral limitation, resulting in adverse tax consequences to the employer and employees under the plan. But there are ways to correct the error. It is important to follow the correction procedures contained in the governing plan document.

Generally, if a participant has excess deferrals based on the elective deferrals made to a single 401(k) plan or plans maintained by the same employer, then the plan must return the excess deferrals and their earnings to the participant no later than April 15th of the year following the year the excess was created [Treas. Reg. § 1.402(g)-1(e)(1)].

In the case of an employee who participates in more than one salary deferral-type plan of unrelated employers, it may be difficult for the plan sponsor to recognize there is an excess deferral. Therefore, the onus is on the participant to notify the plan administrator of the amount of excess deferrals allocated to the plan prior to the April 15th correction deadline (usually a notification date is specified in the plan).

[1] The 2018 limit for deferrals to a SIMPLE IRA or 401(k) plan is $12,500 ($15,500 if age 50 or more).

[2] The 2018 limit for deferrals to a SARSEP plan is 25% of compensation up to $18,500 ($24,500 if age 50 or more).

document). The plan is then required to distribute the excess and earnings to the participant no later than the April 15th correction deadline [Treas. Reg. § 1.402(g)-1(e)(2)].

If the excess deferrals are timely withdrawn by the April 15th correction deadline, then

  • The excess deferrals are taxed in the calendar year deferred;
  • The associated earnings are taxed in the year distributed;
  • There is no 10% early distribution penalty tax; and
  • There is no 20% withholding (since the amounts are ineligible for rollover).

If the excess deferrals are withdrawn after the April 15th correction deadline, then

  • Each affected plan of the employer is subject to disqualification and would need to go through the IRS’s Employee Plans Compliance Resolution System (EPCRS) to properly correct the error;
  • The excess deferrals are subject to double taxation—taxed in the year contributed and in the year distributed;
  • The associated earnings are taxed in the year distributed; and
  • The excess deferrals could also be subject to the 10% early distribution penalty tax if no exception applies.

EXAMPLE 1

Joe, a 45-year old worker, made his full salary deferral contribution of $18,500 to Company A’s 401(k) plan by October 2018. He then left Company A to go to work for Company B, an unaffiliated company, on November 1, 2018, and was immediately allowed to participate in the 401(k) plan. Not understanding how the 402(g) limit works, he begins making salary deferral contributions to Company B’s 401(k) plan. In December his financial advisor informed him that may have over contributed for 2018.

The onus is on Joe to report the excess salary deferrals to Company B. Company B is then required to distribute the excess deferrals and earnings by April 15, 2019.  The plan document also requires forfeiture of any matching contributions associated with the excess deferral.

Conclusion

Although the annual IRC §402(g) employee salary deferral limit is an individual employee limit, exceeding it can have consequences for both the employee and the plan sponsor. Timely correction of the excess is key to minimizing possible negative effects.  Plan sponsors should review the correction procedures outlined in their plan documents, and follow them carefully should they detect or be informed of an excess deferral. Also rely on the IRS’s EPCRS corrections program.

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401(k) Record Retention Rules

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401(k) After-Tax Contributions May Be Testy–But Worth It

“What are the limitations, if any, on making after-tax contributions to a 401(k) plan?” Read more

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When SIMPLE IRA plans are not so simple Part II the 100-employee limit

“My client maintains a SIMPLE IRA plan for his small business. He is planning to expand and hire more employees. What happens to the SIMPLE IRA plan if his payroll grows to more than 100 workers?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Minnesota is representative of a common inquiry related to savings incentive match plans for employees (SIMPLE) IRA plans.

Highlights of the Discussion

Among the employer eligibility rules for maintaining a SIMPLE IRA plan is the “100 employee limit.” In general, an employer may maintain a SIMPLE IRA plan if the business has 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding year [IRC §408(p)(2)(c)(i) IRC §408(p)(2)(c)(i) and IRS Notice 98-4, Q&As B1 and B2].

The IRS provides for a two-year grace period for employers who had 100 or fewer employees, but then grew to exceed the 100-employee limit. An employer that maintains a SIMPLE IRA plan is treated as satisfying the 100-employee limitation for the two calendar years immediately following the calendar year for which it last satisfied the 100-employee limitation, except in the case of a merger or acquisition. If the failure to satisfy the 100-employee limitation is due to an acquisition, disposition or similar transaction involving the employer, then the grace period runs through the end of the year following the year of acquisition or similar transaction. (See When SIMPLE IRA plans aren’t so simple Part 1 for additional guidance on acquisitions involving SIMPLE IRA plans.)

EXAMPLE 1

At the beginning of 2019, Company A employs 75 workers for which it maintains a SIMPLE IRA plan. In response to an expanding client base and increasing demand for products, Company A hires 27 new, full-time workers in July of 2019. Assuming a constant work force and constant salaries, Company A may maintain its SIMPLE IRA plan through 2021. (2019 is considered an eligible year, because eligibility is based on the preceding year. Therefore, the two years immediately following the last eligible year are 2020 and 2021.)

EXAMPLE 2

Assume the same facts as in Example 1, except in 2019 Company A acquires Company B and its 27 full-time workers. Assuming a constant work force and constant salaries, Company A may maintain its SIMPLE IRA plan through 2020. [The grace period runs from 2019 (the year of acquisition) through the end of the year following the year of acquisition.]

Conclusion

Sponsors of SIMPLE IRA plans must understand the ins and outs of the 100-employee limit for eligibility in order to avoid creating excess contributions. The 100-employee limit comes with a grace period that can be tricky to apply.

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When SIMPLE IRA plans aren’t so simple Part 1 Mergers and Acquisitions

Following an acquisition, can a business owner continue to offer both a SIMPLE IRA and a 401(k) plan at the same time?

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Texas is representative of a common inquiry related to savings incentive match plans for employees (SIMPLE) IRA plans. The advisor explained: “A CPA that I network with had a small business client that maintained a SIMPLE IRA plan. The CPA’s client purchased another business in 2018 via a stock acquisition. The acquired business brought with it a 401(k) plan.”

Highlights of the Discussion

Because of the circumstance (i.e., an acquisition) an exception to the “exclusive plan rule” for SIMPLE IRA plans applies.  Among the employer eligibility rules for maintaining a SIMPLE IRA plan is the exclusive plan rule. In general, a single employer may not maintain a SIMPLE IRA plan in the same calendar year it maintains any other type of qualified retirement plan.[1]

In the situation noted above, the merger of the two businesses results in one employer with two plans (a 401(k) and SIMPLE IRA plan) during the same calendar year. Fortunately, a temporary exception to the exclusive plan rule is available. The temporary exception allows the merged businesses to maintain another plan in addition to the SIMPLE IRA plan during the year of merger or acquisition, and the following year as long as, only the original participants continue in the SIMPLE IRA plan (See Q&A B-3(2) of IRS Notice 98-4).

Let’s use this situation as an example. The ownership change occurred in 2018. The SIMPLE IRA plan can be maintained in 2018 and through 2019, along with the 401(k) plan, without running afoul of the exclusive plan rule. Before 2020, however, either the SIMPLE IRA plan or the 401(k) must be terminated.

Conclusion

Acquisitions and mergers involving multiple retirement plans can complicate SIMPLE IRA plan operations due to the exclusive plan rule. It is important to be aware of the transition rule in these scenarios.

[1] Another plan would include a defined benefit, defined contribution, 401(k), 403(a) annuity, 403(b),  a governmental plan other than a 457(b) plan, or a SEP plan.

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Annuity provider selection safe harbor for defined contribution plans

“Has the Department of Labor (DOL) issued guidance on how to prudently select annuity providers for a defined contribution (DC) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.  A recent call with a financial advisor from Massachusetts is representative of a common inquiry related to annuities within defined contribution plans.

Highlights of the Discussion

Yes, the DOL has described a five-step, “safe harbor” procedure for plan sponsors and their advisors to follow in order to satisfy their fiduciary responsibilities when selecting and monitoring an annuity provider and contract for benefit distributions from DC plans. (Note: The DOL is contemplating proposed amendments to the annuity selection safe harbor related to the assessment of an annuity provider’s ability to make all future payments.)

According to DOL Reg. 2550.404(a)-4, issued in 2008, and as further clarified by DOL Field Assistance Bulletin 2015-02, in order to satisfy the safe harbor selection process a plan fiduciary must

  1. Engage in an objective, thorough and analytical search for the purpose of identifying and selecting providers from which to purchase annuities;
  2. Appropriately consider information sufficient to assess the ability of the annuity provider to make all future payments under the annuity contract;
  3. Appropriately consider the cost (including fees and commissions) of the annuity contract in relation to the benefits and administrative services to be provided under such contract;
  4. Appropriately conclude that, at the time of the selection, the annuity provider is financially able to make all future payments under the annuity contract and the cost of the annuity contract is reasonable in relation to the benefits and services to be provided under the contract; and
  5. If necessary, consult with an appropriate expert or experts for purposes of compliance with these provisions.

The safe harbor rule provides that “the time of selection” means:

  • the time that the annuity provider and contract are selected for distribution of benefits to a specific participant or beneficiary; or
  • the time that the annuity provider is selected to provide annuities as a distribution option for participants or beneficiaries to choose at future dates.

The fiduciary must periodically review the continuing appropriateness of the conclusion that the annuity provider is financially able to make all future payments under the annuity contract, as well as the reasonableness of the cost of the contract in relation to the benefits and services to be provided. The fiduciary is not, however, required to review the appropriateness of its conclusions with respect to an annuity contract purchased for any specific participant or beneficiary.

Conclusion

Similar to selecting plan investments, choosing an annuity provider for a DC plan is a fiduciary function, subject to ERISA’s standards of prudence and loyalty. One way to satisfy this fiduciary responsibility is to follow the DOL’s safe harbor selection process as outlined in DOL Reg. 2550.404(a)-4 and Field Assistance Bulletin 2015-02.

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Correcting governmental 457(b) plans

“Does the IRS have a correction program that covers 457(b) plans for governmental employers under the Employee Plans Compliance Resolution System (EPCRS)?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Ohio is representative of a common inquiry related to correcting 457(b) plan errors.

Highlights of the Discussion

Effectively, yes. The two avenues of correction for governmental 457(b) plans are 1) self correction (without a submission); and 2) voluntary compliance (VC) with a formal submission. The IRS accepts VC submissions for governmental plans on a provisional basis under standards that are similar to EPCRS, but that are, technically, outside of the correction system. Qualifying governmental entities are listed in Internal Revenue Code (IRC) § 457(e)(1)(A), and include a

  • State;
  • Political subdivision of a state (e.g., a county, city, town, township, village or school district); and
  • Any agency or instrumentality of a state or political subdivision of a state.

Sponsors of governmental 457(b) plans may self-correct their plans without a formal IRS submission if they did not comply with the Internal Revenue Code (IRC) or regulations in some way. A sponsor has until the first day of the plan year that begins more than 180 days after the IRS notifies it of the failure (IRC Section 457(b)(6) and Treasury Regulation Section 1.457-9(a)). Considering the amount of time governmental entities have to self-correct plan errors, they may not need to make voluntary submissions to the IRS under the following procedures.

The IRS will accept VC submissions for some errors related to 457(b) plans for governmental employers (see Section 4.09 of Revenue Procedure 2016-51 through 2018 and Section 4.09 of Revenue Procedures 2018-52 effective January 1, 2019.) Note, however, the IRS, generally, will not address any issues 1) related to the form of a written 457(b) plan document; nor 2) problems associated with top-hat[1] plans of tax-exempt entities. However, the IRS may consider a submission where, for example, the top hat plan was erroneously established to benefit the entity’s nonhighly compensated employees and the plan has been operated in a manner that is similar to a qualified plan.

The IRS’s VC unit retains complete discretion to accept or

or reject any requests for correction approval. If accepted, VC will issue a special closing agreement.

The steps to voluntary correction are

  1. Complete IRS Form 8950, Application for Voluntary Correction Program (VCP).
  2. Compose a cover letter that describes the problem and includes a proposed solution.
  3. Mail both the form and cover letter to the address listed in the instructions to Form 8950.

Sponsors will receive IRS Letter 5265 acknowledging the submission along with a control number for reference.

Conclusion

The IRS has two avenues of correction for governmental 457(b) plans: self correction without a submission; and voluntary compliance with a submission. Sponsors can refer to IRS Form 8950 and its instructions, along with Revenue Procedure 2016-51 through 2018, and 2018-52 beginning in 2019 for complete details.

 

[1] Nongovernmental 457(b) “Top Hat” plans must limit participation to groups of highly compensated employees or groups of executives, managers, directors or officers. The plan may not cover rank-and-file employees.

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Deferral election timing for the self employed

“Several of my clients are self-employed and have 401(k) plans. What is the date by which a self-employed individual must make his or her salary deferral election?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Nevada is representative of a common inquiry related to 401(k) plan salary deferral elections.

Highlights of the Discussion

Special rules regarding salary deferral elections apply to self-employed individuals (e.g., sole proprietors or partners). They must make their cash or deferred elections no later than the last day of their tax year (e.g., by December 31, 2018, for a 2018 calendar tax year). The timing is connected to when the individual’s compensation is “deemed currently available” [see Treasury Regulation Section (Treas. Reg. §) 1.401(k)-1(a)(6)(iii)].

Often a self-employed individual’s actual compensation for the year is not determined until he or she completes his or her tax return, which, in most cases, is after the end of the partnership or individual’s taxable year. However, the IRS deems a partner’s compensation to be currently available on the last day of the partnership taxable year and a sole proprietor’s compensation to be currently available on the last day of the individual’s taxable year. Therefore, a self-employed individual must make a written election to defer compensation by the last day of the taxable year associated with the partnership or sole proprietorship.

EXAMPLE

A partner can make a cash or deferred election for a year’s compensation any time before (but not after) the last day of the year, even though the partner takes draws against his/her expected share of partnership income throughout the year.

There are also special rules that address when salary deferrals for self-employed individuals are treated as made to the plan (versus when they may actually be made). Treas. Reg. §1.401(k)-2(a)(4)(ii) states that an elective contribution made on behalf of a partner or sole proprietor is treated as allocated to the individual’s plan account as of the last day of the partnership or sole proprietorship’s taxable year.

With respect to the DOL’s deferral deposit deadline, deferrals for self-employed individuals must be deposited as soon as they can be reasonably segregated from the business’s general assets. The DOL’s safe harbor for plans with fewer than 100 employees also applies. Therefore, as long as the deferrals are transmitted within seven business days after the amounts are separated from the business’s assets, the contributions are deemed timely made.

From the IRS’ tax perspective, in no event can the deferrals be deposited after the deadline for filing the business’s tax return, plus extensions.

Conclusion

With respect to making a salary deferral election, a self-employed individual must do so no later than the last day of his or her tax year. The election should be documented in writing for proof in the event the plan later undergoes an audit. Therefore, those self-employed individuals following a calendar tax year must be sure to execute their written deferral elections by December 31, 2018!

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What is a Long-Term Incentive Plan?

“My client says she has a Long-Term Incentive Plan (LTIP). What is an LTIP, and is it a type of qualified retirement plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from New York is representative of a common inquiry related to compensation programs.

Highlights of the Discussion

A Long-Term Incentive Plan or LTIP is a type of compensation incentive program designed to reward executives for achieving the sponsoring company’s strategic objectives while maximizing shareholder value. It in not an IRC Sec. 401(a) qualified retirement plan [e.g., profit sharing or 401(k)], but rather, a way of compensating executives for reaching specified company performance goals.

An LTIP may be one components of a senior executive’s pay package, which may include:

  • Base salary;
  • Performance based annual incentive (e.g. annual bonus);
  • Performance based long-term incentive;
  • Benefits (e.g., Social Security, Medicare, Workers Compensation, and Unemployment Insurance, life and health insurance, 401(k), defined benefit, nonqualified deferred compensation plans, etc.);
  • Executive perquisites or “perks” (e.g., drivers to and from work, convenient parking, installation of home communications systems, financial planning, use of company airplanes for personal travel, etc.) and/or
  • Contingent Payments (e.g., payments to executives in the case of involuntary termination resulting from a merger or acquisition).

According to the Center for Executive Compensation, an LTIP can take the form of stock-based compensation, such as stock options, restricted stock, performance shares, cash, or stock-settled performance units. Usually, LTIPs are a mix of types of equity and may include a cash component. The performance period for an LTIP typically runs between three and five years. The executive does not receive any pay from the incentive program until the end of the performance period and the performance measure is met. Long-term incentive goals vary by company but the most prevalent are focused on Total Shareholder Return (TSR), operational measures such as earnings per share and return measures, such as return on assets.

Conclusion

An LTIP is a general name for a type of compensation for executives, the form of which may vary, depending on the company’s specific pay program. An LTIP can have material impact on an investment client’s overall finances. Therefore, reviewing the documentation associated with such arrangements and understanding their impact can go a long way to achieving a client’s goal of financial wellness.

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