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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