ERISA Advisory

Supreme Court rejects "one strike and out" rule for deference to plan administrator's decisions. In Conkright v. Frommert (4/21/10), a divided court (5 to 3, with Justice Sotomayor recusing herself) refused to narrow further the circumstances under which interpretations of plan terms are entitled to deferential review. The majority held that the mere fact that the plan administrator's initial position was "arbitrary or capricious" did not change the standard of review for its second attempt to find the right answer. The plaintiffs and the US Department of Labor (DOL) had argued for a different rule; namely,  that deference was discretionary with the court if the administrator was wrong the first time.

The case arose from Xerox Corporation's (Xerox) floor/offset pension plan. This relatively rare design consists of a defined benefit pension plan operating in conjunction with an individual account plan. Participants accrue benefits under the pension plan and contributions under the individual account plan. Upon retirement, they receive their account balances in the latter plan. To that is added a pension benefit equal to the actuarial value of the accrued benefit minus the account balance. If the individual account is more valuable than the pension, there is no pension benefit. In effect, then, the pension plan provides a floor benefit to protect participants against investment losses, while leaving them free to reap any gains.

The Xerox plan had a drafting flaw: It did not describe fully what would happen if a participant separated from service, received a distribution, and then returned to employment. It was clear that a person's prior service would be taken into account in calculating his/her pension benefit and that he/she would begin accumulating a new individual account. What the plan did not cover was how the prior distribution would affect future benefits. Ignoring it would give reemployed participants a windfall, since they would receive a pension based on total service while the individual account offset would reflect only contributions during the most recent period of employment.

The plan administrator's solution was to add to the actual balance in the individual account a "phantom account" equal to the amount distributed in the past plus the earnings (or losses) that would have accrued if the distribution had remained in the plan. The plan document had once stated this rule explicitly, but it had been dropped from the text, perhaps inadvertently, by the time the plaintiffs retired. They brought suit, seeking to have the phantom accounts removed from their benefit calculations.

A district court applied the "Firestone rule": A plan administrator's (in this instance, the employer's) interpretation of the terms of the plan must be upheld unless it is "arbitrary or capricious." The court granted summary judgment for Xerox but was reversed by the 2^nd Circuit, which held that absence from the plan document made the phantom account an arbitrary or capricious device. An offset was permissible, the court said, but not one so unintuitive and potentially dramatic in its impact.

The case went back to the district court, where Xerox offered a new method of determining the offset. In place of the phantom account, it would add interest at a market rate to the prior distribution. It is hard to imagine that any judge could regard that methodology as arbitrary, capricious or otherwise objectionable, but the court decided that it no longer had to be deferential. Instead, it fashioned its own remedy, under which the offset would be the amount of the prior distribution without interest. The appeals court subsequently upheld the decision, saying that the plan administrator was entitled to no deference and the lower court had not abused its discretion.

As a further complication, a different appeals court, hearing a case involving the same plan and the same issue but different plaintiffs (Miller v. Xerox Corporation Retirement Income Guarantee Plan (9^th Cir., 2006), rejected the "phantom account" in favor of a methodology very like that proposed by Xerox the second time around in Conkright.

Thus the case reached the Supreme Court, where the Chief Justice for the majority and Justice Breyer for the dissenters batted back and forth cases and treatises regarding the powers of private trustees. The majority's conclusion was that there is no solid support in trust law (on which this aspect of ERISA is modeled) for a rule that removes deference after a single error and much reason for not "creating ad hoc exceptions to Firestone deference." The court found little merit in apprehension "that continued deference would encourage plan administrators to adopt unreasonable interpretations of plans in the first instance, as administrators would anticipate a second chance to interpret their plans if their first interpretations were rejected," an argument that assumes bad faith in the private sector. Rather, "efficiency, predictability, and uniformity" weighed in favor of giving the plan administrator another chance, with the caveat that repeated capriciousness would justify bringing deference to an end.

The disposition by the lower courts should have made this an easy decision. Whatever the intricacies of trust law, requiring the plan to ignore the time value of money was without basis. The dissent makes an attempt to defend it, but the case should have been remanded to fashion a more reasonable remedy.

IASB publishes revised proposal for accounting for pension plans. IAS 19, the international counterpart to the US's FAS 158, will, when issued in final form, govern how companies subject to international financial reporting standards disclose the effect of pensions and other post-employment benefits on their financial statements. US-based companies also have reason to be interested, given the strong likelihood that Generally Accepted Accounting Principles (GAAP) reporting will converge with International Financial Reporting Standards (IFRS) in the not-too-distant future.

The general reaction of pension actuaries is that, compared to current IFRS and GAAP, the latest exposure draft of IAS 19 (4/29/10) would make pension expense more volatile, because it would no longer be possible to "smooth" the effects of gains or losses arising from favorable or unfavorable experience, investment performance, changes in actuarial assumptions, or plan amendments. The effect on profit-and-loss statements would be muted, however, as most of the year-to-year changes would be reported as "other comprehensive income" rather than flowing directly into P&L.

Some of the new rules would tend to increase pension expense, at least in the short run: A change in the handling of interest assumptions would effectively prevent plan actuaries from assuming a rate of return on plan assets in excess of the plan's discount rate, and expected future plan administration costs would have to be factored in to the calculation of the value of plan liabilities. In each case, the higher expense would tend to reverse in the long run, since delaying the recognition of income and accelerating the recognition of costs doesn't ultimately make benefits more expensive to provide.

The International Accounting Standards Board (IASB) initiative that will be most visible to users of IAS 19 reports is the expansion of disclosure requirements to include more detailed information about the characteristics of pension plans and their investment portfolios, plus a sensitivity analysis of the effect of key actuarial assumptions, a description of factors that might lead to significant deviations between contributions and service costs, and other data designed to enhance transparency.

The exposure draft is open for comments through 9/6/10. The IASB's announced intention is to adopt a final version in mid-2011, with a 1/1/13 effective date.

"One-participant" plans face new Form 5500 filing rules. The term "one-participant plan" is among the worst of ERISA misnomers. It refers to a plan that covers only self-employed individuals (including shareholders in LLCs), or only the sole owner of a corporation, and their spouses. Some "one-participant plans" have hundreds or thousands of participants.

As part of its overhaul of Form 5500 reporting, the DOL changed the reporting requirements for these plans. For plan years beginning before January 1, 2009, a one-participant plan was excused from filing Form 5500 with the DOL if, and only if, it was not combined with any other plan for "nondiscrimination" testing purposes and the employer neither was a member of a controlled group nor used the services of leased employees. Plans exempted from Form 5500 reporting did, however, have to file a report with the IRS, Form 5500-EZ, if their assets exceeded $250,000.

In practice, almost all of the plans that qualified for Form 5500-EZ were maintained by sole proprietorships, one-employee corporations, or very small partnerships. Starting in 2009, that situation will change because the DOL has dropped the limitations on Form 5500-EZ eligibility. That form may now be filed by any one-participant plan. Plans with fewer than 100 participants may opt instead to file Form 5500-SF, a cut-down version of Form 5500. Somewhat oddly, Form 5500-EZ is the only choice for larger plans.

Form 5500-EZ is in many ways superior, from the employer's point of view, to Form 5500:

• It is simple, requiring only basic information about the plan and plan assets. In particular, it does not include Form 5500's Schedule C, reporting direct and indirect payments to service providers.
• It is not open to public inspection and is not posted on the DOL's website.
• It does not have to be (in fact, cannot be) filed electronically.
• The penalty for late filing is $25 a day, up to a maximum of $15,000, much lower than the DOL's $50 a day with no cap (more if the DOL discovers the non-filing before the employer complies voluntarily). The IRS is also less reluctant than the DOL to abate penalties. (There are, however, relatively rare cases in which the DOL's Delinquent Filer Voluntary Compliance Program results in lesser penalties than the IRS would impose.)

Some partnerships and LLCs may want to consider spinning the partners off to a separate plan in order to take advantage of simpler reporting, particularly the exemption from public disclosure.

As a small complication, the IRS is months behind schedule in releasing the 2009 Form 5500-EZ. Presumably, the form will appear by the August 2, 2010, filing deadline for calendar year plans. In the meantime, the 2008 form with appropriate modifications, may be used by plans with short years and earlier filing dates.      

Also noteworthy: The Pension Benefit Guaranty Corporation has published its annual report for the year ended 9/30/09, showing a near doubling of its single-employer insurance program's deficit, from $11.2 billion to $21.9, since the end of 2008. Exposure to "reasonably possible losses" stood at $168 billion, up by $47 billion. . . . In Overby v. National Association of Letter Carriers (DC Cir., 2/26/10), an appeals court invalidated a plan amendment. The employer had neglected to obtain a cost estimate from the plan actuary, as required by the amendment procedure set forth in the plan document. That was a fatal defect, even though there was no showing of bad faith or evidence that the actuarial work would have served any useful purpose. . . . Stephens v. US Airways Group (D.D.C., 3/17/10) held that a pension plan did not have to add interest to lump sum distributions paid within 45 days after participants' benefits would otherwise have commenced. . . . In Field Assistance Bulletin 2010-1 (2/27/10), the DOL discussed the conditions for avoiding ERISA coverage of §403(b) plans that provide for contributions only through salary reduction. Of particular note is the statement that the ERISA exemption is not necessarily lost where the plan has only one investment provider, so long as that provider offers a suitably broad range of investment options. Maintaining the exclusion is more important than before, owing to the expansion of Form 5500 reporting requirements for §403(b) plans. At the same time, changes in the tax rules have made multiple vendors more burdensome for employers.