ERISA Advisory

November 2, 2009

What to watch for at year-end. The end of 2009 brings some important deadlines for retirement and deferred compensation plans. Employers should take particular note of the following:

  • Qualified plans must be amended by the end of the plan year beginning in 2009 to comply with the Pension Protection Act of 2006 (PPA’06). PPA’06 provisions were effective at various dates ranging from 2006 through 2008, but no plan amendments were required until now. There is some leeway in drafting them (as IRS guidance is not yet complete): All that is necessary is a good faith attempt to reflect the revised statute and regulations in the terms of the plan. Any imprecise language can be corrected when the plan gets its next IRS determination letter.
  • As of the beginning of the 2010 plan year, §403(b) plans must have written documents in place that accurately reflect all legal requirements. In the past, a §403(b) plan’s tax status was unaffected by the quality of its documentation, and some plans had no documents at all beyond the annuity contracts purchased for participants. New IRS regulations have ended that era. In principle, documents will in the future have to be completely accurate, though the IRS has announced that it will establish a determination letter program similar to the current one for qualified plans, presumably including a remedial amendment period.
  • Year-end is also the deadline for amending performance-based compensation arrangements to bring them into line with the current IRS position on §162(m). Last year, the IRS, reversing what it had said for years in private letter rulings, held in Revenue Ruling 2008-13 that plans that pay out automatically on such events as retirement or involuntary termination are not exempt from the $1 million deduction limit for the compensation of a publicly held company’s highest paid executives. Under a transition rule, plans may be modified to eliminate improper distribution events, so long as action is taken by December 31, 2009.
  • A few plans will have to comply with the Federal Trade Commission’s (FTC) “red flags rule,” designed to hamper identity theft, which became effective on November 1, 2009. The rule requires financial institutions and creditors to establish written policies for detecting and countering attempts by recipients of credit (very broadly defined) to misrepresent who they are. The written policies must then be followed up by appointing a high-level compliance officer, training personnel, and periodically reviewing the policies’ effectiveness. The FTC has, happily, exempted most qualified and §403(b) plans, but the exemption is available only if participants borrow from their own accounts. A few plans, particularly defined benefit (DB) plans, treat participant loans as general plan investments; that is, in fact, the only route available to DB plans. They will need to abide by the “red flags rule” and should act promptly to put the necessary framework in place. The FTC’s website has guidance at The commission is expected to be fairly lenient about enforcement for at least the next several months, but it does have the authority to impose fines of up to $300,000 for non-compliance.

What employers need to know about §436. The IRS published final regulations (Federal Register, 10/15/09) interpreting one of the most pitfall-strewn provisions of the PPA’06, the new I.R.C., §436.

The principal beneficiary of the section’s protection is the Pension Benefit Guaranty Corporation (PBGC). The PBGC insurance fund, which covers most private sector pension benefits, has long been in serious financial trouble. A major goal of the PPA’06 was to minimize the possibility of an eventual tax-funded bailout. One means to that end was limiting the growth of liabilities in poorly funded defined benefit plans and keeping their assets intact. On the liability side, the law takes aim at unfunded benefit increases and, in extreme cases, mandates the cessation of benefit accrual. With regard to assets, it limits lump sum distributions and payments of shutdown benefits.

Two levels of restrictions apply to most companies, with a third for those in bankruptcy proceedings:

  1. If a plan is less than 60% funded, all benefit accruals must be frozen, “accelerated benefit distributions” (primarily lump sums, though some other forms of benefit may be affected, too) are prohibited, and no benefits may be paid that are contingent on “unpredictable events” (a circumlocution for enhanced benefits arising from plant shutdowns and reductions in force).
  2. If the funding level is at least 60% but less than 80%, amendments that increase benefits cannot be implemented. Accelerated distributions are permitted, but only to the extent of half the actuarial value of the benefit. The balance may be paid no more rapidly than under a life annuity option.
  3. If the employer is in bankruptcy proceedings, accelerated distributions are barred unless the plan’s funding level is at least 100%.

The rules for calculating how well a plan is funded (its “adjusted funding target attainment percentage” or “AFTAP”) are the concern of its actuary. From the employer’s point of view, AFTAP comes out of a “black box.” What employers do have to be concerned about is when the calculation is performed and what effects it has.

In principle, most plans’ AFTAP is determined as of the first day of the plan year (there are exceptions, rarely used, for small plans). If it were practicable, the plan’s actuary would certify the funding level on that day. Any required restrictions would then go into effect and would continue until the start of the next year, when AFTAP would be certified for the new year.

In the real world, there is, inescapably, an interval between the first day of the year and the AFTAP certification. During that time, the preceding year’s AFTAP (and any corresponding restrictions) carry over, with modifications as the delay in calculating the real AFTAP grows longer:

  • For the first three months of the year, AFTAP is presumed to be the same as last year.
  • For the following six months (through the end of September for a calendar year plan), AFTAP is presumed to be 10 percentage points lower than it was for the preceding year.
  • At the start of the 10th month of the year, the plan is presumed to be less than 60% funded and becomes subject to all of the restrictions associated with that status. In this case, the restrictions remain effective for the rest of the plan year, even if the actuary furnishes a belated certification.

There is one exception: When an amendment increasing benefits would take effect or an event occurs that triggers shutdown benefits, and the carryover AFTAP does not require any restrictions, the plan’s actuary must perform an estimated calculation to see whether the new benefit or event will take the plan’s funding below the crucial level (80% for amendments, 60% for shutdown benefits). If it does, the increase cannot take effect or the shutdown benefits cannot be paid.

As one would expect, the presumptions yield to an AFTAP certification. Restrictions may then appear or disappear, except that, as already noted, a certification that is delayed until the last quarter of the plan year can’t negate any restrictions until the next year begins. With a handful of exceptions that don’t require discussion here, any change is effective only for the period after the certification is delivered by the actuary to the employer.

The timing of the AFTAP certification is ultimately within the employer’s control. The plan’s actuary is under no compulsion to issue it as soon as the valuation work is completed. Suppose, for example, that a plan was 90% funded in 2009. Under the presumptions, no restrictions will apply during the first nine months of the 2010 plan year. What if the actuary finishes the valuation in March and discovers that the new AFTAP is 75%? The employer may, if it wishes, postpone the AFTAP certification until the very end of the third quarter, allowing lump sums to continue to be paid during that period, benefit increases to go into effect, etc. Of course, it is important not to wait longer than that, since all of the restrictions descend on the plan if there is no certification before the beginning of the tenth month.

Contrariwise, the employer might wish to expedite the certification if the plan’s AFTAP has increased and restrictions will be removed once it is certified. There is a risk, though, in rushed work. If an erroneous certification leads to the mistaken imposition or non-imposition of restrictions, the plan’s qualified status may be jeopardized, necessitating a perhaps expensive trip through the IRS’s Employee Plans Compliance Resolution System to avoid the disaster of disqualification.

If §436 restrictions come into play, they can often be prevented by either making an additional contribution to the plan, above and beyond the minimum funding requirement, or waiting until the plan is better funded and then restoring lost benefits retroactively. There is no easy escape, however, from the restrictions on accelerated distributions. If they become applicable, a plan that is funded in the 60% to 80% range may pay out no more than half the value of a benefit as a lump sum and the remainder as an annuity (it is not, however, required to offer a partial lump sum as a form of benefit). Plans that are less than 60% funded may not pay even partial lump sums. All that a participant who wants a full lump sum can do is postpone taking a distribution. The plan must allow delayed commencement in these circumstances, but not indefinitely. Benefits must begin by April 1 following the year in which the participant reaches age 70½ (or retires, if that is later and he doesn’t own 5% or more of the employer).

The interest rates used to calculate lump sum cashouts are expected to rise over the next few years (and the cashouts therefore to decrease), owing both to market conditions and the effect of the PPA’06 transition rules. Obviously, then, participants who retire in the near future will be unhappy if lump sums are unavailable right away.

IRS official says that deferred compensation plans may get “one last chance” to bring documents into compliance with §409A. Speaking recently at an American Bar Association meeting, IRS Senior Counsel, Stephen Tackney, stated that the agency is considering a program under which employers will be allowed to correct provisions in their nonqualified deferred compensation plans that violate §409A, such as distribution triggers other than those permitted by the statute and regulations. Those who take advantage of this opportunity will most likely have to disclose their actions to the IRS. There was no mention of when the program would start or how long it would be open.

An announcement at this level normally portends something real. If that is the case here, it will be excellent news for companies that failed to vet their plan documents thoroughly before the December 31, 2008 deadline or that have discovered errors since then. We await further developments.

Department of Labor (DOL) responds to queries about new Form 5500 compensation reporting rules. The DOL has posted a supplemental series of questions and answers concerning the reporting of indirect compensation on the revised Form 5500, Schedule C ( The greatly expanded reporting requirements apply to Form 5500’s for plan years beginning in 2009. While those reports are not due until July 31, 2010 at the earliest, data gathering already needs to be (but often isn’t) in progress. Aside from providing guidance on a number of thorny issues raised by the DOL regulations and Form 5500 instructions, the new posting assures employers that they will not be penalized for failing to furnish information that is not reasonably available, though explanations for the lacunae will be necessary. One significant substantive point is that investment funds that are exempt from ERISA’s fiduciary standards solely because less than 25% of their assets are attributable to benefit plan investors will not be ignored for Schedule C reporting purposes. Hence, someone will have to figure out whether and how to report indirect compensation (including such items as investment reports, seminars, meals, holiday gifts, etc.) that they give to plan sponsors’ employees and other service providers.

Plan administrator has no right to deny validity of participant’s divorce, court rules. Cases like Brown v. Continental Airlines (S.D. Texas, 10/19/09) won’t arise often but could be important when they do. Several airline pilots were worried that their employer would go into bankruptcy and terminate its pension plan. The plan was underfunded, so termination would entail a PBGC takeover. The pilots’ accrued benefits were well above the PBGC’s maximum guarantee, so they faced the prospect of a large cutback.

To counter that risk, the pilots divorced their wives, who were then awarded 100% of the airline pensions in property settlements. They then presented the plan administrator with facially proper qualified domestic relations orders. The QDRO’s allowed the ex-spouses to take immediate lump sum distributions (which the pilots themselves couldn’t have done until separation from service). Once the money was in hand, the parties remarried.

As it happened, the plan did not terminate, so the maneuver was unnecessary. The airline nonetheless was annoyed (and perhaps concerned about setting a precedent), so it sued to compel the return of the distributions to the plan. The court refused, holding that the validity of a divorce is a matter for state law and may not be reviewed independently by the plan administrator. It rejected as patently circular the airline’s contention that honoring a QDRO stemming from a sham divorce violates the rule that an order may “not require a plan to provide any type or form of benefit, or any option, not otherwise provided under the plan.” The payment is improper only if one assumes that a QDRO cannot be issued to parties who intend to remarry; that is, however, the question to be decided, not the premise for devising an answer.

Eccentric as the facts may appear, this decision, if upheld on appeal, could become important. As noted in another article, I.R.C. §436 limits the ability of underfunded plans to make lump sum distributions. Participants who anticipate that their plans will soon become subject to that restriction may be tempted to imitate the Continental pilots and arrange for their temporary ex-spouses to pull out their benefits before the fatal AFTAP certification is issued. The scheme won’t work for everybody: A QDRO payee cannot demand a lump sum distribution unless the participant has either separated from service or is at least 50 years old. There is also a risk: If the distribution is rolled into the ex-spouse’s IRA (to avoid an immediate income tax bite), it belongs to her. Should the parties later get a real divorce, the participant will have to fight to get anything back.

Plan administrators who doubt the bona fides of ostensible divorces are short of remedies. A plan probably lacks standing to intervene in state court, and there is no obvious federal recourse. It would, in any event, be difficult and invidious to investigate the intentions of the parties.