INVESTMENT ISSUES

Investment issues are among the most complex and significant issues relating to employee benefit plans, involving the fiduciary relationship of plan sponsors to participants and beneficiaries, as well as larger issues of public policy. In this section, some basic rules and some of the more frequently occurring investment issues are discussed.

Fiduciary Requirements of ERISA and the Internal Revenue Code

A relationship in which one person holds and administers money or property belonging to another is legally described as a fiduciary relationship. A funded employee benefit plan, therefore, involves fiduciary relationships—plan assets are held by a trustee or insurance company, under the direction of the employer, on behalf of plan participants and beneficiaries. The rules governing fiduciary relationships are generally a subject of state law; however, in the case of qualified plans and other employee benefit plans, federal law (primarily ERISA) has superimposed specific federal fiduciary requirements that supersede state law where applicable. The federal requirements are usually stricter than the superseded state law requirements. While these rules are applicable to most employee benefit plans, they have their greatest impact on qualified pension and profit-sharing plans because welfare-benefit plans are typically insured or unfunded, although the use of funded welfare-benefit plans is increasing.

The fiduciary requirements were not intended as a helpful guide for employers and trustees in administering qualified plans. They do not spell out the specific responsibilities of each person involved in designing and maintaining the plan. Rather, the rules are intended to spread a net of liability over various persons involved with the plan, aimed at maximizing the protection of participants and beneficiaries. Thus, there are not always simple rules explaining how employers, trustees, and other persons should act with regard to qualified plans; rather, they must be aware of their fiduciary responsibilities and do their best to comply with them or avoid them.

The definition of fiduciary is broad enough to include the employer, the plan administrator, and the trustee. It also includes a wide variety of other possible targets. However, the government has stated that an attorney, accountant, actuary, or consultant who renders legal, accounting, actuarial, or consulting services to the plan will not be considered a fiduciary solely as a result of performing those services. Also, labor regulations exclude broker/dealers, banks, and reporting dealers from being treated as fiduciaries simply as a result of receiving and executing buy-sell instructions from the plan. Furthermore, a person giving investment advice will be considered a fiduciary only with respect to the assets covered by that investment advice.

Every plan must specify a named fiduciary in the plan document. The purpose of this requirement is not to limit liability to named persons, but rather to provide participants and the government with an easy target in case they decide to take legal action against the plan. Of course, other unnamed fiduciaries can also be included in the legal action.

The duties of fiduciaries specified in the law are primarily of an investment nature. According to ERISA Section 404, a fiduciary must do the following:

• Discharge duties with respect to a plan solely in the interest of the participants and the beneficiaries

• Act for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying the reasonable expenses of administering the plan.

• Act with the care, skill, prudence, and diligence under the prevailing circumstances that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims

• Diversify the investments of the plan to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.

• Follow the provisions of the documents and instruments governing the plan, unless inconsistent with ERISA provisions

In interpreting the prudent-man requirement, labor regulations indicate that the fiduciary must, in making an investment, determine that the particular investment is reasonably designed as part of the plan's portfolio to further the purposes of the plan. The fiduciary must consider (1) the composition of the portfolio with regard to diversification, (2) the liquidity and current return of the portfolio relative to the anticipated cash flow requirements of the plan, and (3) the projected return of the portfolio relative to the funding objectives of the plan.

A major exception to the diversification requirement applies to holdings of employer securities and employer real property. An eligible individual account plan (a profit-sharing, stock bonus, or employee stock ownership plan that specifically permits the holding of employer real property or qualifying employer securities) may hold such property in any amount, and may even hold such property as the exclusive assets of the plan. Other plans can hold such property only up to the extent of 10 percent of the fair market value of the plan assets. The purpose of this exception is, of course, to encourage the adoption of employer stock plans of the type. A qualifying employer security means employer stock or marketable debt obligations meeting the various requirements of ERISA Section 407. Employer real property is real property owned by the plan and leased to the employer, again under limitations set out in ERISA Section 407.

Fiduciaries can delegate fiduciary responsibilities and, therefore, avoid direct responsibility for performing the duty delegated. For example, the employer can delegate duties relating to the handling and investment of plan assets to a trustee, and investment management duties can be delegated to an appointed investment manager. The plan must provide a definite procedure for delegating these duties. The delegation of a fiduciary duty does not remove all fiduciary responsibility. A fiduciary will be liable for a breach of fiduciary responsibility of any other fiduciary under certain circumstances.

The broad scope of the fiduciary liabilities indicates that, in addition to careful delegation of fiduciary duties to well-chosen trustees and advisers, the employer should take care that its liability insurance coverage adequately covers any liabilities that might arise out of the fiduciary responsibility provisions. ERISA specifically prohibits a plan from excusing or exculpating any person from fiduciary liability, but individuals and employers are permitted to have appropriate insurance and employers can indemnify plan fiduciaries.

Prohibited Transactions

In addition to the general fiduciary requirements already described, both Code Section 4975 and ERISA Section 406 include a specific list of "don'ts" for employee benefit plans, including qualified plans. Under-these rules, a party-in-interest is forbidden to do any of the following, with a number of exceptions described later:

• Sale or exchange, or leasing, of any property between the plan and a party-in-interest

• Lending of money or other extension of credit between the plan and a party-in-interest

• Furnishing of goods, services, or facilities between the plan and a party-in-interest

• Transfer to, or use by or for the benefit of, a party-in-interest of any assets of the plan

• Acquisition, on behalf of the plan, of any employer security or employer real property in excess of the limits described previously in this chapter

A party-in-interest—the Code uses instead the term disqualified person—is defined very broadly, again to bring the largest possible number of persons into the net to provide the maximum protection for plan participants. A party-in-interest includes the following:

• Any fiduciary, counsel, or employee of the plan

• A person providing services to the plan

• An employer, if any of its employees are covered by the plan

• An employee organization, any of whose members are covered by the plan

• An owner, direct or indirect, of a 50 percent or more interest in an employer or employee organization

• Various individuals and organizations related to those on this list, under specific rules given in Code Section 4975 and ERISA Section 406

Because of the breadth of the prohibited transaction rules, certain specific exclusions are provided in the law, and the IRS and Department of Labor are also given the authority to waive the prohibited transaction rules in certain circumstances.

First, the specific statutory exemptions: Loans to participants or beneficiaries are permitted under the rules. A loan to an ESOP by a party-in-interest is also permitted under certain circumstances to permit the ESOP to function. Similar provisions permit such a plan to acquire employer securities or real property without violating the prohibited transaction rules. Also, the plan is allowed to pay a reasonable fee for legal, accounting, or other services performed by a party-in-interest. There are provisions permitting various financial services to the plan by a bank or insurance company that is a party-in-interest. Other provisions exempt normal benefit distributions from any possible conflict with the prohibited transaction rules.

In addition to the specific statutory exemptions, the Department of Labor has broad authority to grant an exemption to the prohibited transaction rules for a transaction or a class of transactions, after finding that the exemption is administratively feasible, in the interest of the plan and its participants and beneficiaries, and protective of their rights. There are specific administrative procedures for obtaining such exemptions. Pursuant to this authority, the Department of Labor has granted, among others, a class exemption permitting the sale of life insurance policies by participants to the plan or by the plan to participants. Another exemption, PTE84-14, permits a wide variety of transactions by qualified plan asset managers (QPAMs) such as banks and insurance companies. Individual exemptions have been granted for a variety of transactions, usually involving a sale to the plan by a party-in-interest of property that represents a particularly favorable investment opportunity for the plan.

Penalties

A violation of the prohibited transaction rules can result in a two-step penalty under the Internal Revenue Code, with the initial penalty equal to 15 percent of the amount involved, and an additional 100 percent penalty if the transaction is not corrected within a certain period of time. A violation of the prohibited transaction rules can also result in penalties for breach of fiduciary liability.

Unrelated Business Income

The trust fund under a qualified plan and trust funds used in some other self-insured employee benefit plans, such as Section 501(c)(9) trusts, are given a broad exemption from federal income tax similar to that granted to a variety of other institutions and organizations, such as churches, schools, and charities. However, such tax-exempt organizations are subject to federal income tax on unrelated business taxable income according to Code Sections 511-514. Unrelated business taxable income is income of a tax-exempt organization from a trade or business that is not related to the function that is the basis for the tax exemption. For example, if a charitable organization operates a full-time shoe store in a shopping center, the shoe store income would be taxable to the charity. However, the charity's tax exemption for its other income probably would not be jeopardized unless the effect of operating the shoe store was to shift the focus of the organization totally away from its exempt function.

The basic function of an employee benefit plan trust is to receive, invest, and distribute plan funds to participants and beneficiaries. Thus, passive investment income of the plan trust is usually not unrelated business income unless the investment is debt-financed, as described in the next paragraph. Problems sometimes arise in distinguishing passive investments from activities that might be considered a trade or business. The law specifically exempts dividends, interest, annuities, and royalties, as well as rents from real property and from personal property leased with real property. However, the wide variety of possible leasing arrangements indicates that each rental arrangement must be looked at on the basis of its own facts and circumstances. For example, a number of revenue rulings have held that investments in manufacturing or railroad equipment for leasing constituted an unrelated trade or business, even though these leasing arrangements are usually looked on by investors as strictly investment activities. Another revenue ruling, however, allows a qualified plan trust to hold shares in a real estate investment trust without incurring unrelated business taxable income. In short, the possible impact of unrelated business taxable income is an additional factor that must be taken into account by the investment advisers of a benefit plan trust.

Code Section 514 specifies that income from debt-financed property is to be treated by a tax-exempt organization as unrelated business taxable income. However, there is an exception in Section 514(c)(9) for qualified plans holding certain real estate investments that typically are highly leveraged or debt-financed. Therefore, such investments may still be advantageous to a qualified plan, particularly if they provide long-term growth or other benefits.

Investment Policy

The policy baseline for the investment of qualified plan funds is set by the rules previously discussed—the exclusive-benefit rule, the prudent-expert rule, the diversification requirement, liquidity requirements, the plan document itself, and the additional limitations imposed by the prohibited transaction and unrelated business income provisions. Within these constraints, however, a broad range of investment strategies is possible.

Growth-Oriented Strategies

Trustees governed by fiduciary rules aimed primarily at the preservation of principal generally do not follow aggressive, growth-oriented investment strategies, and pension trustees are no exception. However, qualified plan design offers a number of opportunities for incorporating growth-oriented investment strategies without running into fiduciary problems.

Defined-contribution plans can provide that part or all of each participant's account be put in a participant-directed account, with the participant then choosing the investment strategy. This relieves the trustee of liability for that choice if the plan meets requirements of Department of Labor regulations under ERISA Section 404c. Also, defined-contribution plan funds can be invested in pooled accounts of a bank or insurance company that offer participants choices of investment strategies—an equity fund, a fixed-income fund, and so on.

For defined-benefit plans, there is no provision for participant direction of investment; defined-benefit plan funds can be invested in insurance company funds utilizing separate account funding, with a choice by the employer of investment strategies such as equity or fixed income. It is also possible to structure the trust agreement to allow the employer to recommend investments, and the employer can pursue a growth-oriented strategy. In such a case, of course, the employer is still responsible for the adequacy of the pension fund and is subject to full fiduciary liability for its investment recommendations. Finally, there is the possibility of designing a plan to invest primarily in employer securities, which can be viewed as a type of growth-oriented investment strategy.

Risk

Most of the ERISA investment rules can be seen as prescriptions for avoiding risk, particularly the risk of large losses; for example, the requirement for diversification of investments. Within the ERISA limits, however, the qualified plan investment manager, like any investor, must balance risk and return.

Social Effects

According to the Employee Benefit Research Institute,^[1] at the end of 1992, private pension funds (trusted and insured) in the United States totaled about $2.8 trillion, with government-employee funds comprising an additional $1.3 trillion. This is a sizable portion of the nation's capital. If there is any pattern to the investment strategies of qualified plan investment managers, such a pattern is likely to have an effect on the economy and on society. Because so much pension money is held and invested by large institutions such as banks and insurance companies, current pension investment policies largely reflect the views of these organizations. In general, such organizations will tend to invest in conventional ways that support the status quo. The question is often raised whether there is a role in pension investing for active attempts to support a particular social result not dictated merely by market conditions.

Existing legislation and other laws relating to qualified plan investments focus primarily on fiduciary aspects of the relationship between plan managers and participants; they do not address issues of social policy. That is, they encourage investment managers to invest so as to prevent direct losses to participants and beneficiaries, but they do not deal with possible indirect losses that may accrue to participants and beneficiaries as a result of trends in overall pension investment policy that may be contrary to the social and economic interests of plan participants.

Social Investing

In recent years, objections to prevailing pension investment policies have been raised, particularly on behalf of unionized employees in large manufacturing industries. Although these objections are not always clearly stated, four types of arguments can be distinguished. First, it is stated that the usual pension investment policies contribute to the disinvestment in basic manufacturing industries that has been occurring, particularly in certain geographic areas such as the Midwest. This results in the loss of jobs for persons covered under the pension plans, with the attendant economic and social costs, and also in disinvestment in housing and other facilities in communities where plan participants live. Second, it is stated that pension investors can undercut the union movement by investing in nonunionized corporations. Third, pension investment policies allegedly can affect the welfare of workers adversely by investing in corporations that violate health, safety, or nondiscrimination principles. Finally, some object to investing in certain corporations on moral or political grounds (not directly related to the interests of plan participants), such as environmental pollution or weapons production. Although advocates of social investment for union pension funds sometimes make common cause with religious and academic groups who advocate social investment policies for church or university endowment funds, it is clear that on this issue the interests of unionized employees are quite distinct.

A decision by a pension investment manager to pursue a social investment strategy that attempts to avoid one or more of these objections raises a number of issues. The first relates to fiduciary responsibility. Does a social investment strategy result in a lower return on the fund? There are some studies indicating that an investment portfolio of "good guy" investments has a lower return. However, such studies usually choose the "good" investments using a broad range of criteria, so they do not indicate the effects of narrower targeting such as simply excluding nonunion employers. The "efficient markets" theory proposed by some economists would suggest that in the long run an investment strategy based on social investing should have no effect on investment return, so long as investments are sufficiently diversified and the market includes other investors who do not use the same social criteria.

Some social investment advocates suggest that even if the return is lower, the indirect social and economic benefits to plan participants are a compensating factor. However, under current fiduciary law, both state and federal, this argument probably could not protect an investment manager in the event of a lawsuit by a plan participant injured directly by a low return on the fund. Suggestions have been made in Congress to amend federal legislation to permit social investment of various types, but no such provision has yet been enacted. The Department of Labor is reportedly studying the issue, but no regulations or rulings in this area have been issued.

A second problem is, assuming a social investment strategy has been chosen, how does the investment manager evaluate possible investments to determine their compliance with the chosen social criteria? It is currently difficult to identify corporations that meet even such simple criteria as compliance with health and safety legislation. There are various social investment indices available, but these are generally inadequate as guidance in any specific program of social investing. Because of these difficulties, social investing usually involves additional administrative costs.

The pension investment community has generally reacted with some hostility to social investing, with most pension advisers taking the view that any considerations other than the traditional ones of risk and return have no part in pension investment decisions, and that it would be a violation of fiduciary responsibility to use other criteria.

PLAN ADMINISTRATION

Plan administration encompasses a host of clerical and managerial functions related to a plan, including record keeping, receipt and disbursement of funds, claim administration, and investments. The discussion of plan administration will focus on specific obligations imposed by ERISA and the Internal Revenue Code affecting plan administration.

Many of the administrative requirements of the law involve penalties for noncompliance, so it is important to impose these duties on specific individuals or groups of individuals to limit the scope of this liability to a known group. Otherwise, persons involved with the plan might find themselves held responsible for actions over which they may think they have no control. This problem is greatest in the area of investment decisions; therefore, it is important to be as specific as possible in the plan and trust agreement as to who has responsibility for making investment decisions and how these persons are chosen.

Employee Benefit Plans Other than Qualified Plans

Many of the requirements of ERISA apply to a broad range of employee benefit plans as well as to qualified plans. The rules are discussed in detail here because they typically have a much greater impact on qualified plans than on other plans, particularly the fiduciary rules.

The following employee benefit plans (retirement and other) are exempt from the fiduciary and reporting and disclosure requirements of ERISA:

• Government plans

• Church plans (unless they elect to be covered)

• Plans maintained solely to comply with workers' compensation, unemployment compensation, or disability insurance laws

In addition, through regulations issued by the secretary of labor, certain types of plans have been declared not to be employee welfare benefit plans and are thus exempt from the regulations of ERISA. Among these are the following:

• Compensation for work performed under other than normal circumstances, including overtime pay and shift, holiday, or weekend premiums

• Compensation for absences from work due to sickness, vacation, holidays, military duty, jury duty, or sabbatical leave and training programs to the extent such compensation is paid out of the general assets of the employer

• Group insurance programs under which (1) no contributions are made by the employer; (2) participation is completely voluntary for employees; (3) the sole function served by the employer, without endorsing the program, is to collect premiums through payroll deduction and remit the amount collected to the insurer; and (4) no consideration is paid to the employer in excess of reasonable compensation for administrative services actually performed.

Plan Administrator

Any employee benefit plan subject to ERISA is required to name a plan administrator in the plan document. If none is named, the employer is assumed to be the plan administrator. Some employers prefer to designate a plan committee to be the plan administrator. This committee is usually made up of a group of management and sometimes rank-and-file employees responsible for administering the plan. If this is done, the plan should spell out how committee members are to be named, so that there can be no doubt who has the responsibility of plan administrator. Many employers prefer to simply designate the employer as plan administrator, with administration duties delegated to specific employees, usually in the personnel department, in the same manner as other management functions are carried out. Where the plan is funded through an insurance contract, some administrative duties may be carried out by the insurance company for a fee; this is particularly likely for smaller employers where the amount of administrative work involved does not justify the employment of a qualified plan specialist. Often, plan administrators also rely on outside benefit consultants for assistance with various administrative duties.

Claims Procedure

One of the plan administrator's duties is to evaluate employee claims for benefits and to direct the trustee or other fund holder to make payments as appropriate. If the plan is properly drafted, there should be little ambiguity about whether a particular participant or beneficiary is entitled to a plan benefit. However, due to the complexity of many plan provisions, disputes sometimes arise.

Every plan must include a written procedure under which a claimant can appeal the denial of a plan benefit to the plan administrator. There are specific time limits, 60 to 120 days generally, within which the plan administrator must make a decision on the appeal. The purpose for the claims procedure requirement is to require plans to develop internal procedures for evaluating claims so that participants will not always be compelled to bring a lawsuit against the plan if a claim is denied. If a claim dispute cannot be satisfactorily resolved internally, however, claimants have the right to sue and many will do so.

Tax Withholding

Distributions from a qualified retirement plan are subject to federal income tax withholding in a manner similar to payments of wages or other compensation. However, a recipient can elect not to have tax withholding on the qualified plan distribution, without providing any reason. (This, of course, will not relieve the recipient of any obligation to pay whatever income taxes are due.) The payer of the plan distribution must notify the recipient of the right not to have taxes withheld.

The withholding requirement applies to both lump-sum distributions and periodic payments. The liability for withholding is imposed on the payer of the distribution, but the plan administrator will be held liable unless the plan administrator directs the payer to withhold the tax and provides the payer with the information necessary to make the withholding. If the payer is a different person from the plan administrator, a trustee for example, it is important that there is a clear understanding between the parties about the responsibilities for withholding.

Reporting and Disclosure

The reporting and disclosure provisions, enacted as part of ERISA in 1974, impose a variety of duties on employee benefit plans to report or disclose various plan information to the government and plan participants. The purpose of the reporting and disclosure provisions is to indirectly discourage various plan abuses on the theory that wrongdoers will be deterred by knowing that their wrongdoing may be exposed to public view. This approach to federal regulation is based on the success of the securities laws of the 1930s and is common in other areas of federal regulation. The statutory format in ERISA for reporting and disclosure is extremely complex and confusing, and many modifications of the original statutory procedure have since been made by regulation, although the underlying statutes remain the same.

The reporting and disclosure requirements currently consist of this series of reports, some annual and some not, that must be provided to the participant or filed with the government or both:

• Summary Plan Description (SPD). The SPD is a document intended to describe the plan to its participants in plain language. Whether they ask for it or not, it must be furnished to participants within 120 days after the plan is established or 90 days after a new participant enters the plan. There is no government form for the SPD; it can be designed according to the employer's specifications. However, the contents of the SPD are specified in minute detail by Department of Labor regulations. These regulations require, among other things, clear identification of the plan sponsor and funding entities, the plan's eligibility requirements, any possibilities of losses or forfeiture of benefits, procedures for making claims for benefits under the plan, and a prescribed statement of the participant's rights under the law.

  There is also a plain language requirement, and this can be extremely important in practice. If a participant or beneficiary claims a benefit and is disappointed to find that the benefit was not provided under the plan, it is quite likely that the disappointed claimant will find a lawyer who will look closely at the SPD for any ambiguities that might provide grounds for a lawsuit. Such lawsuits sometimes prove successful.

• Annual Report (Form 5500). This form is the centerpiece of the reporting requirements. The form is filed only with the IRS, but is made available to both the IRS and the Department of Labor. The form includes detailed financial information about the plan, including a signed report by an independent, qualified public accountant, along with any separate financial statements forming the basis of the independent accountant's report. If a qualified plan is subject to the minimum funding requirements, a signed report by the plan's enrolled actuary must be included, along with a certified actuarial valuation.

  Plans covering fewer than 100 participants are subject to simpler reporting requirements designed to reduce the cost of compliance for these plans. To get a better idea of the scope of the reporting requirements, it is useful to obtain from the IRS copies of Form 5500 and accompanying instructions and review them. These are available on the IRS web site.

  Form 5500 also includes schedule SSA, a schedule identifying participants who have separated from service during the year with deferred vested benefits under the plan. It is provided by the IRS to the Social Security Administration so that at retirement any former participant may be notified of a deferred vested benefit from the plan.

• Report on Termination, Merger, or Other Changes (Forms 5310 and 5310A). The plan administrator of a plan covered under the PBGC plan termination insurance must notify the PBGC in advance of the termination. The Code and ERISA also contain a number of other reporting requirements in the event of a plan termination, merger, split up, transfer of assets and various other similar events. These are generally reported on Form 5310 or 5310A.

• Individual Benefit Statement. On written request, the plan administrator must furnish an individual participant or beneficiary with a prescribed statement of his or her vested and unvested current plan benefits. This need not be furnished more than once a year. Some plan administrators provide these individual statements annually, even without a request from participants or beneficiaries.

The Health Insurance Portability and Accountability Act (HIPAA) imposes some additional requirements for information that must be included in summary plan descriptions for group health plans. These include the following:

• Whether a plan is self-funded or whether an insurer (including a health maintenance organization) is responsible for the administration or financing of a plan

• The name and address of any insurer responsible for administration or financing of a plan, the extent to which benefits under the plan are guaranteed by a contract or policy issued by the insurer, and the nature of any administrative services provided by the insurer

• The office of the Department of Labor from which a participant may obtain information about HIPAA

ERISA does not require that a summary plan description be provided on a specific form, only that certain information be provided. Some employers use a single document; other employers incorporate much of the required information into the employee benefits handbook provided to their employees. Electronic transmissions of summary plan descriptions and other required information for participants are acceptable as long as certain conditions are met:

• Electronic documents may be used only for participants who can access the documents at work and convert them to paper form.

• The plan administrator must take appropriate measures to ensure that documents are actually received, such as the use of return receipt electronic mail features.

• The electronic documents must be prepared in accordance with style, format, and content requirements of Department of Labor regulations.

• Each participant must be notified, electronically or in writing, which documents will be furnished electronically, the significance of such documents, and the fact that paper copies of the documents can be received free of charge.

• The plan administrator must furnish a paper copy of any electronically submitted documents free of charge on request of a participant.

The reporting requirements are enforced by various types of penalties, including criminal penalties for willful violations or false statements.

In addition to the specific forms that must be filed or distributed, the reporting and disclosure requirements include a variety of sunshine provisions that give government agencies and participants rights to inspect and copy various documents and records relevant to the plan and its operation. Also, to obtain an advance determination letter or other IRS ruling, the plan documents usually must be submitted to the IRS.

PLAN INSTALLATION

Installing a qualified plan can be fairly complex, particularly if the plan is complicated and the employer wishes to maximize the tax benefits by having the plan effective at the earliest possible date.

Adoption of the Plan

To be effective during a particular year, the plan must be adopted by the employer during that year. For a corporation, the corporate board should pass a resolution adopting the plan before the end of its year for the plan to become effective during that year. It is not proper to back date documents for this purpose—the board must actually act legally before the end of the year. It may not be necessary to draft the final form of the plan at this time; however, the board usually can adopt a resolution merely outlining the basic provisions of the plan. If the plan uses a trust, the trust must be established before the end of the year in which the plan is to be effective. This means that a trust agreement must be executed between the employer and the trustee, and at least a nominal principal contribution may be necessary to establish the existence of the trust. If the plan uses an insurance contract as a funding instrument, the insurer must have accepted the terms of the agreement before the end of the year, although the contract may not be put into final form until sometime later. The plan and insurance contract should be finalized prior to the time the employer makes its first plan contribution other than a nominal contribution required to establish the trust or insurance contract; this usually means the employer's tax filing date, the plan contribution for a given year can be deferred to the tax filing date for that year.

Plan Year

It is possible to establish a plan with a plan year that is different from the employer's taxable year. In that case, one plan year will end and another will begin in the same taxable year of the employer. The employer can then take a deduction that taxable year for a contribution on behalf of either plan year or for partial contributions for both taxable years; however, the employer must follow a consistent procedure so there is no undue tax benefit. For simplicity, it will be assumed that the plan year is the same as the employer's taxable year.

Advance Determination Letters

A central feature of the plan installation process is usually an application to the IRS District Director for a determination letter stating that the plan as designed is a qualified plan eligible for the accompanying tax benefits. It is not necessary for the plan to have such a letter to be qualified; any plan that complies with the applicable Code provisions is a qualified plan. However, if there is no advance determination by the IRS, the IRS will not examine the plan until the time comes for an audit of the employer's tax returns. If the IRS finds at that time that the plan is not qualified, the possible tax consequences can be disastrous: the loss of the employer's tax deductions for plan contributions, the taxation of all plan contributions to participants, and the loss of the trust's tax-exempt status. To avoid this, most employers consider it desirable to have the IRS review the plan in advance and issue a determination letter. There are some other advantages to the determination letter procedure. The process of IRS review will often reveal drafting problems that might otherwise have gone unnoticed. During the review procedure, the IRS usually suggests any changes in the plan that are necessary to make it qualify.

There is a retroactive amendment procedure that allows the employer to make amendments to the plan effective for a prior year if the amendments are necessary to make the plan qualify. In general, retroactive plan amendments may be made up to the employer's tax filing date for the year in question, plus extensions. For example, if a corporate employer uses a calendar year, the tax filing date for the year 2000 is March 15, 2001, with possible extensions to September 15, 2001. Thus, an employer could install a qualified plan effective January 1, 2000, and could amend the plan retroactively to January 1, 2000, as late as September 15, 2001. The filing of a determination letter prior to this deadline extends the retroactive amendment procedure while the determination letter request is pending—this is another advantage of requesting an IRS determination letter.

Generally, the employer wishes to make the plan effective as early as possible to obtain the maximum tax deduction at the outset. This can present a problem if, on filing the application for determination, the IRS finds the plan not qualified and retroactive amendments are unavailable or the employer does not wish to make the amendments the IRS suggests. The employer's prior contributions to the plan then might not be retrievable because the trust generally must be an irrevocable trust. To avoid this problem, the plan can be drafted making the plan's existence and the employer's contribution contingent on obtaining a determination letter.

The IRS provides various forms for purposes of making an application for determination. Some of these are described in the checklist. IRS publishes an annually revised Revenue Procedure that prescribes the requirements for an Application for Determination.

One final point should be made concerning IRS determination letters. Determination letters indicate that the IRS has approved the plan on the basis of the plan documents and the facts submitted to it. They are no guarantee that the plan qualifies and will continue to qualify if these facts are not accurate or if the facts change at a subsequent date. Therefore, the continuing qualification of the plan must always be a concern of the employer and its employee benefit advisers.

Master, Prototype, and Pattern Plans

A qualified plan must be evidenced by a formal written document. Because of the many complex provisions that must be included, it is not unusual for such documents to run to 50 pages or more. If all of the plan language is custom designed, the drafting expense alone can be considerable.

Various methods have been devised to simplify plan drafting for smaller employers. One of the most common is the use of master and prototype plans offered by financial institutions and other types of plan advisers. A prototype plan is a standardized plan form, such as a prototype profit-sharing plan or a prototype money-purchase pension plan, usually offering some choice of provisions in the important features. For example, the plan might allow the employer to specify the contribution rate or choose the vesting schedule. A master plan is similar to a prototype plan, but the term master plan usually refers to a plan form designed by a financial organization and adopted only by employers that wish to use that financial organization for plan funding. The IRS also allows law firms to use pattern plans; these are plans using language that has been examined and approved by the IRS, thus allowing speedier IRS approval of plans to the extent they use the pattern language. Also, most qualified plan consultants use standardized plan language of one kind or another to a considerable extent to reduce drafting costs, even if they do not provide formal master, prototype, or pattern plans.

FEDERAL ESTATE TAX TREATMENT OF QUALIFIED PLAN BENEFITS

The federal estate tax is a tax separate from the income tax that is imposed on the value of a decedent's property at the time of death. The estate tax is payable out of the decedent's estate and, therefore, reduces the amount available to the beneficiaries. Only a small percentage of decedents—less than 5 percent—have enough wealth to be concerned about the estate tax because of a high initial minimum tax credit applicable to the estate tax. No estate tax return need be filed for a decedent whose gross estate is less than $675,000 (in 2000). This amount is scheduled to rise incrementally to $1,000,000 in 2006. Also, there is an unlimited marital deduction for federal estate tax purposes—that is, there is no federal estate tax imposed on property transferred at death to a spouse, regardless of the amount.

As a general rule, a lump-sum death benefit, or the present value of an annuity payable to a beneficiary from a qualified plan, is includable in the estate of a deceased participant for federal estate tax purposes. For some high-income participants, avoiding federal estate taxes on the plan benefit will be important. Their estates may be large enough to attract imposition of some federal estate tax. The marital deduction may not be significant, because they may not wish to pay the plan benefit to a spouse—they may be widowed or divorced or may wish to provide for another beneficiary. Also, even if the benefit is payable to a spouse, a spouse is often about the same age as the decedent, and thus within relatively few years most of the property transferred to the spouse is potentially subject to federal estate tax again at the spouse's death. As a result, it is often useful to design a qualified plan death benefit that can be excluded from the participant's estate.

The general rule of the federal estate tax is that all items of property are includable unless a specific code provision excludes them. Thus, qualified plan death benefits are generally includable because there is no specific exclusion. However, the estate tax law does have a specific provision dealing with life insurance, Section 2042. Under Section 2042, life insurance proceeds are includable in a decedent's estate if the decedent has "incidents of ownership" in the insurance policies. Incidents of ownership are various rights under the policy, particularly the right to designate the beneficiary. If a qualified plan death benefit is provided through a life insurance policy, in most places this provision would require inclusion because the participant retains the right to name the beneficiary. Noninsured death benefits presumably would not be excludable in any event.

EARLY TERMINATION RULE FOR 25 HIGHEST-PAID EMPLOYEES

Potentially, a qualified defined-benefit plan can be used as a one-time tax shelter for key employees if it is designed with the expectation that most of the key employees will retire within a few years, taking most of the plan assets out for their retirement, thus terminating the plan. For many years, the Regulations [Section 1.401-4(c)] have contained a provision designed to limit this abuse by requiring defined-benefit plans to limit benefits for the 25 highest-paid employees if they are paid out within ten years of the plan's establishment or the plan terminates within ten years.

In such cases, benefits to the 25 highest-paid employees are limited by limiting the total employer contributions used to fund such benefits. The employer contributions for each such employee cannot exceed the greater of $20,000 or 20 percent of the first $50,000 of employee compensation multiplied by the number of years the plan was in effect prior to the benefit payment or plan termination. Often, this will produce a lower limit on benefits than the Section 415 benefit limit.

TOP-HEAVY PLANS

The top-heavy rules are another addition to the arsenal of weapons Congress has provided against the use of qualified plans by small businesses primarily as tax shelters for owners and highly compensated employees. The rules (Code Section 416) provide additional requirements that must be met by all qualified plans that meet the definition of top-heavy. To summarize, the top-heavy requirements do the following:

• Put a ceiling on the amount of a participant's compensation that may be taken into account in a plan contribution or benefit formula

• Provide faster vesting of benefits for plan participants who are not key employees

• Provide minimum unintegrated benefit or contribution levels for plan participants who are not key employees

• Reduce the aggregate Section 415 limit on contributions and benefits for key employees in certain situations

• Restrict distributions to key employees

The top-heavy restrictions must be written into the plan document itself, even a plan for a large employer that is unlikely ever to be top-heavy. The plan document must provide that if the plan meets the definition of top-heavy on a given determination date, all of the top-heavy restrictions automatically become part of the plan. So long as the plan is not top-heavy, the top-heavy restrictions need not necessarily apply, although, of course, the planner is free to add these restrictions to the plan even if it is not top-heavy.

Definition of Top-Heavy

A defined-benefit plan is a top-heavy plan for a given plan year if (as of the determination date—see below) the present value of the accumulated accrued benefits for participants who are key employees is more than 60 percent of the present value of all accumulated accrued benefits in the plan. A defined-contribution plan is considered top-heavy if, as of the determination date, the sum of the account balances of participants who are key employees exceeds 60 percent of the aggregate value of the accounts of all employees. Benefits and account balances attributable to both employer and employee contributions are to be taken into account, except for accumulated voluntary deductible employee contributions or rollovers from other plans. The present value of a participant's accrued benefit or the value of the participant's account balance is to be increased by any aggregate distributions made with respect to the participant during the five-year period ending on the determination date. Plans of related groups can be lumped together, and if the contributions or benefits of the overall group are top-heavy, each plan in the group will be considered top-heavy.

Determination Date

The determination date for any given plan year is the last day of the preceding plan year. For the first year of the new plan, the determination date is the last day of the first plan year. The IRS also has the authority to apply the top-heavy provisions on the basis of years other than plan years.

Definition of Key Employee

A key employee is any participant in the plan, including a self-employed person, who at any time in the four preceding years was an officer earning more than 50 percent of the Section 415 defined-benefit dollar limit, an employee owning one of the ten largest interests in the employer (under attribution-of-ownership rules), a more-than-5-percent owner, or a more-than-1-percent owner earning more than $150,000. Because the term officer is not clearly defined, there is a limit on the number of employees that can be treated as officers. No more than 50 employees can be treated as officers in general, while for small employers the limit on the number of officers is the greater of three individuals or 10 percent of the employees (presumably the highest paid). For example, suppose a small company has 25 employees. In determining who are key employees, the IRS cannot designate more than three of these employees (the greater of three individuals or 10 percent of the employees) as officers.

Note that key employee is defined differently from highly compensated employee used in all other nondiscrimination provisions of the law.

In determining ownership in the business for purposes of identifying key employees, the top-heavy provisions have rules for attributing stock ownership from related persons, and there are special rules for aggregating commonly controlled groups of employers and affiliated service groups.

An illustration of what constitutes a top-heavy plan might be helpful in defining the concept of top-heavy.

Suppose that a corporation with ten employees has a defined-contribution money-purchase pension plan. The employees include Wolfe (president and sole shareholder), Hare (vice-president), and Flynn (foreman). All of the other employees are clerical or production workers paid by the hour. The IRS would most likely identify the three named employees as the plan's key employees. As of the end of the 2000 plan year, aggregate account balances of all participants in the plan total $200,000. The account balances for Wolfe, Hare, and Flynn total $100,000. On these facts, the plan is not top-heavy for the plan year 2001 because the aggregate account balances for the three key employees total less than 60 percent of the total account balances as of the determination date, the end of 2000. However, suppose that in 1999 Wolfe received a distribution of $100,000 from the plan. In this case, the account balances as of the end of 2000 would have to be increased by the amount of this distribution, so they would total $300,000. The account balances for the key employees would then be $200,000, because the $100,000 distribution to Wolfe would have to be included for this purpose. Now the plan would be deemed to be top-heavy for the plan year 2001 because the account balances for key employees would be more than 60 percent of the total.

Although the example above involved a plan of a small employer that fell on the line between being top-heavy and avoiding that status, planners find that virtually all plans of employers with fewer than ten employees will be top-heavy at all times. Key employees in such businesses usually have not only higher salaries but also much longer service than regular employees, so their account balances or accrued benefits are much higher as a percentage of the total. Therefore, the top-heavy rules become an additional set of qualification requirements that must be met by all small plans.

Minimum Benefit Requirements

A qualified plan must provide minimum benefits or contributions for top-heavy years. For defined-benefit plans, the benefit for each nonkey employee must be at least a minimum percentage of average compensation. The applicable minimum percentage of compensation for a given employee is two multiplied by the number of the employee's years of service, with a maximum percentage of 20 percent (i.e., ten years of service or more). The average compensation used for this test will generally be based on the highest five years of compensation.

For a defined-contribution plan, employer contributions during a year of topheaviness must be not less than 3 percent of each nonkey employee's compensation.

A top-heavy plan can consider only nonintegrated benefits in meeting the vesting and minimum benefit requirements. That is, these requirements must be met based on benefits from the plan itself. Benefits received by the participant from Social Security cannot be taken into account.

LOANS FROM QUALIFIED PLANS

The law permits loans, within limits, to participants in regular qualified plans and Section 403(b) tax-deferred annuity plans. However, a participant cannot borrow from a plan unless the plan document specifically permits loans, and as discussed below, loan provisions may not be appropriate for all plans. Loans from IRAs and SEPs are effectively prohibited; they are treated as taxable distributions and may be subject to penalties for premature distribution. Also, loans from a qualified plan to an owner/employee (a proprietor or more than 10 percent partner in an unincorporated business) or to an employee of an S corporation who is a more-than-5-percent shareholder in the corporation are prohibited transactions subject to the prohibited transaction penalties.

Terms of Loans

To obtain loan treatment, the loan must be repayable by its terms within five years. The rule noted above for reducing the $50,000 limit by the loan balance in the preceding year was designed to prevent avoidance of the five-year limit by simply repaying and then immediately reborrowing the same amount every five years. The five-year requirement does not apply to any loan used to acquire a principal residence of the participant.

Transactions with an effect similar to that of loans (for example, the pledging of an interest in a qualified plan or a loan made against an insurance contract purchased by a qualified plan) are also covered by the loan limitations and rules.

If the plan permits loans, they must be made available on a nondiscriminatory basis. Also, the loans must be adequately secured and bear a reasonable rate of interest. Usually, the security for a plan loan is simply the participant's vested accrued plan benefit. Interest on the loan is generally consumer interest that is not deductible as an itemized deduction unless secured by a home mortgage. However, if the loan is to a key employee as defined in the top-heavy rules or is secured by 401(k) or 403(b) elective deferrals, interest is not deductible in any event.

Any loan that does not meet these requirements will be treated as a current distribution and may be currently taxable to the employee when received.

Should the Plan Permit Loans?

Whether the plan should permit loans depends on the employer's objectives for the plan. Plan loan provisions are often desired by the controlling employees of closely held businesses because a plan loan provides the advantage of tax sheltering the plan funds without losing control of the cash. However, the same considerations may make plan loans desirable for regular employees as well. A disadvantage of plan loans is that if they are too extensively utilized, they deplete the plan funds available for investment. More fundamentally, however, plan loan provisions are inconsistent with a primary plan objective of providing retirement security. Thus, they are less common in pension plans than in profit-sharing plans. Plan loan provisions are particularly uncommon in defined-benefit plans because such plans have no individual participant accounts; it is complicated to convert a participant's vested accrued benefit to a cash equivalent at a given time to determine the amount of loan that can be allowed. Plan loans also add significant administrative costs to the plan.

QUALIFIED DOMESTIC RELATIONS ORDERS

The prohibition against nonalienation of benefits does not apply to an assignment of a benefit under a qualified domestic relations order (QDRO). Under Code Section 414(p), a QDRO is a decree, order, or property settlement under state law relating to child support, alimony, or marital property rights that assigns a participant's plan benefits to a spouse, former spouse, child, or other dependent of the participant. Currently, therefore, a participant's plan benefits generally become the subject of negotiation in domestic disputes. The pension law itself does not indicate how such benefits are to be divided; this is still a matter of state domestic relations law. The QDRO provision simply provides a means by which state court orders in domestic relations issues can be enforced against plan trustees.

To protect plan administrators and trustees from conflicting claims, a QDRO cannot assign a benefit that the plan does not provide. Also, a QDRO cannot assign a benefit that is already assigned under a previous order. If, under the plan, a participant has no right to an immediate cash payment from the plan, a QDRO cannot require that the trustees make such a cash payment. If a cash settlement is desired, the parties will generally agree to allow one participant to keep the entire plan benefit and pay compensating cash to the other.

FEDERAL TAXATION OF DISTRIBUTIONS

Plan distributions generally are taxed in accordance with the rules for taxing annuity payments found in Code Section 72. A lump sum distribution from a plan is generally taxed in full on receipt unless it is rolled over to an IRA, as discussed below. This section deals with federal income and estate taxation. Some states apply similar tax treatment, but there is considerable variation. Federal taxes are usually the dominant factor in the overall tax burden on plan distributions.

The initial step in determining the taxation of a qualified plan distribution is determining the taxable amount of the distribution. For a distribution upon retirement, disability, or termination of employment, the taxable amount consists of the total amount of the distribution less the following amounts, sometimes referred to as the employee's cost basis in the plan:

• The total nondeductible contributions made by the employee (in the case of a contributory plan)

• The total cost of life insurance reported as taxable income by the participant, assuming that the plan distribution is received under the same contract that provided the life insurance protection

• Any employer contributions previously taxed to the employee (for example, where a nonqualified plan later became qualified)

• Certain employer contributions attributable to foreign services performed before 1963

• Amounts paid by the employee in repayment of loans that were treated as distributions

• In the case of a stock bonus plan or other stock plan, the net unrealized appreciation.

The first two items in the list are the ones most frequently encountered. If the employee is self-employed or was self-employed in the past, the items excludable from the taxable amount are slightly different from the above list. The most important difference is that for a self-employed person who is an owner/employee (a more-than-10-percent owner of an unincorporated business), the insurance costs (the second item above) are not part of the cost basis.

The simplest way to describe the taxation of qualified plan distributions is to distinguish between those benefits that are paid out fully in a single taxable year of the participant and those that are spread out over more than one taxable year. The latter are discussed first.

Payment in One Taxable Year

If the qualified plan distribution is paid to the participant in a single taxable year, the taxable amount (the amount in excess of the participant's cost basis as described above) potentially is all taxable to the participant as ordinary income in the year received. Because this can increase the participant's effective tax rate by pushing up the marginal tax bracket in that year, a special one-time relief provision applies if the distribution qualifies as a lump-sum distribution and is received after age 59½. A lump-sum distribution must meet all of the following requirements:

• It is made in one taxable year of the recipient.

• It represents the entire amount of the employee's benefit in the plan.

• It is payable on account of the participant's death, attainment of age 59½ separation from service (non-self-employed person only), or disability (self-employed person only).

• It is from a qualified plan.

• Except for death benefits, the employee must have participated in the plan for at least five years prior to the distribution.

In determining whether the entire amount of the employee's benefit has been distributed, all pension plans maintained by the employer are treated as a single plan, all profit-sharing plans are treated as one plan, and all stock bonus plans are treated as one plan.

If the distribution qualifies as a lump-sum distribution, the taxable amount of the distribution (the amount remaining after the cost basis is subtracted) is eligible for special tax treatment in certain cases, owing to expiring tax provisions that are retained ("grandfathered") for long-term plan participants. For participants who attained age 50 before 1986, there is a "ten-year averaging" computation. For amounts accumulated before 1974, a special capital-gain treatment is available. All other distributions are treated as ordinary income, to the extent of the taxable amount.

Taxation of Death Benefits from Qualified Plans

The income tax treatment described above also applies in general to plan death benefits paid to beneficiaries of participants. That is, if the death benefit is paid as periodic payments, the annuity rules described above generally apply; if the death benefit qualifies as a lump-sum distribution, the special favorable tax treatment is available to the beneficiary. However, if the death benefit is payable under a life insurance contract held by the plan, the pure insurance amount paid—the difference between the policy's face amount and its cash value is excluded from tax.

Employee Haines dies before retirement and his beneficiary receives a lump-sum death benefit from the plan consisting of $100,000 of the proceeds of a cash-value life insurance contract, the cash value of which was $50,000. The plan was noncontributory, and Haines reported a total of $8,000 of insurance costs on his income tax return during his lifetime as a result of the plan's insurance coverage. The taxable amount of this distribution to the beneficiary is the total distribution of $100,000 less the following:

• The pure insurance amount ($100,000 minus the cash value of $50,000) and

• Haines's cost basis—in this case, only the $8,000 of insurance cost reported during his lifetime.

The taxable amount is therefore $42,000. This amount is taxable income to the beneficiary, subject to the special averaging provisions described above, if applicable.

Federal Estate Tax

The federal estate tax on qualified plan death benefits affects only highly compensated participants (those with a gross estate of at least $675,000) (2000 figure)

MANAGEMENT ISSUES IN DESIGN OF DISTRIBUTION PROVISIONS

Employee interests are best served by maximum flexibility in plan distribution provisions. However, plan designers may find it necessary to reduce this flexibility somewhat to meet the employer's management objectives.

First of all, flexibility increases administrative complexity and costs. In addition, flexibility can potentially cause cash-flow and liquidity problems to the plan fund. Finally, flexibility can create extremely complex federal income tax problems, due to the inordinately complex rules in this area. The rules are merely summarized, but the reader will undoubtedly note that even this summary is startlingly complicated. The complexity is probably due more to congressional inattention to this issue rather than to any clear policy rationale. Simplification is on the congressional agenda.

The complex distribution rules are management's problem as well as the participant's because employees often ask employers about the tax treatment of a plan distribution. An employer's wrong answer likely will subject the employer to liability to reimburse the employee for any excess tax payments that result. And management cannot simply "stonewall" on this issue by refusing to advise employees on tax treatment of distributions because employee resentment as well as legal liability may result that can negate the value of the plan as an employee incentive.

The planner's objective in designing plan distribution provisions is to provide employees with the maximum amount of distribution flexibility that is consistent with management's needs as outlined above. In a small business with limited personnel management resources, this may dictate only very limited distribution flexibility. For example, some smaller plans provide for distributions only in the form of a lump sum at retirement or termination of employment.

Normal Form of Benefit

A qualified plan must specify not only the amount of the benefit but the form of the benefit. In a defined-benefit plan, the normal form of benefit is the basic "defined benefit," the form that quantifies the benefit due and provides a standard for calculating equivalent alternative benefits. At one time, the normal form was the form a participant received if he or she did not choose an alternative form, but this is not necessarily true because of joint and survivor provisions.

The normal form in a defined-benefit plan is usually either a straight-life annuity or a life annuity with period certain. A straight-life annuity simply provides periodic (usually monthly) payments for the participant's life. A life annuity with period certain provides periodic payments for the participant's life, but additionally provides that if the participant dies before the end of a specified period of years, payments will be continued until the end of that period to the participant's designated beneficiary. Specified periods of 10, 15, and 20 years are commonly used.

In comparing defined-benefit plans, it must be remembered that straight-life and life annuities with periods certain are not equivalent; a plan providing an annuity of $100 per month for life with period certain as the normal form of benefit provides a significantly larger benefit than a plan providing $100 per month as a straight-life annuity. Period-certain annuities as the normal form of benefit are most commonly found in plans using insurance contracts for funding.

A pension plan must provide a qualified joint and survivor annuity for the participant and spouse automatically to a married participant (unless the participant elects otherwise). To avoid discrimination against single participants, most plans provide that the qualified joint and survivor annuity is "actuarially equivalent" to the normal form. For example, if the normal retirement benefit would be $1,000 per month as a straight-life annuity, the qualified joint and survivor annuity might be something like $800 per month to the participant for life, then $400 per month to the spouse for life. However, the plan can partially or fully subsidize the joint and survivor annuity; for example, it might provide a straight-life annuity of $1,000 per month or a $1,000/$500 joint and survivor annuity. This might be desirable to the employer even though it would discriminate against unmarried participants.

Defined-contribution pension plans can provide an annuity as the normal benefit form. This is particularly common if an insurance contract is used for funding. The amount of the annuity depends on the participant's account balance at retirement, with annuity purchase rates specified in the insurance contract, if any. Optional forms of benefit, particularly a lump sum, are usually provided in defined-contribution plans.

Optional Alternative Forms of Benefit

Participants generally benefit from having a choice of benefit forms as an alternative to the normal form. Participants can then choose a benefit that is structured in accordance with their individual financial needs, family situations, and retirement activities. In defined-benefit plans, the most common alternative forms (assuming a straight-life annuity as the normal form) are, in addition to the qualified joint and survivor annuity that must be offered, (1) joint and survivor annuities for the participant and spouse or other beneficiary, with varying survivorship annuity percentages such as 50 percent, 75 percent, and 100 percent, and (2) annuities for the participant and beneficiary, with varying periods certain, such as 5, 10, 15, or 20 years. The plan also can allow payouts over a fixed period of years without a life contingency. All these options are subject to the limitations described below.

To avoid undesirable or prohibited discrimination among employees in different situations, the plan should provide that any optional benefit is actuarially equivalent to the normal form of benefit. Under Code Section 401(a)(25), the actuarial assumptions used for this purpose must be specified in the plan, either by stating the actuarial interest and other factors or by specifying an equivalency table for the various benefits, to avoid employer discretion in favor of highly compensated employees.

Lump-Sum Option

A lump-sum distribution can provide planning flexibility for participants. Lump-sum distribution provisions are most common in defined-contribution plans; in fact, in a profit-sharing plan, the lump sum is often the only distribution option. However, even a defined-benefit plan can offer a lump-sum option. The Code provides in Section 417(e) that the lump sum must be at least that determined on the basis of interest and mortality factors specified in the Code.

Higher-income participants often would like a lump sum because they have other sources for retirement income and wish to invest their plan funds in riskier, high-return investment vehicles. A defined-contribution plan can be designed to accommodate this need to some extent within the plan, however, by providing participant investment direction. Also, investment results within the plan are enhanced by the tax deferral on plan income and may provide an effective rate of return that the participant cannot match outside of the plan. However, funds cannot be left in the plan indefinitely; distributions must generally begin at age 70½ or retirement, if later.

In some defined-benefit plans, particularly insured plans, the assumptions used for funding are too conservative. For example, a plan may have accumulated $140,000 to fund a benefit of $12,000 per year to a retiree. In many cases, however, it might be possible for a retiree to individually invest $140,000 and receive a better return than $12,000 per year for life. Thus, the retiree might rather have a $140,000 lump sum from the plan fund than the plan's annuity benefit. In some cases, this situation results from bad plan design, while in others it is done deliberately to increase the benefit for key employees. The Code limits the extent to which this can be done by prescribing minimum interest and mortality assumptions.

Distribution Restrictions

Plan distributions can be designed to provide considerable flexibility, but they must be designed within a rather complex network of rules that have been accumulating in the law over many years. These rules are aimed at protecting the financial interests of participants and, more significantly, they are designed to limit the use of qualified plans merely as a tax-sheltered investment medium for key employees. The significant rules are as follows:

• Distinctions between the types of distributions permitted in pension plans as opposed to profit-sharing plans

• Rules preventing employers from unjustly delaying benefit payments

• Minimum distribution requirements

• Early distribution penalties

• Incidental benefit requirements

• Nonalienation rules

Pension versus Profit-Sharing Plans

The IRS generally will not allow a pension plan to pay benefits prior to retirement, early retirement, death, or disability, although some limited cash-out provisions may be allowed in the event of termination of employment prior to these events, as previously discussed. With a profit-sharing plan, there is much more flexibility, and the plan may allow in-service distributions. However, the 10 percent penalty described below may deter employees from making certain withdrawals.

Delaying Benefit Payments

Under Code Section 401(a)(14), all qualified plans must provide for payment not later than the 60th day after the latest of the following three dates:

1. The earlier of age 65 or the plan's normal retirement date

2. The tenth anniversary of the participant's entry into the plan

3. The participant's termination of service with the employer

The plan may allow the participant to elect a payout that begins at a date later than this maximum limit. However, the extent to which a participant can stretch out payments is limited by the rules.

Minimum Distribution Rules

Congress does not like qualified plans to be used as tax shelters for funds that are not actually needed by participants for retirement income. Therefore, Code Section 401(a)(9) requires that plan distributions begin no later than April 1 of the calendar year following the later of the year in which the employee attains age 70½ or the year of actual retirement. If the employee owns more than 5 percent of the employer, deferral to the actual retirement date is not permitted.

Furthermore, the distribution must be either in a lump sum or a periodic distribution over a specified period. Basically, the distribution must be paid in substantially equal annual amounts over the life of the employee or the joint lives of the employee and a designated beneficiary. Alternatively, the distribution may be made over a stated period that does not exceed the life expectancy of the employee or the life expectancy of the employee and a designated beneficiary. This permits period-certain annuity payouts, as long as the period certain does not exceed the life expectancy limits. A periodic distribution based on an ongoing recalculation of life expectancy is permitted, which tends to stretch out payments somewhat because life expectancy is extended by continuing survival. However, life expectancy can be recalculated no more often than annually. Cost-of-living increases in pension payments to retirees are permitted as long as they are not designed to circumvent the minimum distribution rules.

The minimum distribution rules also have provisions applicable to distributions made to a beneficiary if the employee dies before the entire plan interest is distributed. If distributions to the employee have already begun, the remaining portion of the employee's interest must be distributed at least as rapidly as under the method in effect prior to death. For example, if the employee elected a 20-year period certain annuity and the employee died after ten years, the remaining interest could be distributed in equal annual installments over a term not exceeding ten years. The beneficiary could, however, elect to accelerate these payments.

If the employee dies before distributions have begun, the plan's death benefit must be distributed within five years after the employee's death, with an exception. The five-year restriction is not applicable if (1) any portion of the plan benefit is payable to a designated beneficiary, (2) the beneficiary's interest will be distributed over the life of the beneficiary or over a period not extending beyond the life expectancy of the beneficiary and (3) distributions begin no later than one year after the employee's death. If the designated beneficiary is the surviving spouse, the beginning of the distribution can be delayed to the date on which the employee would have attained age 70½.

Early Distribution Penalty

Code Section 72(t) provides a tax penalty for early distributions from qualified plans. This penalty provision was added by Congress to encourage plan participants to use qualified plans primarily for retirement and not merely for deferral of compensation. The 10 percent penalty tax applies to distributions from a broad range of tax-advantaged retirement plans. As applied to regular qualified plans and 403(b) plans, the penalty applies to all distributions except distributions

• made on or after attainment of age 59½;

• made to a beneficiary or employee's estate on or after the employee's death;

• attributable to disability;

• that are part of a series of substantially equal periodic payments made at least annually over the life or life expectancy of the employee, or the joint lives or life expectancies of the employee and beneficiary (separation from service is required);

• made after a separation from service after age 55;

• related to certain tax credit ESOP dividend payments;

• to the extent of medical expenses deductible for the year under Code Section 213, whether or not actually deducted.

The penalty also applies to IRAs and IRA-funded plans (SEPs and SIMPLE/IRAs), with a somewhat different list of exceptions. Under this penalty provision, a plan may be permitted to make a distribution to an employee without disqualifying the plan, but the distribution may nevertheless be subject to penalty. For example, many hardship distributions from 401(k) plans or 403(b) tax-deferred annuity plans will be subject to the penalty tax.

Despite the penalty, withdrawals from qualified plans may still be important to participants in many situations—to obtain emergency funds, for example. Therefore, plan designers may wish to provide withdrawals in plans, where permitted, despite the existence of the 10 percent penalty.

Incidental Benefit Requirements

Some types of optional benefit forms provide substantial payments to persons other than the participant after the participant's death—for example, a 20-year-certain annuity with payments continued to a beneficiary. Because these are death benefits, they must be incidental.

Code Section 401(a)(9)(G) and corresponding regulations provide rules for determining whether survivorship benefits are incidental. For example, if a participant has a 10-year life expectancy at retirement, he or she could not elect a 25-year certain annuity because this would result in too much of the expected benefit to be paid as a death benefit. This incidental rule does not apply to a survivor annuity for spouses; thus, for example, a plan could provide a joint and 50 percent survivor annuity for a 65-year-old retiree and his 25-year-old spouse, even though actuarially, the participant's present interest in the benefit would be less than half of the total.

Nonalienation Rules

A qualified plan must provide that plan benefits may not be assigned or alienated [Code Section 401(a)(13)]. This means, for example, that a plan participant can't pledge future anticipated qualified plan payments as security for a bank loan. For divorce, child support, and similar domestic disputes, there are special provisions.

Examples

The distribution restrictions described in the preceding pages appear so complex as to defy summary. Probably the best way to see how these restrictions work is to look at some examples. Consider the following proposed plan distribution options, offered to a married male participant in a qualified defined-benefit plan retiring at age 65. Assume that the participant and his spouse have waived any required joint and survivor annuity. The following options will be analyzed to see if they are permissible under the distribution restrictions:

• A joint and 100 percent survivor annuity for the lives of the participant and his daughter, age 35

• A 25-year period-certain annuity for the lives of the participant and his spouse

• Equal periodic distributions over five years beginning when the participant reaches age 75

• Equal monthly payments over a fixed period equal to the participant's life expectancy, but if the participant survives, the payout period is extended (the monthly payments are actuarially reduced) annually to reflect the increased life expectancy

The first potential distribution would meet the first restrictions of Section 401(a)(9), because it extends over the lives of a participant and named beneficiary, but it does not meet the incidental benefit tests under the regulations. According to tables in the regulations, no more than a 60 percent survivor annuity could be payable to the daughter.

The second distribution—the 25-year period-certain annuity for the lives of the participant and spouse would meet Section 401(a)(9) as long as the joint life expectancy of the participant and spouse is at least 25 years. As for the incidental test, the regulations provide that a survivor annuity for a spouse will generally qualify regardless of the difference in ages.

The third option, a distribution beginning at age 75, is not permitted because distributions must begin not later than April 1 following the calendar year in which the employee reaches age 70½.

Finally, a fixed-period payout over the participant's life expectancy, with annual recalculations of life expectancy, is permitted. This can be an advantageous way of receiving the benefit because payments can continue to a relatively advanced age, reducing the danger that retirement income will stop while the participant is still living.