Statutory and regulatory mandates impact administration and design of compensation, retirement, and welfare arrangements

Congress and the Departments of Labor and Treasury have had a busy year in 2008.  The legislative and regulatory agenda affecting employee benefit plans has been quite broad.  Changes in the statutory and regulatory landscape over the last several years have imposed a plethora of requirements on employee benefit plans, their plan sponsors, and administrators.  The compliance dates for a number of these requirements are December 31, 2008, and January 1, 2009.  The final quarter of calendar year 2008 is upon us, and three months is a very short turnaround time for adopting and implementing some of the measures discussed in this article.  The last few months of 2008 present a chance for employers to make sure that, as they ring in the new year, their employee benefit plans don’t suffer from a hangover.  The scope of these requirements (actual and anticipated) is exceptionally broad.  It includes administrative and disclosure requirements for retirement and welfare plans, as well as executive compensation.  With respect to employee benefits and compensation, the end of the year typically involves a great deal of looking forward – including the annual open enrollment process.  While the addition of these issues may be seen as “piling on,” they are nonetheless issues over which employers need to gain control as the year comes to a close.  The following article identifies and discusses, in broad terms, a number of compliance issues that employers should make sure they consider and address in the coming months. 

401(k) Plans

Employers that sponsor and administer 401(k) plans have their own set of issues to deal with as the year winds to a close.  Because plans are generally required to be amended on an annual basis (rather than waiting to the end of a plan’s determination letter cycle), sponsors of 401(k) plans should review the cumulative list of amendments created by the Internal Revenue Service (IRS) and determine what, if any, interim amendments should be adopted for their plans. 

Interim amendments are required to be made not later than: (1) the due date of the employer’s tax return for the tax year in which the plan was required to implement the interim amendment; or (2) the last day of the plan year in which the amendment became effective.  This is true with respect to both required and discretionary modifications made during the plan year. 

Plan sponsors whose plans are required to undergo the IRS’s determination letter process during Cycle C must file their determination letter applications by January 31, 2009.  Before submitting any determination letter application, however, a plan sponsor should have the plan document reviewed to confirm that all amendments were properly adopted (timely and with the appropriate degree of formality). 

The review also should ensure that the plan document is restated, and that the text of any amendments required by the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) are integrated into the text of the plan document (and not by means of a so-called “snap-on” amendment).

Plan sponsors also should review the terms of their plan to ensure compliance with the more specific definition of “compensation” imposed by the final regulations under Code Section 415.  These limits generally became effective in 2008, and any plan amendment should likely be adopted prior to January 1, 2009.

403(b) Plans

In July 2007, the IRS published final regulations that apply to 403(b) plans for employees of public schools and Code Section 501(c)(3) tax-exempt organizations.  The final regulations are generally effective January 1, 2009, with delayed effective dates for 403(b) plans offered under collective bargaining agreements, and certain 403(b) plans sponsored by governments and certain church organizations.  Sponsors of 403(b) arrangements should review their documents to ensure compliance with the final regulations prior to the applicable effective dates.

The final regulations also impose a number of specific substantive requirements on 403(b) plans.  Highlights of the final regulations include:

  • Written Plan Document.  The final regulations require all 403(b) plans (including non-ERISA plans) to be maintained pursuant to a written plan document, and that the document contain: all terms and conditions for eligibility, contributions and limitations; form and timing of distributions; optional plan provisions, such as loans and hardship distributions; contracts available under the plan; and the party responsible for administration and compliance.  Plan documents may meet these requirements by incorporating other relevant documents (e.g. annuity contracts or custodian accounts) by reference.  Plan sponsors will want to ensure that they have a compliant plan document in place, whether that involves adopting a new document or reviewing an existing document for compliance.  Plan sponsors should generally avoid relying on “draft documents” from their custodial service providers (unless they have them reviewed by their benefits counsel), and plan sponsors should ensure that the terms of the documents reflect the terms of any annuity contracts or custodial agreements used to fund the plan.  Employers that are considering using the model document created by the IRS should be cautious – the terms may not accurately reflect the terms of their plan.
  • Universal Availability of Salary Deferrals.  Subject to certain exceptions (e.g., for nonresident aliens, students, and employees who are eligible for Section 457(b) deferrals or normally work fewer than 20 hours per week), the final regulations also require that if any employee of the employer sponsoring a 403(b) plan is allowed to make salary deferrals under the plan, all employees of the employer are allowed to do so.  The final rules also eliminate an employer’s ability to exclude union employees from a 403(b) plan, subject to transition rules.
  • Employer Contributions.  The final regulations make clear that employer contributions to 403(b) plans are subject to the same nondiscrimination tests that apply to employer contributions to other tax-qualified retirement plans, including the average contribution percentage (ACP) test.
  • Controlled Group Rules.  The final regulations impose new controlled group rules on tax-exempt entities.  Under the final rules, control by one organization of 80% or more of the board members of another organization will cause the organizations to be treated as a single employer for benefit plan purposes.  These new rules also amend the Section 414 regulations, and will affect nondiscrimination testing for the retirement and welfare plans of tax exempt organizations.  The new rules include additional requirements relating to the tracking of eligibility and vesting service, calculating plan contribution and benefit limits, and determining eligibility for distributions.  The new controlled group rules do not apply to governmental entities or certain church plans.
  • Severance from Employment.  The final regulations provide that a severance from employment occurs when an employee ceases to be employed by an employer that is eligible to sponsor a 403(b) plan (an “eligible employer”), even if the employee continues to be employed by an entity that is part of the same controlled group but which is not an eligible employer.  This is important in determining when an employee is entitled to a distribution from a 403(b) plan.
  • Terminating a 403(b) Plan.  The final regulations permit a plan sponsor to terminate its 403(b) plan provided the written plan document allows for such a termination.  For a 403(b) plan to be considered terminated, all plan benefits must be distributed to participants and beneficiaries within a reasonable period after termination, and the employer may not contribute to another 403(b) plan for at least 12 months.
  • Information Sharing Agreements.  The final regulations also require employers to enter into Information Sharing Agreements with certain of their 403(b) plans’ vendors when a change of investments among vendors is allowed within the same plan.  These Information Sharing Agreements are intended to reduce compliance problems that tend to arise from a lack of communication.  Among other things, Information Sharing Agreements should require vendors to provide the employer and other vendors with information necessary to implement applicable 403(b) rules (for example, to enable another vendor to determine the amount of any plan loans or rollover accounts available to a participant in order to satisfy the financial need under the hardship withdrawal rules).  Subject to certain transition rules, any required Information Sharing Agreements must be in effect by January 1, 2009.

Proposed Regulations on Fee and Expense Disclosures for Individual Account Plans under ERISA

On July 23, 2008, the U.S. Department of Labor (DOL) issued proposed regulations which will impose specific disclosure requirements on ERISA plan fiduciaries with respect to fees and expenses.  The proposed regulations, entitled “Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans” are scheduled to take effect for plan years beginning on or after January 1, 2009.  Although the final rules may be delayed, and the DOL may accordingly extend the compliance date, employers should take prompt action to comply with the rules in their proposed form.

The proposed regulations require the disclosure of “plan-related” information, including: how participants give instructions regarding their investments and the limits on those instructions, including any restrictions on transfers to or from investments; voting and other rights of the participant related to particular investments; investment alternatives; and investment managers to whom participants may give directions. 

The proposed regulations also require the disclosure of administrative fees and expense information (e.g., legal, accounting, and recordkeeping fees) which are not among the investment-related fees charged against participant accounts on a plan-wide basis.  The proposed regulations would also require plan fiduciaries to disclose whether such plan-wide expenses will be charged on a pro rata or per capita basis. 

The proposed regulations further require plan fiduciaries to disclose any services that would result in expenses assessed against an individual account and to disclose the actual amount of any expenses assessed against individual accounts during the previous quarter.  Such expenses typically include fees for administering qualified domestic relations orders or processing plan loans. 

Finally, the proposed regulations would require the disclosure of “investment-related” information to all participants and beneficiaries, including: the name and category of the “designated investment alternative”; whether the investment is actively or passively managed; performance data; benchmark indices related to the investment type; and fee and expense information. 

Under the proposed regulations, most of this information will have to be furnished before or at the time an individual becomes eligible to participate in the plan, and annually thereafter.  Updated information also will have to be provided within 30 days of any material changes.  The preamble to the proposed regulations also suggests that much of this information could be made available in the plan’s summary plan description. 

For those plans that permit participants to direct the investments of their individual accounts, plan sponsors and administrators should consult with their plans’ recordkeepers, custodians, mutual fund companies, and investment managers, to ensure that they will be able to meet the disclosure requirements imposed by the proposed regulations before the start of the next plan year beginning on or after January 1, 2009. 

Employers also should determine the means by which they intend to effect the required disclosures, and if they intend to do so via inclusion of the required information in the summary plan description, to work closely with their legal professionals to amend summary plan descriptions, review quarterly benefit statements, and review the charts of investment options to ensure that the required information is included and disseminated to participants and beneficiaries on time and in the proper form.

Defined Benefit Pension Plans

Benefits under a defined benefit plan are typically paid in the form of an annuity.  Therefore, adjustments are required where the benefit is paid in another form, such as, for example, a lump sum.  For purposes of making this adjustment, the interest rate used must comply with statutory rules.  Prior to the enactment of the Pension Funding Equity Act of 2004 (PFEA), the interest rate used could not be less than the greater of: (1) the rate applicable in determining minimum lump sums, i.e., the 30-year Treasury rate, or (2) the rate specified in the plan.  The PFEA imposed a special rule providing that the interest rate used could not be less than the greater of: (1) 5.5% or (2) the interest rate specified in the plan.  The PFEA required that plans be amended to reflect this change by the last day of the first plan year beginning in 2006.

The Pension Protection Act of 2006 (PPA) amended the PFEA to provide that the interest rate to be used generally must not be less than the greater of: (1) 5.5%, (2) the rate that provides a benefit of not more than 105% of the benefit that would be provided if the rate applicable in determining minimum lump sums was used, or (3) the interest rate specified in the plan.  In addition to amending the change made by the PFEA, the PPA also extended the time by which defined benefit plans must be amended to reflect the 5.5% interest rate assumption enacted by the PFEA, so that the amendment does not have to be added until on or before the last day of the first plan year beginning on or after January 1, 2008. 

For a calendar year plan, the amendment must be adopted no later than December 31, 2008.  Technical corrections pending in Congress would further delay the time for an adoption of such an amendment.  Specifically, the technical correction would extend the deadline for amending plans to conform to the PPA deadline (i.e., the last day of the first plan year beginning on or after January 1, 2009).  If these technical corrections are not enacted, the deadline will remain the last day of 2008.

Cafeteria Plans

Proposed Section 125 Regulations

The Treasury Department issued proposed regulations governing cafeteria plans on August 6, 2007.  Those regulations are currently scheduled to take effect for plan years beginning on or after January 1, 2009.  Final regulations were expected to be issued in late 2008.  As more time passes, however, it is possible that the regulations will not be issued in final form until 2009, or that the Treasury Department may extend the effective date for some or all of the final rules.  Nonetheless, plan sponsors should review their cafeteria plans to ensure compliance with the rules (in their current, proposed form) before year end.  A compliance review should include the following considerations:

  • Written Plan Document.  Does the plan meet the requirement for a formal plan document under the proposed regulations?  The proposed rules provide a checklist of items that must be contained in a written plan, and clarify that the requirements may be met through the use of more than one document.
  • Analysis of Benefits Offered.  Is the plan structured properly to include a choice between at least one taxable benefit and one qualified benefit?  This seems like a relatively simple matter, but should be confirmed.  Employers also should confirm that no impermissible benefits are made available through the plan.  A plan that offers impermissible benefits ceases to qualify under Internal Revenue Code Section 125.  In such a case, all benefits provided under the plan (not just the impermissible ones) then become taxable income to the participating employees.
  • Administration.  Is the plan administered in accordance with the terms of the plan documents, existing guidance, and the new regulations (as currently proposed)?  The proposed rules are punitive in this regard, as one failure has the potential to disqualify the entire plan.
  • Nondiscrimination Requirements.  Does the plan pass the nondiscrimination tests applicable to cafeteria plans?  Under the proposed regulations, employers would be required to perform annual nondiscrimination testing of cafeteria plans as of the last day of each plan year.  Although the statute authorizing cafeteria plans has always contained a nondiscrimination requirement, the new rules include detailed instructions on how to perform these tests.  With the proposed January 1, 2009 effective date, a calendar year plan would test for nondiscrimination for 2009 as of December 31, 2009, taking into account employee compensation for the preceding year.  Employers should test cafeteria plans for the 2008 plan year based upon a good-faith interpretation of the regulations as proposed.

Heroes Earnings Assistance and Relief Tax Act of 2008

On June 17, 2008, President Bush signed the Heroes Earnings Assistance and Relief Tax (HEART) Act of 2008.  Under the HEART Act, employers may amend the terms of their cafeteria plans and health flexible spending accounts (FSAs), to protect reservists who are called to active duty, and who would otherwise fall victim to Section 125’s “use-it-or-lose-it rule.”  Under the HEART Act, employers may (but are not required to) amend their cafeteria plans or health FSAs to make “qualified reservist distributions” that will not jeopardize a plan’s status as a cafeteria plan or health FSA (and the associated favorable tax treatment its participants receive). 

A “qualified reservist distribution” is a distribution of all or a portion of the participant’s health FSA balance on or after June 17, 2008, if: (1) the participant is a reservist called to active duty for a period of at least 180 days or for an indefinite period; and (2) the distribution is made during the period beginning with the call to active duty and ending on the last date reimbursements could otherwise be made for the plan year that includes the date of the call to active duty.

The decision to offer qualified reservist distributions is optional, and employers are not required to permit such distributions.  Employers that wish to amend their cafeteria plan or health FSA to permit qualified reservist distributions should amend the plan document and related summary plan description as soon as possible.  The plan amendment should be drafted to describe when and how such distributions will be made (e.g., will the plan automatically distribute the unused balance of the reservist’s health FSA on or before the last day of the run-out period or will the participant be required to apply for the distribution?  If the reservist must request the distribution, when will the distribution occur – at the time of the request, the last day of the run-out period, or at some other time?).  Employers that want to incorporate the qualified reservist distributions into their plan documents for the current plan year should amend their plans before the end of the year to provide for these distributions.

Group Health Plans

Genetic Information Nondiscrimination Act of 2008

On May 21, 2008, President Bush signed the Genetic Information Nondiscrimination Act (GINA) of 2008 into law.  GINA amends the portability rules under the Health Insurance Portability and Accountability Act (HIPAA) of 1996, as amended to prohibit group health plans and health insurers from:

  • Adjusting group premiums or contribution amounts based on genetic information (however, group premiums and contribution amounts may be based on an enrolled individual’s actual manifestation of a disease or disorder);
  • Requesting or requiring an individual (or family member) to undergo a genetic test; and
  • Requesting, requiring or purchasing genetic information for underwriting purposes, or collecting genetic information about an individual before he or she is enrolled or covered under the plan.

GINA defines “genetic information” broadly; the definition includes: (a) an individual’s genetic tests; (b) a family member’s genetic tests; and (c) the manifestation of a disease or disorder in a family member (e.g., family medical histories). 

Finally, GINA provides for penalties of $100 per day per individual for each day of noncompliance, establishes minimum and maximum penalties and provides for the waiver of excessive penalties in certain situations.  GINA’s provisions become effective for plan years beginning one year after the date of enactment.  While this sets a January 1, 2010 compliance date for calendar year plans, plans with other plan years could face a substantially earlier compliance requirement.

While GINA does provide employers with some time to amend their group health plans to incorporate the statute’s provisions, employers should review their plan documents, as well as their HIPAA policies and procedures promptly to determine whether they will have to amend their plans for plan years beginning on or after May 21, 2009.

Medicare Part D

The Medicare Part D regulations issued pursuant to the Medicare Modernization Act of 2003 (MMA) require employer groups to notify all Medicare-eligible individuals covered under their plan periodically if their pharmacy coverage under the employer’s group health plan meets the “creditable coverage” requirements of the regulations.  Generally, a plan will be considered creditable if its benefits are equal to, or better than, those provided under a Medicare Part D plan.

The purpose of this notice is to help Medicare-eligible individuals decide whether to enroll in a Medicare Part D plan during their initial enrollment period (IEP), or wait for a later date.  Individuals who do not enroll during their IEP, and who do not have creditable coverage, may be required to pay a late enrollment penalty (essentially an increased premium).  Individuals who decline coverage under a Medicare Part D plan during their IEP, but who do have creditable coverage, may be able to avoid the increased premium if they enroll in a Medicare Part D plan at a later date.

Group health plans that provide prescription drug coverage must provide a Medicare Part D notice of creditable coverage to all Medicare-eligible individuals by November 15th of each year.  Earlier this year, the Centers for Medicare & Medicaid Services (CMS) updated its model notices of creditable coverage and posted these revised notices on its website.  Employers should compare their current notices with the CMS’s revised model notices now to determine if any changes are necessary.  Employers also should ensure that the Medicare Part D notices of creditable coverage be provided to all Medicare-eligible individuals by November 15, 2008.  These notices may be distributed separately or with the group health plan’s annual enrollment materials.

Code Section 409A Compliance Deadline – December 31, 2008

In 2004, in response to the corporate scandals of the early part of this decade (including the Enron collapse), Congress enacted Section 409A of the Internal Revenue Code.  This section was intended to address perceived abuses related to certain types of executive compensation arrangements (so-called “nonqualified deferred compensation plans”). Section 409A applies to any arrangement under which an employee has a legally binding right to compensation that is payable in a subsequent tax year.  Section 409A potentially could apply to any compensation earned in one year but paid in a subsequent year. 

Basic Requirements.  Agreements subject to Section 409A must satisfy stringent documentary and operational requirements or recipients of deferred compensation will face severe tax penalties.  If an arrangement is subject to Section 409A, it must be in writing.  It also must limit the timing of elections to defer compensation, restrict the events that trigger a distribution of deferred compensation, and require that the timing and form of distributions are determined at the same time as the election to defer compensation is made.  The arrangement also must prohibit both the acceleration and postponement of scheduled payments in nearly all circumstances.  It also must impose a six-month delay on payments to certain “specified employees” of publicly traded companies upon their separation from service.

Penalties.  Section 409A imposes some of the most severe tax penalties of any provision in the Code.  The failure of a deferred compensation arrangement subject to Section 409A to comply with all of its provisions will result in the following: (1) immediate taxation of all vested amounts (regardless of whether these amounts have been distributed); (2) 20% penalty tax on all amounts included in income; and (3) interest on the deferred amounts at the IRS interest rate plus 1% penalty interest.  The IRS has proposed a narrow correction program for certain limited operational failures, but most failures (including all plan document failures) under Section 409A probably will result in confiscatory taxation of the individual recipients.

Arrangements Typically Subject to Section 409A.  Although not defined by the statute or the final regulations, the following types of arrangements often provide for deferral of compensation (although some can be structured to fit within one of Section 409A’s exceptions): (1) traditional nonqualified deferred compensation plans, including top-hat plans, supplemental executive retirement plans, supplemental executive pension plans, pension or 401(k) restoration plans, executive deferred compensation plans, phantom stock plans, and director retirement plans; (2) excess benefit plans; (3) employment or independent contractor agreements; (4) equity compensation, such as stock options, restricted stock, phantom stock or stock appreciation rights; (5) bonus and long-term incentive plans; (6) change of control agreements; (7) severance agreements and separation pay plans; (8) split-dollar life insurance policies; (9) reimbursement arrangements; (10) discriminatory medical benefits; (11) tax gross-up payments; and (12) Code Section 457(f) plans for government and tax exempt entities.

Documentary Requirements. Under the final Section 409A regulations, a nonqualified deferred compensation arrangement must specify the recipient of the deferred compensation, the amount of the deferred compensation (or the formula for determining it), and the time and form of payment.  Also, where applicable, the written arrangement must include the six-month payment delay for “specified employees” of publicly traded companies receiving distributions on account of separation from service.  Although some of Section 409A’s definitions may be incorporated by reference, the document may not simply incorporate Section 409A compliance by reference.  Thus, a “savings clause” purporting to strike noncompliant provisions will not satisfy Section 409A’s documentary requirements.

Compliance Deadline and Transitional Relief.  The final regulations under Section 409A become effective January 1, 2009.  While certain nonqualified deferred compensation arrangements will fall within one of the available exemptions, those that do not have only until December 31, 2008 to come into compliance.  Employers must therefore identify which of their compensation arrangements are subject to Section 409A, and if no exception applies, reduce those arrangements to writing (or amend written arrangements accordingly) not later than December 31, 2008.  Until the end of 2008, employers and employees have the flexibility to change elections relating to timing and form of payments under a nonqualified deferred compensation arrangement, and the Section 409A restrictions regarding subsequent elections will not apply.  Employers should consider taking advantage of this flexibility to change plan provisions to simplify their nonqualified deferred compensation arrangements, thereby decreasing the likelihood of operational errors in the future.  The transitional relief applicable to the 2008 calendar year permits changes in the timing and form of payments, provided the election: (1) is made on or before December 31, 2008; (2) applies only with respect to amounts that would not otherwise have been payable in 2008; and (3) does not cause an amount to be paid in 2008 that would not otherwise have been payable in 2008.


Although many of the provisions and requirements discussed in this article will not apply to all employers, it is essential that those who are subject to any of those requirements take steps to adopt and implement appropriate measures to ensure their plans’ compliance.  However modest the requirements may be with respect to a particular plan, the failure to timely implement any required changes could create substantial liability and cost in the event that remedial action is needed at a later date. 

Note: This article was published in the October 14, 2008 issue of the Benefits eAuthority.

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