February 2010

The following highlights the most significant New Developments published in the Pension Plan Guide since the last update on February 1, 2010.

During the past month, two significant cases emerged from the Federal Appeals Courts: (1) the Ninth Circuit ruled that automatic survivor annuity requirements imposed by the Internal Revenue Code and ERISA do not apply to 401(k) plan proceeds rolled over to an IRA and do not override beneficiary designations made when establishing the account, and (2) the Third Circuit held that an amendment to a union welfare benefit plan that conditioned the receipt of retiree health care benefits on a participant’s rejection of the right to elect a lump-sum distribution option (instead of a monthly periodic payment) under a union pension plan violated ERISA's anti-cutback rule.

The IRS has issued a private letter ruling that provides guidance on the use of variable annuity contracts to provide annuity distributions to participants in self-directed defined contribution plans. The ruling clarifies many ambiguities that may have discouraged the use of variable annuities as distribution options by addressing the application of the required minimum distribution rules to benefits under an annuity contract and whether the election of periodic payments constitute the election of payments in the form of a life annuity for purposes of the joint and survivor annuity requirements under Code Sec. 401(a)(11).

Finally, in advance of the looming March 15, 2010 deadline by which plans need to make corrective distributions of 2009 excess contributions and excess aggregate contributions in order to avoid an onerous excise tax, this Update discusses some of the applicable considerations.

NEW DEVELOPMENTS

1. ERISA’s Survivor Annuity Requirements Inapplicable to 401(k) Funds Rolled Over to IRA

The automatic survivor annuity requirements imposed by the Internal Revenue Code and ERISA do not apply to 401(k) plan proceeds rolled over to an IRA and do not override beneficiary designations made when establishing the account, the U.S. Court of Appeals at San Francisco (CA-9) has ruled. The ruling confirms the position that the surviving spouse protections of ERISA and the IRC do not follow amounts rolled over from a qualified plan to an IRA.

In 1994, an individual took a distribution from a 401(k) plan that he had maintained from a previous employer and rolled the proceeds over to an IRA. In 2002, he opened a second IRA, which he funded by transferring approximately half the proceeds from the first IRA. He named his four adult children from a previous marriage as his primary beneficiaries of the IRA. The individual died in 2005, survived by his wife and the four children, who asserted competing rights to the funds in the IRA.

The wife’s primary claim to automatic surviving spouse benefits was based on ERISA Sec. 205(a)(2) which requires that ``in the case of a vested participant who dies before the annuity starting date and who has a surviving spouse, a qualified preretirement survivor annuity shall be provided to the surviving spouse of such participant.’’

In affirming the decision of the trial court, the appeals court initially conceded that the 401(k) plan in which the individual participated was covered by ERISA and that his surviving spouse at the time of his death never consented to the designation of another beneficiary. However the court stressed that these facts did not entitle the wife to automatic surviving spouse benefits under ERISA. Although the account holder was at one time a participant in an employee benefit plan subject to ERISA's protections and limitations, ERISA ceased to apply when, long before his remarriage, he terminated his participation in the 401(k) plan and transferred the proceeds to an independent IRA that was established and maintained by the decedent and not by his employer or any employee organization.

The court also rejected the spouse’s alternative argument that, because Code Sec. 408(a)(6) requires the IRS to provide regulations similar to those under Code Sec. 401(a)(9), the incidental death benefits provided to pension plan participants under Code Sec. 401(a) are meant to also incorporate the surviving spouse provisions under Code Sec. 401(a)(11). The court stressed that IRS Reg. 1.408-8 does not impose automatic surviving spouse rights on IRAs, but leaves the designation of beneficiaries to the individual account holder. Accordingly, the court could find no basis for imposing the automatic survivor annuity requirements of Code Sec. 401(a)(11) on the IRA and overriding the beneficiary designations made by the decedent in establishing the account.

Charles Schwab and Company v. Debickero was reported in PEN Report 1824 (February 15, 2010) at Par. 24,006K.

2. IRS Private Ruling Highlights Means for Using Variable Annuity Contracts to Provide 401(k) Plan Distributions

The IRS has issued a private letter ruling that provides guidance on the use of variable annuity contracts to provide annuity distributions to participants in self-directed defined contribution plans. The ruling addresses the application of the required minimum distribution rules to benefits under an annuity contract and whether the election of periodic payments constitute the election of payments in the form of a life annuity for purposes of the joint and survivor annuity requirements under Code Sec. 401(a)(11).

Nonqualified variable annuity contracts provide annuity distributions to plan participants. A life insurance company proposed to issue two types of nonqualified variable annuity contracts, a group variable annuity contract and an individual variable annuity contract, to qualified defined contribution plans that permit participants to direct the investment of their account balances.

Group annuity. The group annuity would be owned by the plan and used to offer plan participants an annuity form of distribution among other optional forms of distribution. Participants who elected the annuity distribution option would then allocate amounts among fixed and variable investment options available under the group annuity.

The life insurance company would hold amounts allocated to the fixed account in its general account. The amount would earn interest at a rate declared by the company, subject to a guarantee of principal and a minimum guaranteed interest rate.

However, amounts allocated to the variable investment option would be held in a separate account that would be segregated from the company's general assets. The separate account would be further divided into variable sub-accounts. The variable sub-accounts available under each group annuity would correspond to the mutual funds available as investment options under the plan.

Distributions from group annuity. Distributions from the group annuity would be paid to the plan as the owner of the annuity. The plan would distribute amounts to participants who chose the annuity distribution option. The distributions would begin after the participant's allocation of amounts to the annuity distribution option and would be calculated based on the allocations made by the participant under the group annuity.

Stream of income payments in two phases. The group annuity would generally provide a stream of income payments to be made over the lifetime of a participant or the joint lifetimes of a participant and designated beneficiary through two phases. Phase I would begin on the valuation date on which the first periodic payment is calculated and ends on the date Phase II begins. At the conclusion of Phase I, the participant would no longer be able to stop and start periodic payments, make additional contributions to the group annuity, or access the surrender value via partial withdrawal or full surrender.

Individual annuity. The individual annuity would operate much the same as the group annuity. Accordingly, the individual annuity would provide a fixed investment option and a variable investment option that corresponds to the investment options that would be available under the plan to which the group annuity was issued.

Annuitization determines application of RMD rules. The IRS concluded that, for purposes of satisfying the required minimum distribution requirements of Code Sec. 401(a)(9), the required minimum distributions from the group and individual annuities would be determined under IRS Reg. 1.401(a)(9)-5 during Phase I (when the participant controlled the amount and timing of payments) and under IRS Reg. 1.401(a)(9)-6 during Phase II of the annuity (when the timing and amount of distributions are fixed and satisfy the definitions of amounts received as an annuity).

Election of life annuity. In determining whether Code Sec. 401(a)(11) applies to participants, the IRS explained that the election of an annuity distribution option, rather than the election to receive periodic income payments during either the Phase I or the Phase II period, would constitute the election of payment in the form of a life annuity. Accordingly, neither a participant’s election to begin receiving periodic income payments during the Phase II period, nor the election to receive periodic income payments during the Phase I period alone would constitute the election of a life annuity for purposes of Code Sec 401(a)(11).

IRS Letter Ruling 200951039 was reported in PEN Report 1823 (February 8, 2010) and reproduced at Par. 17,431Z.

3. Welfare Plan Amendment that Conditioned Receipt of Benefits on Rejection of Accrued Lump-Sum Benefits Violated ERISA

An amendment to a union welfare benefit plan that conditioned the receipt of retiree health care benefits on a participant’s rejection of the right to elect a lump-sum distribution option (instead of a monthly periodic payment) under a union pension plan violated ERISA's anti-cutback rule. The US Court of Appeals in Philadelphia (CA-3) held that the pension plan had been constructively amended to decrease an accrued pension benefit.

Following the merger of two union chapters, one chapter was dissolved and its members were transferred to a second surviving chapter. The chapters' pension and welfare plans were combined. The surviving chapter's pension plan was amended to allow the transferred members to retain a lump-sum distribution benefit option for benefits accrued under the dissolved chapter's pension plan. However, for benefits accrued in the surviving pension plan after the merger, the transferred members were required to take distributions in the form of periodic monthly payments --the plan's prevailing distribution option. In addition, the surviving chapter's welfare plan was amended after the merger to condition a retiree's receipt of health care benefits on the retiree not choosing the lump-sum distribution option offered in the surviving chapter's pension plan.

Anti-cutback violation. The issue before the court was whether the modification of the plan constituted a plan amendment decreasing accrued benefits in violation of ERISA anti-cutback rule.

The court concluded that the amendment constructively amended the pension plan by adding a condition to the receipt of an accrued benefit under that plan. In addition, the court rejected the union contention that the amendment merely restricted access to health care benefits and did not decrease any accrued benefit. The amendment, the court explained, imposed a condition on the receipt of the lump-sum benefit, thereby decreasing the value of an accrued benefit.

Battoni, Jr. v. IBEW Local Union No. 102 Employee Pension Plan was reported in PEN Report1825 (February 22, 2010) at Par. 24,006M.

4. White House Retirement Savings Initiative Includes Auto IRAs and Expanded Saver's Credit

President Obama has announced several retirement plan initiatives that will be included in the fiscal year 2010 budget and that are among several recommendations made by the Middle Class Task Force chaired by Vice President Biden. The initiatives are designed to make it easier to save for retirement by: providing voluntary automatic IRAs for workers without access to existing retirement plans through their jobs, incenting employers to automatically enroll employees in 401(k) plans, authorizing a match for Saver’s credit contributions, and implementing new disclosure requirements and other safeguards to protect retirement savings.

Automatic IRAs, 401(k)s. The Administration proposes to establish a system of automatic IRAs in the workplace by requiring employers who do not currently offer a retirement plan to enroll their employees in a direct-deposit IRA unless the employee opts out. The contributions would be voluntary and matched by the Savers Tax Credit for eligible families.

In addition, the Administration plans to streamline the process for employers to automatically enroll workers in 401(k) plans. New tax credits would help pay employer administrative costs and the smallest firms would be exempt.

Saver's credit. The Administration also intends to help working families save for retirement by expanding and simplifying the Saver's Credit to match 50 percent of the first $1,000 of contributions by families earning up to $65,000 and providing a partial credit to families earning up to $85,000. The tax credit would be made refundable to allow taxpayers to take advantage of the credit even if they have no income tax liability.

Annuity distribution options. The Administration is further looking to promote the availability of annuities and other forms of guaranteed lifetime income, which transform savings into guaranteed future income, reducing the risks that retirees will outlive their savings or that their retirees' living standards will be eroded by investment losses or inflation.

IRS, EBSA RFI on lifetime income options. In response to the White House initiative, the IRS and Employee Benefits Security Administration (EBSA) have issued a request for information (RFI) on steps the Agencies could take, by regulation or otherwise, to facilitate access to arrangements designed to provide a lifetime stream of income to participants and beneficiaries in employer-sponsored retirement plans and IRAs. The RFI is designed to solicit views, suggestions and comments from plan participants, employers and other plan sponsors, plan service providers, and members of the financial community.

Among the questions being asked are the following:

1. Is the fact that the vast majority of individuals choose a lump sum distribution from their retirement plan or IRA instead of a lifetime income option. the result of a market failure or other factors (e.g., cost, complexity of products, adverse selection, poor decision-making by consumers, desire for flexibility to respond to unexpected financial needs, counterparty risk of seller insolvency, etc.)? What steps could the Agencies take to overcome participant reluctance to request or elect lifetime income options

2. What are the advantages and disadvantages from the standpoint of the plan sponsor of providing an in-plan option for lifetime income as opposed to leaving to participants the task of securing a lifetime income vehicle after receiving a plan distribution?

3. Can or should the 401(k) rules, other plan qualification rules, or ERISA rules be modified, or their application clarified, to facilitate the use of behavioral strategies (such as those underlying default or automatic arrangements (e.g., automatic enrollment in 401(k) plans)) to further promote lifetime income options?

4. Should some form of lifetime income distribution option be required for defined contribution plans (in addition to money purchase pension plans)?

5. Should an individual benefit statement (required under ERISA Sec. 105) present the participant's accrued benefits as a lifetime income stream of payments in addition to presenting the benefits as an account balance?

The White House proposals were discussed in PEN Report 1823 (February 8, 2010). The IRS/ EBSA Request for Information was reported in PEN Report 1823 and reproduced at Par.17,203Y-24.

PEN ENHANCEMENTS

Pending March Deadline for 2009 Corrective Distributions Needed to Avoid Excise Tax
Plan sponsors and administrators need to be aware of the pending March 15, 2010 deadline for making corrective distributions of 2009 excess contributions and excess aggregate contributions (adjusted for earnings) to highly compensated employees. In the event excess contributions and allocable income are distributed later than March 15 (i.e., 2 ½ months after the close of the plan year) the employer will be subject to a 10 percent excise tax. However, an employer maintaining an eligible automatic contribution arrangement may avoid the applicable excise tax by making a corrective distribution of excess contributions under the arrangement within 6 months after the end of the plan year (i.e., June 30, 2010).

Reporting corrective distributions.
Corrective distributions of excess contributions and excess aggregate contributions are reported on Form 1099-R, as taxable to the recipient in the year of distribution. The payer must complete Form 1099-R by:

• Stating the total amount of the distribution in Box 1;
• Reporting the taxable amount of distribution in Box 2a; and
• Classifying the distribution as taxable in the year distributed by using Code 8 in Box 7.

Note: The distribution amount will generally equal the taxable amount, unless the corrective distribution includes Roth 401(k) contributions.

Losses are not reported separately. An employer must report the amount distributed to a participant on Form 1099-R. Losses are not reported separately.

For example, assume an employer following the failure of the ADP test is required to make a corrective distribution to a highly compensated employee of $1000. However, the participant's account has sustained a loss of $100. Accordingly, the amount distributed is $900.

The amount reported on Form 1099-R would be the amount of the distribution ($900). The $100 loss would not be reported as a separate item.

Federal income tax withholding. As nonperiodic distributions, corrective distributions of excess contributions and excess aggregate contributions are subject to 10 percent withholding. However, the taxpayer recipient may request additional withholding on Form W-4P or claim an exemption from withholding.

QNECs and QMACs enable employer to avoid excise tax. An employer may avoid the 10 percent excise tax if the plan uses QNECs or QMACs to correct excess contributions and excess aggregate contributions (and pass the ADP and ACP tests), even if the QNECs or QMACs are made more than 2 1/2 months after the close of the plan year.

Contributions made 12 months after year for which allocated. QNECs and QMACs may be contributed as late as 12 months after the year for which they are allocated. Even if the QNECs and QMACs are added after the filing date for the plan’s Form 5500, the testing failure is cured and the employer is not liable for the 10-percent excise tax.

Deductibility of contributions after filing date. Employers are cautioned that contributions made after the filing date are not deductible by the employer for the prior plan year. Rather, the contributions are counted, with other employer contributions, against the Code Sec. 404 deduction limits in the year in which they are made.

The correction of excess contributions is discussed beginning at PEN Par. 7592. The correction of excess aggregate contributions is detailed beginning at PEN Par 7622.

Keeping Up with PPA Guidance
The Pension Protection Act of 2006 represents the most sweeping overhaul to the pension law in more than 30 years. In addition to making myriad changes to the Internal Revenue Code and ERISA, the PPA requires government agencies to issue perhaps hundreds of guidance items over the next several years.

Keeping track of these guidance issuances will be a monumental task for pension and benefit practitioners. CCH has created a valuable search aid --the Table of PPA Guidance --which allows practitioners to quickly locate PPA guidance items. The Table lists official guidance issued by government agency (Internal Revenue Service, Department of Labor, Pension Benefit Guaranty Corporation, and joint agency releases), form of guidance, date of issuance, short description of the guidance, and the CCH paragraph number at which the guidance item may be found in full text. Internet customers can quickly link from the Table to a specific guidance item. The Table of PPA Guidance is designed to help busy practitioners stay abreast of the continuing flow of PPA issuances and is available exclusively to CCH PENSION PLAN GUIDE subscribers.

The Table of PPA Guidance is at PEN Par. 51C.

Comprehensive Plan Reporting and Disclosure Calendar Chart
Employee benefit plans are subject to numerous reporting and disclosure requirements that require information to be provided to plan participants and beneficiaries and filed with the IRS, DOL, PBGC, and other government agencies. Failure to comply with any applicable reporting requirement can result in significant penalties.

In order to assist plan administrators and others in satisfying their reporting obligations, PEN features a plan reporting calendar that neatly capsulizes all the various reporting requirements. The calendar lists the reports required in a calendar year in chronological order. In addition, the calendar highlights the subject matter of a report and indicates both the party required to file the report and the party to whom the report must be directed.

The Plan Reporting Calendar is at PEN Par. 36.

Check "Calendars . Tables . Interest Rates" for Quick Answers
Electronic and print customers of the CCH Pension Plan Guide can find many pertinent pension facts and figures by consulting the handy "Calendars . Tables . Interest Rates" section of the Guide.

Some of the helpful features of this section are:

• Current withholding tax tables (PEN Pars. 46, 46A, and 46B)
• Cost-of-living adjustment charts for retirement plans, IRAs, and social security (PEN Par 48)
• PBGC monthly benefit chart (PEN Par. 49)
• Table of Public Laws Amending the Internal Revenue Code and ERISA (PEN Par. 51B)
• Table of current and historical interest rates (PEN Par. 52 and following)

Print customers will find the "Calendars . Tables . Interest Rates" division in Volume 1 of their Guide. Internet customers will find the same information by selecting "Pension Plan Guide" under the "CCH Pension Explanations" blue bar, then clicking on "Tables and Other Documents," the first item on the menu.