Employee Benefits & Executive Compensation Blog

The View from Proskauer on Developments in the World of Employee Benefits, Executive Compensation & ERISA Litigation

A Good 403(b) or a Bad 403(b)? A Question IRS Auditors Look to Answer

In each case, the answer depends on whether the document and operation are in compliance with the many technical requirements for section 403(b) plans. IRS officials have recently indicated that the IRS expects to launch audit initiatives this summer targeting section 403(b) plan compliance, so now is a good time for employers with section 403(b) plans to take a close look at their documents and administrative practices.

Tax-exempt organizations and public schools often sponsor section 403(b) plans for retirement. Sometimes vendors will market the section 403(b) plans as “turn-key” products where the employer simply signs up with the vendor and the vendor takes it from there. It seems like an easy way to make a retirement savings plan available to employees with a minimum amount of employer involvement.

Yet the tax rules governing section 403(b) plans can be quite technical and are sometimes overlooked. For example, section 403(b) plans are subject to a “universal availability” requirement. See our blog on recent developments in this area. If a plan does not comply with that rule, there could be significant tax consequences for employees.

If plan sponsors self-identify errors, they can take advantage of the IRS Employee Plans Compliance Resolution System (EPCRS) to correct the mistakes—often without penalty. Many errors can be self-corrected without even having to request IRS approval. Even if IRS approval is required, the cost of voluntary correction is generally less than if the IRS discovers errors on audit.

The old saying goes “To err is human; to forgive divine.” But when it comes to plan administration, administrators tend to be more human than the IRS is divine. Therefore, it is well worth the effort to conduct a compliance review, identify errors, and correct them before the IRS comes calling.

Third Circuit Resuscitates Claims Against University 403(b) Plan Fiduciaries

Over the past several years, the ERISA plaintiffs’ bar has targeted university-sponsored 403(b) plans, arguing that the plan fiduciaries breached their fiduciary duties and engaged in prohibited transactions in connection with offering certain investment options and the administrative fees associated with such plans. Among other things, they have argued that the plan fiduciaries offered too many investment options, and that the investment options were imprudent because they were too expensive and/or underperformed. They also have argued that the plans retained too many record-keepers and paid those record-keepers unreasonable fees. To date, these lawsuits have had mixed results. Some have been dismissed at the initial pleading stage; some have settled after motions to dismiss were denied; and one lawsuit was dismissed after a full trial.

The Third Circuit recently issued the first circuit court decision addressing these claims and, in doing so, issued a split decision that breathed new life into a case involving a 403(b) plan sponsored by the University of Pennsylvania. Sweda v. Univ. of Penn., No. 17-3244, 2019 WL 1941310 (3d Cir. May 2, 2019). In Sweda, the plaintiffs-plan participants argued that the plan fiduciaries breached their fiduciary duties by:  (1) locking the plan into investment arrangements with the plan’s record-keepers for up to ten years, (2) paying unreasonable administrative fees insofar as they used two plan record-keepers instead of one, (3) paying record-keeping fees through an asset-based arrangement instead of a flat per-participant fee, (4) investing in more expensive retail share class mutual funds when identical lower cost institutional share classes were available, (5) offering numerous duplicative investment options, and (6) selecting and retaining expensive, underperforming funds. Plaintiffs also alleged that the defendants violated ERISA’s prohibited transaction rules by paying record-keeping fees through revenue sharing rather than a per participant fee basis and by agreeing to the lock-in agreement.

The district court dismissed all of the claims at the initial pleading stage, and, in doing so, observed that many of the allegations sought to fault the University for rational and competitive business strategies. In a split (2-1) decision, the Third Circuit reversed the district court’s decision dismissing all of the fiduciary breach claims, but affirmed the dismissal of plaintiffs’ prohibited transaction claims.

As a preliminary matter, the Third Circuit determined that an ERISA plan participant is not required to rule out every lawful explanation for the plan fiduciary’s conduct in order to state a plausible claim for relief. According to the Court, that pleading requirement, established in Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007), is limited to antitrust cases because in such cases “a conclusory allegation of agreement at some unidentified point does not supply facts adequate to show illegality.”

The Third Circuit next rejected the University’s argument that the Court’s earlier decision in Renfro v. Unisys Corp., 671 F.3d 314 (3d Cir. 2011) insulated plan fiduciaries from liability for a breach of fiduciary duty where plans offer a mix and range of investment options, because such a ruling would allow a fiduciary to avoid liability by stocking a plan with hundreds of options even if the majority were overpriced or underperforming. Furthermore, it would hinder courts from evaluating fiduciaries’ performance against contemporary industry practices because practices change over time and ERISA fiduciaries have a duty to act prudently according to current practices.

Next, the Court concluded that plaintiffs plausibly alleged their breach of fiduciary duty claims because there were several “well-pleaded facts” in the complaint. For instance, the Court determined that plaintiffs plausibly alleged that the plan paid $4.5 to $5.5 million in annual record-keeping fees when similar plans paid $700,000 to $750,000 for the same services. The Court also cited plaintiffs’ allegation that the percentage-based fees increased as assets in the plan grew, despite there being no corresponding increase in record-keeping services. Plaintiffs also included a table comparing options in the plan with “readily available cheaper alternatives,” which allegedly showed that 60% of plan options underperformed comparable benchmarks. The Court further observed that plaintiffs provided examples of prudent actions taken by similarly situated universities, but not here, including hiring an independent consultant to request record-keeping proposals, offering a single record-keeper, and negotiating for revenue sharing rebates. Construing the allegations in the light most favorable to plaintiffs, the Court determined that Plaintiffs had plausibly alleged their breach of fiduciary duty claims.

Lastly, the Court held that plaintiffs’ prohibited transaction claims were properly dismissed. In so ruling, the Court determined that plaintiffs did not plausibly allege that the record-keeper was a party-in-interest who provided services to the plan at the time the first lock-in agreement was entered into. The Court also determined that the allegations of revenue sharing did not amount to a prohibited transaction because, among other things, mutual funds were not plan assets and therefore plaintiffs did not plausibly allege that revenue sharing involved a transfer of plan property or assets.

In a separate opinion, Senior Judge Roth agreed with the majority’s decision affirming the dismissal of the prohibited transaction claims, and stated that he also would have affirmed the dismissal of all of the fiduciary breach claims. Judge Roth stated his belief that the majority misapplied the Third Circuit’s prior ruling in Renfro, and that the fiduciary breach claims presented here were “virtually identical” to the claims that the Court dismissed in Renfro. Judge Roth also expressed the concern that, by exposing university sponsors and volunteer fiduciaries to the risk of litigation, the majority’s decision would cause universities to stop offering benefit plans.

IRS Announces Limited Expansion of its Determination Letter Program for Individually Designed Retirement Plans – But Questions Remain

On May 1, 2019, the IRS released Revenue Procedure 2019-20 which provides for a limited-scope expansion of its determination letter program for individually designed plans. Beginning on September 1, 2019, the IRS will accept determination letter applications submitted for the following types of plans:

  • Statutory hybrid plans (e.g., cash balance or pension equity plans). Applications will need to be filed during the 12-month period beginning on September 1, 2019 and ending on August 31, 2020.
  • “Merged Plans” (i.e., plans that have had other plans merged into them in connection with business transactions). Applications for merged plans will be accepted on an ongoing basis provided that (i) the plan merger was completed by the end of the first full plan year following the business transaction, and (2) the application is submitted by the end of the first full plan year following the plan merger.

By way of background, prior to 2017, individually designed retirement plans were generally required to renew IRS determinations of qualified status every five years (called the “remedial amendment cycle program”). The IRS announced in Revenue Procedure 2016-37 that it was ending the remedial amendment cycle program effective January 31, 2017, and that it would review only new or terminating individually designed plans going forward. The IRS reserved the right to open limited review periods at its discretion to ensure that plans are properly amended for law changes during the applicable remedial amendment period, which for required amendments, generally runs from the date the IRS issues the applicable “Required Amendment List” to the end of the second full plan year following that date. Similar to the old “Cumulative Lists,” the Required Amendment List is an annual list of required plan amendments issued by the IRS.

In 2018, the IRS sought comments on whether and to what extent the determination letter program should be expanded. In response to those comments, the IRS has now expanded the program to cover two areas ripe for IRS review – hybrid plans and merged plans. Key aspects of the new revenue procedure, including the deadlines and eligibility rules, are summarized below.

Individually Designed Statutory Hybrid Plans – Special One-Year Period for Review

As explained above, the IRS reserves the right to open limited review periods to ensure required amendments are timely adopted. Overall, there have been relatively few statutory and regulatory changes requiring amendments after the remedial amendment cycle program for individually designed retirement plans ended.

There have been, however, required amendments for statutory hybrid benefits plans that were not covered by prior IRS determinations. The IRS is opening a limited review period to pick up these changes. In brief, statutory hybrid plans are generally defined benefit plans that use either: (i) a cash balance formula (the balance of a hypothetical account maintained for the participant); or (ii) a pension equity formula (an accumulation percentage of the participant’s final average compensation).

Although it is not entirely clear, it would appear that the one-year review period would be open to any defined benefit plan that has a hybrid benefit formula, even if the plan’s hybrid formula applies only to a subset of the plan’s participants. In that case, the IRS would still review the entire plan for compliance with the 2017 Required Amendments List and all Required Amendments Lists and Cumulative Lists issued prior to 2016. As explained below, the IRS will assess penalties if it finds a plan document failure that is not related to the hybrid plan regulations.

Employers and other organizations sponsoring hybrid defined benefit plans should consider submitting their plans to the IRS in the upcoming review period. The guidance includes a favorable penalty structure in the event the IRS finds a plan document failure (whether or not related to the hybrid plan regulations). Even if a plan sponsor is confident that its plan has no document failures, obtaining a new determination letter provides important protection if the IRS audits a plan (and would mitigate some of the complications described in our May 3, 2017 blog entry describing life without a determination letter program). Further, although expiration dates on determination letters are no longer applicable (as set forth in Rev. Proc. 2016-37), plan sponsors cannot rely on a determination letter with respect to provisions that have been affected by a change in law.

Merged Plans – Ongoing Determination Letter Program

Beginning on September 1, 2019, the IRS will accept determination letter applications for individually designed “merged plans,” which are defined to include a single individually designed plan that results from the consolidation of two or more plans maintained by unrelated entities in connection with a corporate merger, acquisition, or other similar transaction between unrelated entities.

At first glance, the merged plan review procedure appears relatively straight-forward. However, the guidance gives rise to a number of important issues:

  • Are Sponsors Required to Submit Merged Plans for Review? Although IRS determinations are technically optional, the old remedial amendment cycle program imposed a significant cost for not participating – prior determinations would expire. After the old determination letter program was terminated, the IRS issued guidance stating that expiration dates in determination letters were no longer operative. Nevertheless, that guidance stated that a plan sponsor could rely on a determination letter only with respect to plan provisions that were not amended or affected by a change in law. Plan mergers require amendments related to, among other things, eligibility, vesting, transfer of assets, and maintenance of protected benefits. By not submitting a merged plan for review under the expanded review program, a sponsor would not be able to rely on a prior determination letter for provisions added to effectuate a plan merger occurring after the prior determination letter program was issued.
  • Merging Pre-Approved Plans into Individually Designed Plans. It is clear that in order to be eligible for the new merged plan review program, the end-product (i.e., the merged plan) must be individually designed. It is not clear, however, whether each merging plans needs to be individually designed. For example, many large companies routinely acquire small companies with pre-approved plans and then merge those pre-approved plans into the company’s individually designed plan. Although a pre-approved plan should be covered by an IRS opinion letter, it would make sense for the individually designed merged plan to be eligible for review.
  • Plan Document Failures from Acquired Plans. Even pre-approved plans can cause a plan document failure if the sponsor is unable to produced signed documents and amendments in connection with a determination letter review. Although the IRS’s expanded determination letter program has a favorable penalty structure when compared to the old remedial amendment cycle program, the program’s penalties for document failures in acquired plans are still higher than under the IRS’s Voluntary Correction Program. Therefore, the IRS has maintained an incentive to use the Voluntary Correction Program for document failures unrelated to provisions necessary to effectuate a plan merger.
  • Pre-2017 Transactions. Under the timing requirements set forth above, a number of plan mergers that occurred after the old remedial amendment cycle program ended would not be eligible for review.
  • Multiple Plan Mergers. Many companies make acquisitions every year. For these companies, complying with the expanded determination program could be burdensome. To get IRS review of each plan merger (and, thus, take advantage of the favorable penalty structure), these companies would have to submit their merged plans for review every year.

Special Sanction/Penalty Structure

The IRS also outlined a special sanction structure for plan document failures identified during the expanded determination letter review program. The IRS will not impose sanctions for any document failure (i) related to a plan provision required to meet the statutory hybrid plan regulations, or (ii) related to a plan provision intended to effectuate a plan merger (provided application timing requirements are met). For plan document failures unrelated to plan provisions implementing the statutory hybrid plan regulations or to the plan provision effectuating a plan merger, the IRS will impose a reduced sanction as if the plan sponsor self-identified the error through the IRS’s Voluntary Correction Program (provided that the error was made in good faith).

For all other plan document failures identified during the determination letter review process, the IRS will impose a sanction equal to 150% or 250% (depending on duration of failure) of the IRS user fee that would have applied had the error been self-identified under the Voluntary Correction Program. Under this special sanction structure, penalties (if any) for document failures are generally less severe than they would have been had they been discovered by IRS review under the old remedial amendment cycle program. The IRS maintained the incentive to correct under the Voluntary Correction Program, which is generally a cheaper option when correcting document failures.

The IRS is accepting comments on the expanded determination letter program. A plan sponsor considering whether to submit a plan for review under the expanded program should consult with counsel to ensure that the plan is eligible for the program and that all potential qualification issues are considered prior to submission.

[Podcast]: Suspension of Benefits Issues

proskauer benefits brief podcast

In this episode of the Proskauer Benefits Brief, partner Paul Hamburger, and associate Katrina McCann discuss the suspension of benefits rules, and the unique and interesting issues that arise when defined benefit plan participants work beyond their normal retirement age.  Plan sponsors and administrators should tune in, as these rules are quite complicated and are often misunderstood.

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[Podcast]: Attorney-Client Privilege in the Employee Benefit Plan Context

proskauer benefits brief podcastIn this episode of the Proskauer Benefits Brief, Paul Hamburger, co-chair of Proskauer’s Employee Benefits & Executive Compensation Group, and associate Joe Clark discuss how the attorney-client privilege rules apply in an employee benefit plan context. The attorney-client privilege allows for the free flow of information between an attorney and a client in order to insure that the client gets the best possible representation. We discuss the various specific rules that apply in the employee benefit plan context where information is often shared between attorneys and plan fiduciaries.

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New Excise Tax For Tax-Exempts Can Ensnare For-Profit Employers: Comment Deadline Fast Approaching

As discussed here, the IRS’s initial interpretation of a new excise tax under Section 4960 of the Internal Revenue Code could catch for-profit employers who set up foundations, trusts, PACs, and other tax-exempt entities off guard.  The tax is 21% of certain compensation paid to the top five highest paid employees of the tax-exempt entity.  Although the tax was designed to apply for compensation to high-paid executives of tax-exempt entities, an aggregation rule in the IRS’s initial guidance (Notice 2019-9) picks up compensation paid by related employers, even if they are for-profit companies.

For example, suppose a for-profit company controls more than 50% of the board of a tax-exempt foundation, and the company’s treasurer also serves as an officer of the foundation.  If the foundation is treated as a common law employer of the treasurer (even if the for-profit company is also a common law employer), the CIO could be a covered employee of the foundation.  If the treasurer makes more than $1 million—whether in the current year or in the future—the excise tax can be triggered, even if all of the treasurer’s compensation is paid by the for-profit company.  A similar issue could arise if the treasurer receives significant separation pay, even if it does not reach the $1 million threshold.  The tax would be owed by the for-profit employer and any others who pay the treasurer’s compensation.

The deadline for submitting comments to the IRS is April 2nd.  Employers who are affected by the rule’s broad net should consider submitting comments (and we can help).

ERISA Administrative Appeal Barred As Untimely

The First Circuit held that a plaintiff failed to timely exhaust her administrative remedies under a long-term disability plan because the plan’s 180-day time limit for submitting appeals commenced on the date the plaintiff received notice of the decision that it was going to terminate her long-term disability benefits, not the actual date her benefits were terminated.  In so ruling, the Court rejected plaintiff’s argument that the doctrine of substantial compliance and the state’s notice-prejudice rule somehow excused her late-filed appeal.  The Court first concluded that the doctrine of substantial compliance, which is sometimes used by a plan administrator to excuse a failure to comply perfectly with ERISA’s notice requirements, could not be used by the plaintiff to excuse her late filing because such an expansion of the doctrine would render it “effectively impossible” for plan administrators to enforce administrative deadlines.  The Court also concluded that the plaintiff could not invoke the state’s common law notice-prejudice rule, which requires an insurer to show that it was prejudiced by an untimely notice of appeal in order to deny certain types of claims, because doing so would undercut the policy purposes behind the exhaustion requirement.  The case is Fortier v. Hartford Life & Accident Ins. Co., No. 18-1752, 2019 WL 697989 (1st Cir. Feb. 20, 2019).


Plaintiffs Not Entitled to Jury Trial for ERISA Breach of Fiduciary Duty Claims

Massachusetts Institute of Technology persuaded a federal district court to toss a jury demand in a case alleging that the MIT 401(k) plan fiduciaries breached their duties by charging unreasonable administrative and management fees, engaging in prohibited transactions and failing to monitor those to whom the fiduciaries delegated their responsibilities.  In so ruling, the court held that plaintiffs had no Seventh Amendment right to a jury trial because actions under ERISA to remedy alleged violations of fiduciary duties are equitable rather than legal in nature.  The court explained that the “great weight of authority” has concluded that claims by plan participants against plan fiduciaries are analogous to claims against trustees typically heard only in a court of equity. The case is Tracey v. Massachusetts Institute of Technology, No. 1:16-cv-11620, 2019 WL 1005488 (D. Mass. Feb. 28, 2019).


IRS Reopens Opportunity to Cash Out Retirees in Pay Status—At Least For Now

One de-risking tool for employers with defined benefit pension liabilities is to allow participants to receive lump-sum distributions. Although lump sums result in a short-term cash drain, they reduce the plan’s long-term liability—reducing the sponsor’s exposure to contribution volatility.

Over the last several years, there has been a question whether lump-sum cashouts may be offered to retirees who are already receiving annuities. Ironically, the concern was based on the IRS’s minimum required distribution rules. Although the purpose of minimum required distributions is to force participants to take their money, the rules prohibit an increase to the payment amount after payments start, subject to limited exceptions. The concern is that a lump-sum cashout could be a prohibited increase to the payment amount.

In 2012, the IRS issued two Private Letter Rulings that said a cashout would not be prohibited if (1) cashouts are available only during a limited window and (2) annuitants did not previously have a right to cash out annuities in pay status. The IRS reasoned that, under those circumstances, the increase to the payment amount is caused by an amendment to increase benefits, which is one of the limited circumstances when an increase to the payment amount is permitted. The IRS’s conclusion was consistent with the underlying policy of minimum required distributions: if the annuity in place will pay out fast enough, cashing out must be okay because it results in payment being made even faster.

Following those rulings, many employers looked into offering cashout windows to retirees in pay status. Seeing the interest, IRS officials stated informally that it considered the analysis in the Private Letter Rulings to be settled law, and the IRS issued favorable determination letters for plans that allowed cashout windows.

But the IRS changed course in 2015. In Notice 2015-49, the IRS recanted its 2012 analysis. Instead, the IRS said it intended to amend its minimum required distribution regulation to state that cashing out annuities in pay status would be a prohibited acceleration; the IRS also said the new regulation would be effective July 9, 2015. With that, the opportunity to cash out annuities in pay status went away.

In the time since, the IRS never issued the intended regulation, and the project was eventually removed from the Treasury Department’s Priority Guidance Plan. On March 6, 2019, in [Notice 2019-18] the IRS announced that it no longer intends to amend the minimum required distribution regulation. Until further notice, the IRS will not assert that a window to cash out annuities in pay status violates the minimum required distribution rules.

The IRS cautioned that it will continue to examine the issue, and nothing prohibits the IRS from changing its view. In addition, the IRS cautioned that any cashout window must comply with all of the other requirements for tax-qualification.

For now, the guidance gives plan sponsors another de-risking tool.

Supreme Court Says that Equitable Tolling Cannot Extend Rule 23(f) Deadline

In a unanimous decision authored by Justice Sotomayor on February 26, 2019, the Supreme Court held that the 14-day deadline to seek permission to appeal a decision granting or denying class certification under Federal Rule of Civil Procedure 23(f) cannot be extended through the doctrine of equitable tolling. Nutraceutical Corp. v. Lambert. The Court reversed the Ninth Circuit’s decision, which had accepted a petition filed more than 14 days after the trial court’s decertification order, because the plaintiff had “acted diligently.”

Read the full post on Proskauer’s Class and Collective Actions blog.