As corporate employers shift from defined benefit to defined contribution plans, the burden of ensuring retirement income sufficiency has shifted from employer to employee—and most employees are ill-equipped to handle the responsibility.

About 50% of private-sector employees have access to a retirement plan; but access to defined benefit plans has dropped off significantly. In 1980, 83% of those employees were covered by a defined contribution plan. But by 2008, that number had dropped to 31%, leaving about 85% of employees fending for their own retirement security.

In response to employees’ increasing retirement worries, insurance companies and financial services firms have developed new financial products and plan features providing income sufficiency for participants in defined contribution plans.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of retirement studies in Advisor’s Journal, see How Much to Allocate to Annuities: A Critical Analysis (CC 11-109) & How Are IRA Owners Investing Their Money? (CC 11-112).

For in-depth analysis of qualified plans, see Advisor’s Main Library: A—General Introduction to Qualified Plans.

Why is This Topic Important to Wealth Managers? This blogticle discusses one avenue for retirement planning solutions for small businesses. Wealth managers who have small business clients may consider a discussion on the automatic payroll deduction IRAs as one simple way to help employees save for retirement.

A payroll deduction individual retirement account (IRA) is one simple way for businesses to give employees an opportunity to save for retirement. The program is easy to implement; the employer sets up the payroll deduction IRA program with a bank, insurance company or other financial institution, and then the employees choose whether and how much they want deducted from their paychecks and deposited into the IRA. Depending on the IRA service provider, some employees may also have a choice of investments depending on the IRA provider. Wealth managers can add value to employees and employers by, not only establishing a plan, but by also working with employees to help them manage their IRAs.

Under a payroll deduction IRA, the employee makes all of the contributions, thus there are no employer contributions. By making regular payroll deductions, employees are able to contribute smaller amounts each pay period to their IRAs, rather than having to come up with a larger amount all at once.

One advantage of these accounts is that there is little administrative cost and no annual filings with the government. Moreover, businesses of any size can participate as there is no requirement that an employer have a certain number of employees to set up a payroll deduction IRA.

Another element that makes the program attractive to some small businesses is that the program will not be considered an employer retirement plan subject to Federal requirements for reporting and fiduciary responsibilities as long as the employer keeps its involvement to a minimum.

Here’s how the IRAs generally work: The employer sets up the payroll deduction IRA program with a financial institution, such as a bank, mutual fund or insurance company. The employee establishes either a traditional or a Roth IRA (based on the employee’s eligibility and personal choice) with the financial institution and authorizes the payroll deductions. The employer withholds the payroll deduction amounts that the employee has authorized and promptly transmits the funds to the financial institution. After doing so, the employee and the financial institution are responsible for the amounts contributed.

Generally however, the employer needs to remain neutral with respect to the IRA provider. It cannot negotiate with an IRA provider to obtain special terms for its employees, exercise any influence over the investments made or permitted by the IRA provider, or receive any compensation in connection with the IRA program except reimbursement for the actual cost of forwarding the payroll deductions.

Commonly, any employee who performs services for the business (or “employer”) can be eligible to participate. The decision to participate is left exclusively up to the employee. The employees should understand that they have the same opportunity to contribute to an IRA outside the payroll deduction program and that the employer is not providing any additional benefit to employees who participate.

Employees’ tax-deferred contributions are generally limited to $5,000 for 2011. Additional “catch-up” contributions are permitted for employees age 50 or over. This special catch-up amount is currently limited to $1,000 per year.

Tomorrow’s blogticle will continue to discuss simple wealth management solutions.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

Why is this Topic Important to Wealth Managers? This blogticle provides a general lesson regarding diligence for wealth managers. That a court shall not grant the same legal weight to plan summaries as plan descriptions and documents themselves means wealth managers should look to original plan documentation. This rule should apply to all investment and insurance products and arrangements. Summaries alone will not provide a legally sufficient basis to create a contract. As such the agreement between the parties should be thoroughly examined as the binding document.

The U.S. Supreme Court recently ruled that summary plan descriptions for pension plans need not represent the full plan details and terms; the interpretation by the plan participant of the summary is legally insufficient as to create a remedy without a showing of fraud or serious harm. Thus, the Court significantly narrowed the grounds by which an employee may bring an action for additional pension benefits based on errors in a plan’s summary plan description (SPD).

The Court held unanimously that an SPD should be accurate, but it need not be as complete as the underlying plan documents, and participants cannot sue to enforce their interpretation of the SPD in the same way that they could sue to enforce the actual terms of the plan. [1]

CIGNA Corp., the pension plan sponsor involved in the case, converted a traditional defined benefit pension plan, which used a funding formula based on the assumption that an employee would spend many years at the company, into a cash balance plan. An employer that sponsors a cash balance plan simply puts in a set amount of cash each year. The amount of benefits accrued each year is the sum of the contribution and interest earnings on the contribution.

J. Amara, the lead plaintiff in the class action argued that the SPD for the new plan – the document that was supposed to describe the plan in terms that participants could understand — was misleading, because it said employees would do at least as well as in the old plan and failed to explain that a drop in interest rates could affect the ultimate benefits. The conversions however under the new plan left some participants worse off given present value calculations and assumed interest rates.

The lower courts ruled that the SPD was incomplete and inaccurate, that the participants were “likely harmed” by the inaccuracies, and that all 27,000 plan participants should share in a recovery.

However, the Supreme Court held that ERISA did not give the district court authority to reform CIGNA’s plan, but that statute does give a participant, beneficiary, or fiduciary an opportunity to seek “’other appropriate equitable relief” to redress violations of ERISA ‘ or the [plan’s] terms.’” [2]

The Court interpreted the law as allowing “equitable relief,” such as a surcharge only if SPD errors were the result of fraud or that the errors had led to serious harm.

“To make the language of a plan summary legally binding could well lead plan administrators to sacrifice simplicity and comprehensibility in order to describe plan terms in the language of lawyers,” wrote Justice Stephen Breyer in his opinion.

On the other hand, by enforcing the summaries as a binding legal agreement would likely “bring about complexity that would defeat the fundamental purpose of the summaries,” Breyer said. “For these reasons taken together we conclude that the summary documents, important as they are, provide communication with beneficiaries about the plan, but that their statements do not themselves constitute the terms of the plan.”

Tomorrow’s blog will discuss topics related to life insurance.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] See CIGNA Corp. v. Amara, No. 09-804.

[2] See generally ERISA Section 502(a)(1)(B).

Segments of this article were adopted from Lifeandhealthinsurancenews.com, Supreme Court Favors CIGNA in Summary Plan Description Case, By Arthur D. Postal. Published 5/16/2011. You can access the full article here.

Retirement plan sponsors face increasing regulatory scrutiny and significant liability as plan fiduciaries. Can you leverage off these fiduciary concerns and generate advisory business for your firm?

There are a couple of key approaches you can use to address sponsors’ concerns about their fiduciary responsibilities and sell to the plans and their sponsors.

Believe it or not, there are a number of plans that don’t use an advisor—with the plan sponsor choosing to go it alone to save a few dollars. As reported in a previous edition of the Advisor’s Journal, a significant of number of employee retirement plans (19%) don’t use an outside investment advisor.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of plan sponsor’s fiduciary duty in Advisor’s Journal, see Plan Clients: Where Are the Advisory Margins? (CC 11-63).

For in-depth analysis of qualified retirement plans, see Advisor’s Main Library: Qualified Retirement Plans.

A significant of number of employee retirement plans don’t use an outside investment advisor, often because of the cost. Demonstrating your firm’s flexibility and splitting fiduciary responsibility for the plan could be the key to reaching those underserved plans. Customizing your level of service gives these plans what they need—advice—while allowing you to prune services that aren’t cost effective for your firm.

According to the Retirement Plan Survey 2011, released by Grant Thornton LLP, Drinker Biddle & Reath and Plan Sponsor Advisors, greater than 50% of plans use a limited scope investment advisor and 14% of plans use an outsourced investment advisor. Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

An executive top-hat plan can be a great way to attract and retain highly qualified executives or supplement a business owner’s compensation, but the plans have a big downside. Because the plans are generally unfunded, major events at the sponsor, like a sale or insolvency, can decimate a plan and leave participants empty handed. The effect on a top-hat plan when a sponsor liquidates its assets is illustrated by a recent Seventh Circuit Court of Appeals case. Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of deferred compensation plans in Advisor’s Journal, see Tax Court Calculates FMV of Policies Distributed from Terminated 419 Plan (CC 11-35) & Tax Courts Holds Employee Taxable for Value of Life Insurance Owned by Welfare-Benefit Plan (CC 11-14).

For in-depth analysis of nonqualified deferred compensation plans, see Advisor’s Main Library: Non-Qualified Plans, Split-Dollar.

An employer who does not want to, or cannot, institute a qualified pension or profit-sharing plan, or who does not want to extend benefits to all of its full-time employees, can use a “Section 162 plan” to meet its executive compensation needs.   A Section 162 plan leverages life insurance to provide supplemental compensation to select employees while also allowing the employer to take an income tax deduction for the premium payments.

In a Section 162 plan, an employer applies for, and pays premiums on, a life insurance policy on its employee’s life. The employee, however, owns the policy and has the right to appoint beneficiaries; the employer does not take an interest in the policy’s death benefit.

As an example of Section 162 plan and its tax advantages, … read this complete article at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For in-depth analysis of Section 162 plans, see Advisor’s Main Library: Section 15 C—Executive Bonus – I.R.C. �162 Plan

We invite your questions and comments by posting them below or by calling the Panel of Experts.

Why is this Topic Important to Wealth Managers? Provides information on one additional planning tool that many wealth managers find useful for affluent clients who own a small business.  Gives an overview of the nonqualified plans as well as proving a common use of life insurance to fund plan obligations well into the future.    

Simply a nonqualified pension plan is a retirement plan that does not meet the requirements under the tax code and federal employment law to be considered qualified, and therefore the nonqualified plan is treated differently for tax purposes. [1]

What are some of the advantages of using a nonqualified plan over a qualified retirement plan? [2] 

• Flexibility and selectivity—because the plan is not subject to requirements under the qualified plan rules, employers have much more control in terms of who may be included and the varying terms of each individual participant. 
• Vesting and contingencies—nonqualified plans allow for the employer to exclude all amounts not met by vesting conditions or contingencies that the employee must achieve to obtain the benefit.  Say for example, that the retirement funds become available to the employee after 10 years of faithful service to the company.  If the employee does not work for 10 years, no benefits have thus accrued and the employee has no benefit under the plan. 
• Cost savings through minimal reporting requirements—since nonqualified plans do not usually fall within major regulatory scope of qualified plans, the cost to administer these plans is generally less than some alternatives.

How are nonqualified plans treated for tax purposes?

Employees are generally not taxed on the benefits received under a nonqualified plan until they actually receive the compensation. [3]  Accordingly, the deduction for employee benefits is generally not taken by the employer until the benefits are paid to the plan participant. [4]

In addition, many nonqualified plans include the purchase of life insurance.  Since the value of the policy may grow at a tax-free rate inside the insurance policy, when the time comes for the payment of benefits, the deduction taken by the employer will generally be much larger than a qualified defined contribution plan.  However, the event causing the payment of benefits may not occur until some time long into the future, therefore significantly delaying the deduction in time. 

One consideration that is essential to the creation of a proper nonqualified plan is a carefulness in avoiding constructive receipt—If the plan benefits are actually realized by the taxpayer, i.e., the participant has a present right to withdrawal from the pension, the amount will be taxable to the employee when the employee is said to have constructively received the income. One such instance can occur when an insurance policy is purchased to fund plan obligations, but the beneficiary is listed as the insured and not the business.  Since the employee realizes a current benefit it is a taxable event.  For a detailed discussion of the constructive receipt doctrine, see AdvisorFYI: All Together Now: Gross Income, Increase in Wealth, Realization, Barter, and Constructive Receipt, as well as Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit.

Tomorrow’s blogticle will discuss Section 1035 exchanges in today’s marketplace.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Leimberg, Doyle.  Tools and Techniques of Life Insurance Planning, 4^th Ed.  493.  2007.  The National Underwriter Company.  Cincinnati, Ohio. (A Summit Business Media Co.) 

[2] Leimberg, Doyle.  Tools and Techniques of Life Insurance Planning, 4^th Ed.  At 494. 

[3] See generally 26 U.S.C. § 404. 

[4] 26 U.S.C. § 404 (a). 

Why is this Topic Important to Wealth Managers? Discusses additional events and situations that may or may not trigger specific tax consequences related to common transactions.  Also provides distinctions common to these theories as well as methods to recognize particular fact patterns in relation to such.

The economic benefit doctrine is at issue when the taxpayer receives some benefit in connection with a business or contractual relationship with a current, real and measurable value. [1] One instance when an individual receives an economic or financial benefit or property is for compensation for services, whereby the value of the benefit or property is currently includible in the individual’s gross income. [2] This instance will be examined in further detail below.

Another common example is a promise to pay, which also provides a good illustration of how the doctrine applies.  A mere promise to pay, unsupported by notes or other evidences of indebtedness which by and large is unsecured, is not income to a cash method taxpayer. [3]

On the other hand, there is the cash equivalency doctrine, which states, where a promise to pay that is supported by notes or otherwise secured by a solvent obligor, which is unconditional and assignable, not subject to sett-offs, and issued at a reasonable discount, is therefore considered a cash equivalent.  Since, such notes are considered cash equivalents the notes are taxable in a like manner as cash, i.e., if cash instead of the note was received by the taxpayer the taxpayer would be taxed on the cash received.  “More simply, the cash equivalency doctrine provides that, if the right to receive a payment in the future is reduced to writing and is transferable, such as in the case of a note or a bond, the right is considered to be the equivalent of cash and the value of the right is includible in gross income.” [4]

Two additional examples of the economic benefit doctrine to further illustrate:

A football player entered into a two-year standard player’s contract with the Giants in 2009. In addition to salary, he received a signing bonus that was to be paid to an escrow agent designated by him. Under the agreement, the bonus plus interest were payable to the player over five years. The football player is taxed in full in 2009 when the payment was made to the escrow agent, because in that year, “the employer’s part in the transaction ended, and the amount of the compensation was fixed and irrevocably set aside for the player’s sole benefit” [5]

At the other end of the spectrum, consider ABC, a cash-basis taxpayer, who shares the top floor of an office building with the landlord. On December 31, 2009, a tenant from another floor mistakenly leaves cash rent in ABC’s office lobby, and ABC inadvertently deposits it. ABC discovers the error on January 5, 2010, and promptly issues a check to the landlord. The fact that ABC had dominion and control over the cash rent is irrelevant since it did not represent economic income to ABC. Therefore, ABC is not required to pay tax on the rent. [6]

Additionally, as briefly mentioned above, if an individual receives “any economic or financial benefit or property as compensation for services, the value of the benefit or property is currently includible in the individual’s gross income.” [7] Furthermore, an employee is required to include in his gross income, the value of assets that have been vested unconditionally and irrevocably, and transferred into a fund for the employee’s sole benefit, so long as the employee’s interest is not subject to financial forfeiture or transferable.  [8] A common example of this situation occurs when employee retirement programs are funded with employer stock options.

Tomorrow’s blogticle will discuss the ever popular economic substance doctrine.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] See generally, Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit.

[2] Internal Revenue Service—Department of the Treasury.  “Nonqualified Deferred Compensation Audit Techniques Guide”.  02-2005.  http://www.irs.gov/businesses/corporations/article/0,,id=134878,00.html. Page Last Reviewed or Updated: March 31, 2010.  Last Accessed 10/23/10.

[3] Tax Management Federal Income Portfolio. “Economic Benefit, Cash Equivalency, and Assignment of Income”.  No. 385 s V, (BNA), 20XX WL 4742238 (FEDERAL).  Compensation Planning Series– 385-4th: Deferred Compensation Arrangements.  Westlaw.  Citing Rev. Rul. 60-31

[4] Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.

[5] Tax Management Federal Income Portfolio. “Economic Benefit, Cash Equivalency, and Assignment of Income”.  Citing Ex. 4 of Rev. Rul. 60-31, Rev. Rul. 55-727, [other citations omitted]; Rev. Rul. Rul. 60-31.

[6] CCH Federal Taxation Comprehensive Topics. Chapter 13, Exhibit 17b.  35 of 70.  blue.utb.edu/…/2006%20CCH%20Comp%20Topics%20Ch%2013.ppt.  Last accessed 10/23/10.

[7] Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.

[8] 26 U.S.C § 83; Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit. ([09-36] 09/01/2009); Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.