Allocating Retirement Plan Administrative Expenses to Terminated Participants

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1 provides total retirement plan solutions by combining TPA services with the employee benefits practice at The Law Firm of Anthony L. Scialabba, LLC. Allocating Retirement Plan Administrative Expenses to By: Anthony L. Scialabba, Esq. An issue that sometimes arises in connection with the allocation of the administrative costs of a retirement plan is whether the accounts of the participants of a plan who have separated from service with a plan sponsor could be charged more administrative expenses than what is being charged to the accounts of participants who are currently employed by the plan sponsor. Obviously, this would encourage terminated employees with account balances over the cash-out threshold set forth in a plan (generally $5,000) to obtain distributions from the plan. The law provides that a plan may charge vested separated participant accounts with their share (on a pro rata basis, per capita basis, etc.) of reasonable plan expenses, without regard to Inside Allocating Retirement Plan Administrative Expenses to By: Anthony L. Scialabba, President Plan Design Tip: The Utilization of Prior Year Testing to Avert ADP/ACP Failures By: Anthony L. Scialabba, President Wholesaler Corner Featuring Stewart Rauchman Provider: Lincoln Financial Focus Market: Retirement Plan Services Product Type: Both Open Architecture Mutual Fund Platform and Group Variable Annuity Platform Key Products Feature: Tremendous Fiduciary Support including 3(21) and 3(38) for Plan Sponsors and Advisors, Custom Asset Allocation Models which can incorporate risk tolerance, Annual automatic repricing. Target Market: $500,000 to 20 Million Education: Michigan State, University of Pennsylvania Dental School, Rutgers University BS. Professional Background: Private Business owner for 22 years, Sales and Director of Sales CheckPoint HR 6 years. Residence: Marlboro, NJ with wife Janine, 6 young adult and adult children Hobbies: Scuba Diving, Tropical Fish, Work Quote: When you are interested in something, you will do what is convenient, when you are committed to something, you will do whatever it takes. Wholesaler Corner featuring Stewart Rauchman Welcome to Mary Burke `

2 Continued.. Allocating Retirement Plan Administrative Expenses to whether the accounts of active participants are charged such expenses. Thus, certain administrative expenses of the plan (ERISA audit costs, third-party administrative fees, etc.) can be paid from the accounts of terminated vested participants while other administrative costs can be paid by the plan sponsor. Therefore, the accounts of terminated vested participants of the plan could be charged their share of these costs that are reasonably related to their accounts even though a plan sponsor pays for such costs in connection with its non-terminated vested participants. The following is written to discuss this matter in more detail. I. The Law A. ERISA The Employee Retirement Income Security Act of 1974, as amended ( ERISA ), provides that a fiduciary of a retirement plan must operate the plan for the exclusive benefit of the participants of the plan. In addition, ERISA sets forth that a fiduciary of a retirement plan must operate the plan in a prudent manner. Despite these rules, ERISA does not directly address how fiduciaries of a retirement plan should allocate fees for administrative services. However, the Department of Labor ( DOL ) issued Field Assistance Bulletin ( FAB ) in 2003 which does concern this issue. FAB noted that nothing in ERISA restricts the ability of a plan sponsor to pay only certain plan expenses or only expenses on behalf of certain plan participants. In the latter case, the FAB stated that such payments by a plan sponsor on behalf of certain plan participants are equivalent to the plan sponsor providing an increased benefit to those employees on whose behalf the expenses are paid. Thus, the DOL asserted that a plan may charge the vested separated participant accounts with their share (e.g., a pro rata basis, per capita basis) of reasonable plan expenses, without regard 2 to whether the accounts of active participants are charged such expenses. B. Internal Revenue Code Although the DOL would permit a plan to charge vested separated participant accounts with their share of reasonable plan expenses, section 411(a)(11)(A) of the Internal Revenue Code of 1986, as amended ( Code ), sets forth requirements that must be satisfied with respect to certain distributions in order for a plan to be taxqualified. This statute provides that if the present value of a participant s nonforfeitable benefit exceeds $5,000, a plan satisfies the requirements of section 411(a)(11)(A) if the plan provides that the benefit may not be immediately distributable without the consent of the participant (This rule is generally known as the cash out rule.). The Treasury regulations promulgated under section 411(a)(11)(A) state that consent to a distribution is not valid if, under the plan, a significant detriment is imposed on any participant who does not consent to the distribution. The regulation further provides that whether the cash out rule has been violated is a facts and circumstances determination that can be made by the Commissioner of the Internal Revenue Service ( IRS ). Thus, the IRS has the authority to address whether charging administrative expenses to separated participants causes an impermissible cash out. The IRS resolved any possible conflicts with the DOL with respect to this matter by issuing Revenue Ruling In this revenue ruling, the IRS held that an allocation of administrative expenses of a defined contribution plan to the individual account of a participant who does not consent to a distribution is not a significant detriment within the meaning of the Treasury regulations at issue if that allocation is reasonable and otherwise satisfies the requirements of ERISA. The rationale that the IRS provided for this holding

3 Continued.. Allocating Retirement Plan Administrative Expenses to was that such an allocation does not impose a detriment so significant as to be inconsistent with the deferral rights mandated by section 411(a)(11). The government further provided that this is because analogous fees would be imposed in the marketplace, either implicitly or explicitly, for a comparable investment outside the retirement plan (e.g., fees charged by an investment manager for an IRA investment). Although Revenue Ruling held that an allocation of administrative expenses of a defined contribution plan to the individual account of a participant who does not consent to a distribution is not a significant detriment, the IRS stated in the ruling that not every method of allocating plan expenses is reasonable, and a method that is not reasonable could cause a significant detriment to occur. In this regard, the IRS provided an example of an allocation of plan expenses that was not reasonable by asserting that allocating the expenses of active employees pro rata to all accounts, including the accounts of both active and former employees, while allocating the expenses of former employees only to their accounts would not be reasonable.. The ruling stated that this is because former employees would be bearing more than an equitable portion of the plan s expenses. Thus, the IRS stated that such an allocation of expenses could be a significant detriment. Therefore, the administrative costs of the active participants cannot be subsidized from the accounts of the terminated vested employees. In addition to precluding allocations that would not be reasonable, the IRS in Revenue Ruling stated that the allocation of plan expenses must comply with the nondiscrimination requirements of section 401(a)(4). In this regard, Treasury section 1.401(a)(4)-4(e)(3)(i) sets forth that a taxqualified retirement plan may not discriminate in favor of highly compensated as defined under section 414(q) of the Code employees on the 3 basis of benefits, rights and features with respect to the timing of plan amendments. In Revenue Ruling , the IRS explained how this rule can apply to the allocation of plan expenses in an example. In this regard, the government stated that if a plan was amended so that the expenses for purposes of determining whether a domestic relations order is a qualified domestic relations order as defined under section 414(p) of the Code in connection with an HCE who has an impending divorce are allocated pro rata rather than to an individual participant s account, this could cause a plan to fail to satisfy the rule that prohibits discrimination in connection with the availability of benefits, rights and features with respect to the timing of plan amendments. II. Permissible Allocations As mentioned above, a plan may charge vested, separated participant accounts their share of reasonable plan expenses, without regard to whether the accounts of active participants are charged such expenses. Thus, reasonable administrative fees that are paid by a plan sponsor in connection with a plan could be allocated to the accounts of all participants of a plan on either a pro rata or per capita basis. Subsequently, a plan sponsor could decide to only pay for the fees for such services for the active participants while the same costs for the terminated, vested participants are paid by their accounts. Although an allocation of administrative expenses of a defined contribution plan to the individual account of a participant who does not consent to a distribution is not a significant detriment for purposes of the cash out rule, the plan fiduciaries of a plan cannot implement a method of allocating plan expenses which is not reasonable. For example, the fiduciaries could not pay the entire amount of reasonable ERISA audit or attorney fees only from the accounts of the terminated vested employees. In addition, the allocation of administrative expenses cannot be discriminatory.

4 Continued.. Allocating Retirement Plan Administrative Expenses to III II. Fee Policy Statement As mentioned above, ERISA requires that a fiduciary act prudently in connection with his or her operation of a plan. Thus, plan fiduciaries should ensure they understand the pricing features with respect to a plan. The fiduciaries should also understand the features that affect the plan and its participants. In general, adequate documentation is important to establishing that the decisions of fiduciaries in this regard were prudent. Thus, fiduciaries should maintain detailed documentation regarding expenses and how they are allocated to participant accounts. This will be helpful if the fiduciaries are questioned about the prudence of their decisions in this regard. Unfortunately, plan fiduciaries often create well-documented records regarding their analysis of the reasonableness of fees, but fail to adequately document their decisions in connection with fee allocation. In an article published 2014 by The Vanguard Group, Inc. entitled Slicing and dicing retirement plan fees: Allocation considerations for plan sponsors at page 6, this fact was discussed and the article stated that one way to resolve this issue is to create a fee policy statement designed to provide structure for discussions and decisions about fees. ERISA does not require that fiduciaries have such a policy. However, it can be a valuable and useful guide for deriving fee decisions. If a fee policy statement is adopted, the plan fiduciaries should comply with its terms. In Tussey v. ABB, Inc. (2014), the 8th Circuit Court of Appeals held plan fiduciaries liable for a failure to operate a plan in accordance with its terms and for a breach of prudence for failing to follow the terms of an investment policy statement. An investment policy statement and a fee policy statement both concern the operations of a retirement plan. Thus, the holding in Tussey could easily be applied by analogy to a situation involving a fee policy statement. Under certain circumstances, if the terms of a fee policy statement cannot be followed, then amending it should be considered. However, if the statement is amended too often, this could eviscerate its value. In addition to the potential liability caused by the Tussey case, the drafting of a fee policy statement imposes an additional cost to a plan sponsor of a plan. Thus, a fee policy could be challenging to afford, especially for a smaller employer. In addition to complying with the terms of a fee policy statement, plan fiduciaries should ensure that the statement remains updated to reflect various factors that can affect fee decisions. Such factors can include, for example, changes in investment policy, employee demographics, and the services being provided by plan vendors. Plan Design Tip: The Utilization of Prior Year Testing to Avert ADP/ACP ACP Failures By: Anthony L. Scialabba, Esq. One of the major challenges for plan sponsors of 401k plans is how to handle the situation where a retirement plan fails either the Actual Deferral Percentage Test ( ADP Test ) or the Actual Contribution Percentage Test ( ACP Test ). Usually, when such a failure occurs, a plan sponsor will make give back distributions of either elective deferral or matching contributions (and earnings accrued thereon), depending on which test is at issue, to the participants of the plan who are Highly Compensated Employees ( HCEs ) in an amount that is necessary to satisfy the test(s). However, this can cause morale issues with respect to such employees. Less frequently, a plan sponsor may provide a special non-elective employer contribution to the participants of a plan who are Non-highly 4

5 Continued.. Plan Design Tip: The Utilization of Prior Year Testing to Avert ADP/ACP Failures Compensated Employees ( NHCEs ). This contribution is fully and immediately vested when made, and is known as a Qualified Nonelective Employer Contribution (This contribution is also referred to as a QNEC.). The challenge to providing QNECs to resolve an ADP or ACP failure is that this can be costly to an employer. In general, aside from kicking money out of a plan back to HCEs or contributing QNECs to NHCEs, a plan sponsor could augment its employee communication program to better educate the NHCEs on the advantages of contributing to a 401k plan. This could help abate the disparity between the amount that the NHCEs and the HCEs are receiving in connection with a plan. However, even if an employer has a sound employee communication program in place, if an employer is not willing to make a matching contribution to a plan, it is difficult to motivate NHCEs to contribute. If a plan sponsor knows that a plan will fail either the ADP or ACP Tests, then the employer may be able to have HCEs cease to make elective deferrals to the plan. In this regard, an estimate on how a plan will fare under the ADP or ACP Tests may be made. However, until the plan year at issue ends, there can only be an approximation as to when an employer should have the HCEs cease their elective deferrals. The Internal Revenue Code of 1986, as amended ( Code ), provides a resolution to the mid-year testing dilemma. In this regard, the Code permits two methods of testing for nondiscrimination in connection with a retirement plan. The first method is current year testing where current year elective deferral and matching contribution percentages are used to compare the percentages of both HCEs and NHCEs. The other method is prior year testing where the elective deferral and matching contribution percentages for NHCEs in the prior year are compared with HCE elective deferral and matching contribution percentages in the current year. The mechanics of prior year testing are as follows. In the first year of a 401(k) plan, or the first year 401(k) provisions are effective in an existing plan, a special rule applies. This is because there are no prior year percentages to use for the test. In this situation, the employer can assume a prior year percentage for the NHCEs for both the ADP and ACP tests is three percent or the employer can use the actual results of the first year s test. With regard to testing for the second year, the maximum HCE percentage will be based on the NHCE percentage from the first year. At the end of the second year, the test will be performed. This serves two purposes. First, the average HCE percentage will be compared to the maximum permitted average percentage (based on the NHCE percentage from the first year) to verify that the maximum was not exceeded. In addition, the NHCE average percentage will be used to determine the maximum average HCE percentage for the third year. The prior year testing method provides employers the ability to know the ADP and ACP limits for the HCEs in advance. This reduces the chance of a failed test at year end and the need for give back distributions or other corrective measures. Thus, if a plan uses current year testing and a plan sponsor would like to know the limits that will be imposed once the nondiscrimination testing is completed in advance, the plan should be designed to utilize prior year testing in the plan. Although prior year testing can allow an employer to know the results of ADP or ACP testing in advance, there is a drawback to the use of the prior year testing methodology. In this regard, if a plan has an improving test each year going forward, the plan sponsor will not be able to take advantage of such results for one year. Thus, if an employer believes that the ADP and/or ACP test results will improve over time, it may be better to utilize the current year methodology. 5

6 Welcome to Mary Burke We are pleased to announce that Mary Burke recently joined RetireWell Administrators, as the head of our Administrative Services Team. Mary has over 15 years of experience in employee benefits and pension plan administration. She was the Head of Pensions for Marsh McLennan Ireland (providing retirement plan administration services to their clients); an Associate Director Business Development & Marketing with Aon Hewitt Worldwide; and a Pension Administration Manager with Towers Watson. Mary comes to RetireWell Administrators with an extensive administration, compliance and new business development background. Mary is also a Fellow of the Irish Institute of Pension Managers. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this letter (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. This newsletter is for informational purposes only, and is distributed with the understanding that RetireWell Administrators, LLC is not rendering legal advice. If such advice is desired, you should consult your independent legal counsel. 2015, RetireWell Administrators, LLC Third-party Pension Administration and Consulting Services 6