United States: Employee Benefits - October 2006

EXECUTIVE COMPENSATION: RECENT DEVELOPMENTS

IRS announced a compliance extension for Section 409A regulations until January 1, 2008. IRS has announced that final regulations under Code Section 409A, applicable to nonqualified deferred compensation plans, will not be effective until January 1, 2008. IRS Notice 2006-79, issued October 4, 2006.

The transition relief provided by the 2005 proposed regulations is also extended through 2007 except with respect to certain discounted stock rights subject to backdating concerns. Additional transition relief is provided for certain payment elections in "linked plans" and certain collective bargaining arrangements. Under the transition relief, employers have until the end of 2007 to amend agreements to bring them into compliance with Section 409A. The transition relief is also extended for certain plans that took advantage of transition relief for 2005.

The long-awaited final regulations under Section 409A are expected by the IRS to be issued later this year. The IRS also expects to issue initial guidance on income tax reporting and withholding and Section 409A penalty assessments.

Good faith operational compliance with the statutory requirements of Section 409A continues to be required. Until the anticipated January 1, 2008, effective date of the final regulations, compliance with the initial Section 409A guidance contained in IRS Notice 2005-1, the proposed regulations, or the final regulations will constitute reasonable, good faith compliance with the statute. Deferred amounts that were earned and vested before January 1, 2005, are generally "grandfathered" unless the previous arrangement has been materially modified.

Notice 2006-79 reiterates the prior position of the IRS that a Section 409A violation might affect the entire plan or only the affected participant. As an example, if the employer, with respect to any plan participant, exercises discretion to delay or extend payments of nonqualified deferred compensation in a manner that violates Section 409A, the entire plan is in violation. However, if an individual participant exercises a right under a plan that is solely with respect to that participant’s benefits in a manner that causes the plan to fail to meet Section 409A requirements, only that participant will be treated as violating Section 409A, not the entire plan.

The opportunity to change payment elections or conditions of payment provided in the proposed regulations generally continues to be available through December 31, 2007, subject to limitations with respect to certain discounted stock rights. However, elections made in 2006 may only apply with respect to amounts not otherwise payable in 2006 and may not cause an amount to be paid in 2006 that would not otherwise be payable in 2006. Similarly, elections made in 2007 may only apply with respect to amounts not otherwise payable in 2007 and may not cause an amount to be paid in 2007 that would not otherwise be payable in 2007.

The ability to link a payment election under a nonqualified deferred compensation plan to an election under a qualified plan is extended through December 31, 2007. In addition, it is extended to quasi-qualified plans, such as Section 403(b) annuities, Section 457(b) eligible plans, and foreign broad-based plans.

The extended transition relief beyond December 31, 2006, is not available for discounted stock options or stock appreciation rights granted with respect to publicly-traded stock to Securities Exchange Act Section 16 officers and directors where the company either has reported or reasonably expects to report a financial expense due to the issuance of the stock right with an exercise price lower than the fair market value of the underlying stock at the date of grant that was not otherwise timely reported.

Except with respect to severance arrangements, typical collective bargaining unit employees are not participants in nonqualified deferred compensation plans. The proposed regulations generally protect those severance arrangements from Section 409A penalties. However, for those collective bargaining agreements that provide for nonqualified deferred compensation arrangements that may trigger Section 409A concerns, Notice 2006-79 provides special transitional relief. Such plans in effect on October 3, 2004, are not required to comply with Section 409A on or before the earlier of the date the collective bargaining agreement terminates (without regard to extensions after October 3, 2004) or December 31, 2009.

Notice 2006-79 does not provide guidance regarding Form W-2 reporting of nonqualified deferred compensation for 2006. However, Treasury officials have stated that the one-year deferral of the withholding and reporting obligations announced earlier this year will not be extended and that employers will have to comply with the withholding and reporting obligations of Section 409A for 2006. This assumes, presumably, that necessary guidance will be issued this year.

The IBM cash balance pension plan did not violate ERISA prohibitions against age discrimination because the plan did not stop making allocations or accruals to the plan or change the rate of benefit accrual on account of age, according to a unanimous three judge panel of the Seventh Circuit Court of Appeals. Cooper v. IBM Personal Pension Plan (7 Cir. No. 05-3588, 8/7/06). The Pension Protection Act of 2006 ("PPA") put an end to future legal uncertainty with respect to age discrimination for cash balance pension plans by establishing a simple age discrimination standard for all defined benefit plans. Its standard was not, however, adopted retroactively. Taken together, though, in the view of many commentators, this decision and the enactment of the PPA’s age discrimination standard for pension plans combine to make it far less likely that plaintiffs will prevail in age discrimination lawsuits challenging an employer’s right to convert traditional defined benefit plans to cash balance or similar hybrid pension plans.

Regulations are proposed under Section 624(a) of the PPA, which created ERISA Section 404(c)(5) to provide relief to plan fiduciaries who invest participant assets in certain types of "default" investments. (Prop. Labor Reg. 2550.404c-5) Default investment vehicles are needed, for example, when a 401(k) plan uses automatic enrollment features, which are also encouraged by other changes included in the PPA. A safe harbor "qualified default investment alternative" (or "QDIA") must satisfy five requirements outlined in the proposed rules:

• No holding or acquiring of employer securities except for employer securities held by a mutual fund or pooled investment vehicle that is independent of the plan sponsor, or if the employer securities were acquired as a matching contribution from the employer/plan sponsor or at the direction of the participant or a beneficiary;
• No imposing financial penalties or otherwise restricting the ability to transfer investments from one investment alternative to any other investment;
• Managing the investment alternative by an investment manager or a mutual fund;
• Diversifying investment alternatives to minimize the risk of large losses; and
• Using one of three types of products:

• A life-cycle or targeted fund account which is a mutual fund or model portfolio designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant’s age, target retirement date, or life expectancy.
• A balanced fund, which is a mutual fund or model portfolio designed to provide long-term appreciation and capital preservation through a mix of equity and fixed income exposures consistent with a target level of risk appropriate for participants of the plan as a whole; or
• An investment management service, which allocates assets to achieve varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures, offered through investment alternatives available under the plan, based on the participant’s age, target retirement date, or life expectancy.

Other safe harbor conditions are that the participant or beneficiary must have had the opportunity to direct the investment of the assets, but did not do so; the participant or beneficiary must have been furnished with appropriate notice within a reasonable time; the plan must provide that any material furnished to the plan relating to the investment, such as account statements, prospectuses, and proxy voting materials must be provided to the participant or beneficiary; the participant or beneficiary must have the opportunity to direct investments out of the QDIA with the same frequency available for other plan investments, but no less frequently than quarterly, without financial penalty; and the plan must offer the opportunity to invest in a broad range of investment alternatives within the meaning of ERISA Section 404(c).

The U. S. Court of Appeals for the Fifth Circuit held that inclusion in the merger agreement between Halliburton Co. and Dresser Industries of a limitation on how the Dresser Retiree Medical Plan may be amended after the merger was a plan amendment enforceable by plan participants after the merger. The merger agreement provided that Halliburton must maintain the Dresser Retiree Medical Program but could modify it if the modifications were consistent with changes in the medical plans provided by Halliburton for similarly situated active employees. Halliburton Co. Benefits Committee v. Graves, 38 EBC 2245 (5 Cir., 8/30/2006). The merger agreement also contained a "no third-party beneficiary clause" purporting to prevent third parties from attempting to enforce the terms of the merger agreement.

The court found that the merger agreement’s provision limiting future amendments to the Dresser Retiree Medical Program constituted a plan amendment that restricted the surviving corporation in the merger from making changes to the plan that were not also made with respect to active employees. The court also held that plan participants were entitled to seek enforcement of the terms of the plan, as amended, without regard to the merger agreement’s prohibition against third-party beneficiary actions.

The case emphasizes (among other things) the need for careful consideration of any employee benefits provisions in mergers and acquisition agreements.

The President signed homeland security appropriations legislation that includes a provision allowing limited importation of prescription drugs from Canada for personal use. (Department of Homeland Security Appropriations Act, 2007, H.R. 5441.) Section 535 of the Act provides that funds made available under the law's provisions for customs and border protection may not be used "to prevent an individual not in the business of importing a prescription drug . . .from importing a prescription drug from Canada that complies with the Federal Food, Drug, and Cosmetic Act." The provision only applies to individuals transporting personal-use quantities (limited to a 90-day supply) of prescription drugs.

Although the Act allows limited importation of prescription drugs, by limiting the ability of law enforcement officials to stop it, the law does not make the importation by individuals of prescription drugs from Canada "legal." Until the government advises that it is legal to do so, administrators of health FSAs and HRAs should wait for further clarification before reimbursing the cost of drugs that are imported under this law because HRAs and FSAs are only permitted to reimburse the cost of legal drug purchases.

For 2007 HSAs

A High Deductible Health Plan for HSA purposes for 2007 will be a health plan:

• With an annual deductible of at least $1,100 for individual coverage and $2,200 for family coverage; and
• Under which the annual out-of-pocket expenses required to be paid for covered benefits does not exceed $5,500 for individual coverage and $11,000 for family coverage.

The maximum annual contribution to an HSA is the sum of the limits determined separately for each month, based on status, eligibility, and health plan coverage as of the first day of the month. For 2007, the maximum monthly contribution to an HSA for self-only coverage under an HDHP is 1/12th of the lesser of the annual deductible under the HDHP or $2,850. For individuals with family HDHP coverage, the maximum monthly contribution is 1/12th of the lesser of the annual deductible under the HDHP or $5,650.

A High Deductible Health Plan for Archer MSA purposes for 2007 will be a health plan:

• With an annual deductible of at least $1,900 and not more than $2,850 for self-only coverage;
• With an annual deductible of at least $3,750 but not over $5,650 for family coverage; and
• Under which the annual out-of-pocket expenses required to be paid for covered benefits does not exceed $3,750 for self-only coverage and $6,900 for family coverage.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.