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Current developments in employee benefits.

Part II of this two part article analyzes a variety of qualified plan issues, including revised nondiscrimination rules, SIMPLE plans, model corrective and amendment procedures, contemplated benefit changes, correction of improper plan investments and distributions, excess Sec. 415 amounts, distributions of illiquid assets, the "same desk" rule, vesting of survivor benefits and receipt of mutual fund fees.

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I, published in November, focused on current developments in welfare benefits and compensation (excluding changes made by the Taxpayer Relief Act of 1997 (TRA '97)). Part II, below, focuses on current developments affecting qualified retirement plans (excluding changes made by the TRA '97).

Revised Nondiscrimination Rules


Attempting to simplify plan administration, the IRS released Notice 97-2(21) to provide guidance on (1) the new Sec. 401(k) and (m) rules(22) permitting nondiscrimination testing based on nonhighly compensated employees' (non-HCEs) actual deferral percentages (ADP) and (2) returning excess deferrals to highly compensated employees (HCEs).

Prior to the Small Business Job Protection Act of 1996, plans had to use current-year data to determine the ADP and actual contribution percentages (ACP) for both HCEs and non-HCEs. After 1996, plans can use prior-year data in determining the ADP and ACP of non-HCEs, while using current-year data for HCEs.

Notice 97-2 provides that the ADP for non-HCEs for the preceding plan year is the ADP for the preceding plan year for the group of employees who were non-HCEs in the preceding plan year, using the definition of HCE in effect for the preceding plan years. Thus, for purposes of Sec. 401(k)(3)(A)(ii), the individuals taken into account in determining the prior-year's ADP for non-HCEs are those individuals who were non-HCEs during the preceding year, without regard to their status in the current year. For example, an individual who was a non-HCE for the preceding plan year is included in this calculation even if he is no longer employed by the employer or has become an HCE in the current plan year.

Future guidance will address the extent to which Sec. 401(m) matching contributions and qualified nonelective contributions can be used in determining the non-HCEs' ADP or ACP for nondiscrimination testing.

Plan sponsors can use current-year data in determining the ADP or ACP for non-HCEs for the 1997 plan year and use prior-year data in the 1998 and future plan years without IRS approval. For the 1997 plan year, no plan amendment or formal election is required. Guidance will be issued on how employers who use current-year data for 1998 and later years may switch to using prior-year data in subsequent plan years.

Excess Contributions

The process for distributing excess contributions and excess aggregate contributions requires the amounts returned to be based on the total dollar amount in excess. This method will not necessarily result in the ADP, if recalculated after the distributions, meeting the Sec. 401(k)(3) requirements.

Example: HCE1 has elective contributions of $8,500 and $85,000 in compensation, for an actual deferral ratio (ADR) of 10%; HCE2 has elective contributions of $9,500 and compensation of $158,333, for an ADR of 6%. As a result, the ADP for HCE1 and HCE2 under the plan is 8%. The ADP for the non-HCEs is 3%. Under the Sec. 401(k)(3)(A)(ii) ADP test, the ADP of HCE1 and HCE2 under the plan may not exceed 5% (i.e., two percentage points more than the ADP of the non-HCEs under the plan).

Under Sec. 401 (k)(8)(B), Regs. Sec. 1.401(k)-1 (f)(2) and Notice 97-2, the total excess contributions for the HCEs is determined as follows:

Step 1: The elective contributions of HCE1 (the HCE with the highest ADR) are reduced by $3,400, which reduces HCE1's ADR to 6% ($5,100/$85,000), which is HCE2's ADR. Because the HCEs' ADP still exceeds 5%, the Sec. 401(k)(3)(A)(ii) ADP test is not met; further reductions in elective contributions are necessary. The elective contributions of HCE1 and HCE2 are each reduced by 1% of compensation ($850 and $1,583, respectively). Because the ADP of the HCEs now equals 5%, the Sec. 401(k)(3)(A)(ii) ADP test is met; no further reductions in elective contributions are necessary.

Step 2: The dollar amount of excess contributions for the HCEs that must be distributed is $5,833, the total reductions in elective contributions under Step 1 ($3,400 + $850 + $1,583). Under Sec. 401(k)(8)(C), the $5,833 in total excess contributions for the 1997 plan year would then be distributed as follows.

Step 3: The plan distributes $1,000 in elective contributions to HCE2 (the HCE with the highest dollar amount of elective contributions) to reduce HCE2's elective contributions to $8,500, the dollar amount of HCE1's elective contributions.

Step 4: Because the total amount distributed ($1,000) is less than the total excess contributions ($5,833), step 3 must be repeated. As the dollar amounts of remaining elective contributions for both HCE1 and HCE2 are equal, the remaining $4,833 of excess contributions must be distributed equally to HCE1 and HCE2, $2,416.50 each.

HCE1 must receive a total distribution of $2,416.50 of excess contributions; HCE2 must receive a total distribution of $3,416.50 of excess contributions. This is true even though HCE1's ADR exceeded HCE2's ADR. The plan is now treated as satisfying the Sec. 401(k)(3) nondiscrimination test, even though the ADP would fail that section if recalculated after distributions.(23)


Rev. Proc. 97-9(24) supplies a model amendment allowing employers to adopt Savings Incentive Match Plan for Employees (SIMPLE) Sec. 401(k) plans if they currency have Sec. 401(k) plans that have received determination letters that take into account the requirements of the Tax Reform Act of 1986 (TRA '86). Eligible adopters include sponsors of individually designed plans, master and prototype plans, regional prototype plans or volume submitter specimen plans.

Because the procedure essentially applies only to plan sponsors that currently have a Sec. 401(k) plan with a determination letter, the procedure will be of use to institutions offering model plans, but of limited or no use to individual employers who have not in the past sponsored Sec. 401(k) plans. Also, because SIMPLE Sec. 401(k) plans must be on a calendar year, if the employer currency sponsors a fiscal-year plan, it must be converted to a calendar year if it is amended to become a SIMPLE Sec. 401(k) plan.

Model Corrective Amendments

Rev. Proc. 96-55(25) contains a model amendment for certain sponsors of profit-sharing and stock bonus plans that sponsors could have used until June 30, 1997 to comply with Rev. Rul. 94-76,(26) relating to a transfer of assets from a qualified money purchase pension plan to an otherwise qualified profit-sharing or stock bonus plan.

Rev. Rul. 94-76 states that a transfer of assets and liabilities of a qualified money purchase pension plan (Plan A) to a qualified profit-sharing or stock bonus plan (Plan B) does not divest Plan A's assets and liabilities of their attributes as pension assets and liabilities. Thus, to satisfy Sec. 401(a), the assets and liabilities transferred from Plan A to Plan B must remain subject to the restrictions on distributions from a qualified money purchase pension plan. Because a money purchase pension plan cannot provide for in-service distributions, the application of an in-service distribution provision in Plan B to the accrued benefits transferred from Plan A would result in the merged plan failing to satisfy Sec. 401(a).

To remain qualified, Plan B would need to be amended to provide that on and after the transfer, the accrued benefits attributable to the Plan A assets and liabilities (the account balances and post-transfer earnings) would be distributable only on or after events permissible under qualified pension plans. This amendment would generally need to be adopted by the date of the transfer. The right to take an in-service distribution is a Sec. 411(d)(6) protected benefit; thus, if Plan B is amended to eliminate that right with respect to accrued benefits, the amendment would violate the Sec. 411(d)(6) anti-cutback rules.

The IRS's model amendment provides language for amending a profit-sharing or stock bonus plan under the relief provision in Rev. Proc. 94-76. Eligible plan sponsors may amend their plans by adopting the IRS's model amendment verbatim. Neither an application to the IRS nor a user fee is required; the IRS will not issue new opinion, notification, advisory or determination letters for plans amended solely to add the model language.

The model is available only to master and prototype, regional prototype, volume submitter specimen and individually designed plans (including volume submitter plans) (1) eligible for Rev. Rul. 94-76 relief from failure to qualify under Sec. 401(a) and (2) that, as of the date of the adoption of the model amendment, have reliance on a favorable opinion, notification, or determination letter that takes into account the requirements of the TRA '86, under Rev. Proc. 89-9,(27) 89-13,(28) 90-20,(29) 91-41,(30) 91-66,(31) 93-39(32) or 96-6.(33) Affected plans required to make the amendment had until June 30, 1997 to do so.

Retroactive Amendment Procedures

The Eleventh Circuit ruled that a plan administrator that followed IRS procedures for retroactively amending plans to comply with certain nondiscrimination provisions could thereby retroactively reduce accrued benefits. In Scott v. Allstate Agents Pension Plan,(34) several Allstate plan participants claimed--and the district court agreed--that the plan administrator had not followed the IRS's procedures for retroactively amending the plan, so the amendments were ineffective.

The TRA '86 required plan sponsors to amend discriminatory benefit formulas by Jan. 1, 1989. Regulations were supposed to be issued, but never were. Thus, the IRS issued guidance(35) providing several alternatives for employers to maintain their rights to retroactively amend their plans to Jan. 1, 1989. Allstate adopted the alternative that did not require notice to plan participants. Subsequent IRS guidance in Rev. Proc. 89-65(36) extended that suspension of benefit accruals until Dec. 31, 1990 without notice to plan participants, and to Dec. 31, 1991, if Employee Retirement Income Security Act of 1974 (ERISA) Section 204(h) notice was sent to participants. The defendants sent four notices to participants, from February 1989 through September 1990.

While the Eleventh Circuit agreed with the district court's conclusion that an Oct. 26, 1990 board resolution relating to a modification of the benefit formula did not constitute a plan amendment, it disagreed that the plan administrator had not provided the necessary ERISA notice. ERISA Section 204(h) requires the plan administrator to notify participants of any plan amendments that will significantly reduce the rate of future benefit accruals. The notice generally must be provided after adoption of the plan amendment and no less than 15 days before the amendment's effective date. The IRS recognized that the notice required by Rev. Proc. 89-65 could not meet ERISA Section 204(h)'s timing requirement, because of the amendment's retroactive application. Both courts recognized that the substantive content of the notice would necessarily differ from the typical ERISA Section 204(h) notice. According to the Eleventh Circuit, the notice needed to state that there would be a change in the formula for calculating benefit accruals beginning in 1989, and that the new formula would be determined after the IRS issued regulations. While the district court found that none of Allstate's four letters informing participants of the TRA '86 changes met that requirement, the Eleventh Circuit concluded that the first such notice was sufficient.

According to the Eleventh Circuit, the average plan participant would clearly understand from that notice that the old benefits accrual formula would apply through Dec. 31, 1988, and that thereafter, benefits would continue to accrue, but there would be a change in the formula that could not be determined until the IRS published its guidelines. The notice sent in February 1989 clearly communicated the information required by Rev. Proc. 89-65. Further, nothing in ERISA Section 204(h) or Rev. Proc. 89-65 required a second notice after the amendment was formally adopted in November 1991.

Contemplated Benefit Changes

A recent Third Circuit decision, Kurz v. Philadelphia Electric Co.,(37) examined whether a plan administrator had breached its ERISA fiduciary duty by denying or failing to disclose, when asked by prospective retirees, that the employer was "seriously considering" plan changes. The court analyzed a series of events to determine the point at which "serious consideration" began.

Kurz is very fact specific, but provides some guidance in helping clients decide when contemplated plan modifications may have to be disclosed. However, the Third Circuit cautioned that it was not establishing a bright-line test.

Starting in 1986, Philadelphia Electric Company (PECo) noted that its benefits were not as competitive as in the past; consultants were engaged to analyze various change scenarios. Several prospective retirees asked their benefits counselors at PECo whether changes to the pension plan were being considered. The counselors truthfully answered that they were not aware of any contemplated changes. A number of employees, relying on such statements, retired before the benefit increase was announced, and were thus ineligible to benefit from the plan change. These employees filed suit against PECo, alleging that the company had long known of its intent to change the plan, and had breached its fiduciary duty under ERISA Section 404 by misrepresenting that no change was under consideration. The district court granted PECo summary judgment; the Third Circuit reversed,(38) holding that PECo could be liable for breach of ERISA fiduciary duty if it had made affirmative misrepresentations, such as denying that changes were being considered, when a change was under "serious consideration." The case was remanded to the district court to determine when "serious consideration" first existed.

On remand, the district court concluded that PECo began seriously considering a benefits increase when its vice president met with an employee organization to discuss an increase in pension benefits and PECo's consultants began calculating the effect of various plan changes. Thus, the court ruled in favor of those retirees who asked about pension benefits and retired thereafter.

On appeal, the Third Circuit once again reversed the district court, holding that serious consideration requires: (1) a specific proposal, (2) discussed for purposes of implementation, (3) by senior management with the authority to implement the change. Gathering information, developing strategies and analyzing options are not enough. Nevertheless, the court concluded that for those retirees who had queried about benefit changes and retired after "serious consideration" began, the statute of limitations had run on their claims.

Payment Correcting Improper Investment

The IRS ruled in Letter Ruling 9727026(39) that an employer's cash payment to restore losses resulting from a plan's failure to invest elective deferrals and matching contributions according to the participants' instructions was not a contribution for Secs. 404 and 4972 purposes, was not an annual addition under Sec. 415 and did not adversely affect the plan's qualification under Sec. 401(a)(4).

The employer maintained a profit-sharing plan that provided for discretionary employer contributions, elective deferrals under a Sec. 401(k) arrangement and a match. Certain participants who terminated service and received benefits claimed their earnings were understated as a result of the improper investment of their elective deferrals and matches. In anticipation of potential claims for breach of ERISA fiduciary obligations relating to the allegedly improper investments, the employer proposed to restore the allegedly lost earnings by making "corrective cash payments" to the affected participants' accounts. Distributions of the proposed payments would be made in single-sum payments in accordance with the participants' prior benefit elections.

The IRS noted that the proposed payments were intended to place the affected participants in the same position they would have been in had earnings been credited to their elective deferrals and matching accounts in accordance with their investment directions up to the distribution date. Thus, the proposed payments were payments that replace earnings, rather than contributions. Accordingly, the proposed payments were not contributions for purposes of the Sec. 404 deduction limits or the Sec. 4972 excise tax on nondeductible contributions, nor were they annual additions under Sec. 415. Further, the proposed payments would not adversely affect the plan's qualification under the Sec. 401(a)(4) nondiscrimination rules.

The IRS also ruled that the proposed payments would not be taxable to the participants when made to the plan; rather, when they are distributed from the plan, they will constitute eligible rollover distributions under Sec. 402(c)(4), and will be subject to the tax rules then applicable to such distributions.

This problem arose as a result of the employer's practice of segregating the participants' elective deferral and matching accounts on termination of employment and investing those accounts at the trustee's, rather than the participant's, discretion. The ruling points out that under Rev. Rul. 96-47,(40) if a profit-sharing plan provides that terminated employees may no longer choose among investment alternatives and that their accounts will instead be invested in accordance with specific plan rules (e.g., in a money market account), the plan fails to meet the Sec. 411(a)(11) consent requirements because it imposes a significant detriment to any employee who does not consent to a distribution.

Incorrect Plan Distributions

Letter Ruling 9633041(41) addressed correction of a plan defect and the tax treatment thereof The IRS's position is rather startling, given its concerns about self-correction.

In 1992, a participant received a full distribution from two employer plans, Plan Y, a money purchase plan, and Plan X, a profit-sharing plan. The total distributions, approximately $165,000, were timely rolled over into five individual retirement accounts (IRAs). In 1994, the plan administrator discovered that the participant had been overpaid by approximately $15,000 from Plan Y and had not received more than $4,600 of interest that had accrued in his final plan year in Plan X. The participant agreed to return the excess distribution, but asked the IRS for the tax consequences of taking said distribution from his IRA. He also asked if such action would affect the original lump-sum distribution treatment, and if the remaining approximately $4,600 in Plan X could be rolled over into an IRA.

The IRS ruled that the failure to distribute the over $4,600 remaining in Plan X did not harm the participant's right to roll over the original Plan X distribution to an IRA,(42) and the Plan X balance could be rolled over.

The IRS also concluded that the excess $15,000 from Plan Y was never eligible for rollover and was an excess IRA contribution that should have been included in the participant's income in 1992; further, the Sec. 4973(a) 6% excise tax applied each year. However, the earnings on the excess $15,000 would not be taxable until actually distributed (the IRS did not suggest that the earnings had to be distributed immediately). The IRS noted that earnings on excess amounts are not included in the definition of "excess amounts." The excess $15,000 would not be subject to the Sec. 72(t)(1) early withdrawal penalty when distributed from the IRA; however, the earnings thereon will be subject to that penalty when distributed from the IRA.

On the status of the IRA, the IRS concluded that subsequent events (such as excess contributions) affect an IRA's tax treatment, but not its underlying validity. Thus, neither the acceptance of the $15,000 nor the corrective distribution affected the IRA's status.

Distributions of Excess Sec. 415 Amounts

In considering distributions for Sec. 415 violation purposes for plan years after 1995, the regulations were silent as to whether the earnings on elective deferrals had to be distributed. Regs. Sec. 1.415-6(b)(6)(iv)(43) clarified this for 1996 plan years and beyond, by specifying that earnings on elective deferrals in excess of the Sec. 415 limits must be distributed. Failure to distribute such earnings results in their being classified as employer contributions.

Distribution of Illiquid Assets

The IRS has ruled that a distribution of illiquid assets from a plan can be rolled over. In Letter Ruling 9726032,(44) an employer maintained a qualified combined money purchase pension and profit-sharing plan. The plan, which was frozen, had two participants, both of whom were fully vested. Participant B's ex-spouse, individual A, was awarded half of his interest in the plan.

Included in the plan's assets were certain real estate holdings. In the trustees' opinion, the real estate, which had been subdivided, had to be sold in lots to receive the highest return on investment. The trustees estimated it would take four to five years to sell all the subdivided parcels of land. The remainder of the plan assets was liquid.

The employer intended to terminate the plan and distribute all the assets; the real estate was to be distributed to a separate, nonqualified trust. Certificates of participation would be issued to the plan participants, including A; income from the trust would be paid to the beneficiaries annually. The participants could then transfer their distributions into their own IRAs, via a direct or regular rollover.

The IRS ruled that the distributions of the participants' account balances, less the value of the real estate, together with the certificates of participation in the real estate trust, would constitute eligible rollover distributions under Sec. 402(c)(4). Thus, if the amounts distributed were transferred to an IRA in a direct rollover or within the time prescribed in Sec. 402(c)(3), they would not be includible in gross income in the year paid.

The IRS was persuaded by the fact that participants would receive an economic interest in the assets transferred to the nonqualified trust and would ultimately receive the full amount outstanding and credited under the plan. If the distributions were not part of a tax-free rollover, they would have been includible in gross income.

"Same Desk" Rule

In Letter Ruling 9706017,(45) the IRS denied a retirement care company's request that its former employees at a certain facility be permitted to take Sec. 401(k) distributions after the company leased the facility to another entity and terminated them. The lessee hired the employees to work at the facility. This denial expands the "same desk" rule to cover business transactions other than sales.

Under Sec. 401(k), a plan participant may take a distribution only on death, disability, age 59% 1/2, retirement or separation from service. Sec. 401(k) plans also may be terminated and plan assets distributed on certain sales of subsidiaries or assets. In Rev. Rul. 79-336,(46) the IRS held that when a participant has a new employer because of a liquidation, merger or consolidation of the former employer, and the participant will be performing the same job in the same location for the new employer, no separation from service and no right to a distribution exist. In Rev. Rul. 80-129,(47) the same desk rule was extended when the employee of a partnership or corporation, the business of which is terminated, continues on the same job for a successor employer. The rationale is that the employee is doing the same job at the same desk and cannot be viewed as having terminated his employment. The IRS's rule is based partly on basic pension policy, under which plan distributions should be discouraged when possible.

In Letter Ruling 9706017, a company ran a nursing care facility staffed by its own employees. In 1996, it decided to stop running the nursing home and leased it to a large health care system that intended to continue the nursing home facility. The company terminated all employees who worked at the nursing home. As part of its leasing agreement, the system was allowed (not obligated) to hire the employees terminated by the company and did hire some of them.

As part of the arrangement, the lessee agreed to set aside a certain number of nursing home beds for long-term company clients. It also agreed that if it employed any of the terminated nursing home employees, such employees would be given credit for their prior company service (even though the two entities were completely unrelated). Giving prior service credit for work with a completely unrelated entity is permitted under the IRS's imputed service rules in Regs. Sec. 1.401(a)(4)-11(d), if there is a legitimate business reason for the credit and it is given on a nondiscriminatory basis. The lessee hired some of the lessor's former employees, all of whom retained the same jobs they previously had.

The IRS ruled that the employees were not entitled to a Sec. 401(k) plan distribution due to a separation from service if they ceased work with the lessor but were subsequently employed by the lessee. The IRS ruled that the employees would be doing the same job at the same location and that there would be an ongoing relationship between the lessor and the lessee.

Survivor Benefits Vest on Retirement

The Fourth Circuit, in a case of first impression, Hopkins v. AT&T Global Information Solutions Co.,(48) ruled that surviving spouse benefits vest in the participant's spouse on the date the participant retires. Vera Mae Hopkins sued her ex-husband's pension plan after he retired to enforce a qualified domestic relations order (QDRO) giving her the right to a portion of current retirement benefits and naming her the surviving spouse.

When Hopkins and her husband divorced, the latter's pension assets were listed as marital property; no QDRO was issued and the plaintiff was given no rights under the plan. She was awarded alimony in the divorce and had a garnishment order against her ex-husband's income. The ex-husband remarried while still working; when he retired, he became eligible for a qualified joint and survivor annuity (QJSA) under his employer's retirement plan that paid a fixed income for life and paid a surviving spouse half that amount.

The plaintiff sought a QDRO to receive a portion of current benefits and to be named surviving spouse in place of the current spouse, as permitted by ERISA and Sec. 414(p)(5). The state court issued a QDRO that was later separated into two orders, the first ordering monthly payments from the pension benefits (the Pension Order), and the second ordering payment from the surviving spouse benefits (the Surviving Spouse Order). The employer conceded that the Pension Order was a QDRO, but argued that because the surviving spouse benefits had already vested in the current spouse, the Surviving Spouse Order was not a QDRO.

The Fourth Circuit is the first circuit to determine whether a participant's current or former spouse has a vested interest in the surviving spouse benefits. The court noted that ERISA does not explicitly state when a current spouse's interest in the surviving spouse benefits vests. However, after carefully reviewing the overall framework of ERISA, it concluded that the surviving spouse benefits vest in the participant's spouse on the date the participant retires.

The court reasoned that a participant can change a QJSA only during the 90-day window prior to retirement. Thus, the court ruled that the surviving spouse benefits vest in the participant's current spouse on the day the participant retires. Once the survivor benefits are in place, they are no longer benefits payable with respect to a participant and, therefore, are not reachable by a QDRO. The court made it clear that had spousal benefits been ordered before the participant's retirement, the outcome would have been different.

Plans Accepting Rollovers

The IRS issued a proposed regulation(49) to protect retirement plans from disqualification if they accept an invalid rollover contribution, whether or not the contribution was a direct rollover, as long as the plan administrator reasonably concluded that the contribution was valid and, on determining the contribution was invalid, distributed that amount plus earnings.

The proposed regulation is designed to extend the protections of Regs. Sec. 1.401(a)(31)-1, which protect a plan accepting a rollover contribution from disqualification if the distributing plan is not qualified under Sec. 401(a) or 403(a) at the time of the distribution, as long as the receiving plan administrator reasonably concluded the distributing plan was qualified.

The proposed regulation, issued as Regs. Sec. 1.401(a)(31)-1, Q&A-14, also would protect the receiving plan if the plan administrator reasonably concluded the distribution was an eligible rollover distribution, but later learned that it was not. The proposed regulation would treat this as a rollover distribution for plan qualification purposes. For example, such a distribution would be treated as a rollover distribution rather than an employee contribution for purposes of computing Sec. 415 limits or Sec. 401(m) tests.

The proposed regulation would also extend these protections to rollover contributions that were not direct rollovers from a qualified plan; for example, such protections would apply to contributions from conduit IRAs or to checks issued to the participant.

The proposed regulation includes examples of actions by the plan administrator of reasonably concluding the rollover was eligible (e.g., representations from the distributing plan, the IRA trustee and/or the employee).

Mutual Fund Fees

The Department of Labor (DOL) recently released two ERISA opinion letters addressing whether fees received from a mutual fund in which a pension plan invested constituted a prohibited transaction under ERISA Section 406. In each case, the DOL found no prohibited transaction, as long as the arrangements were fully disclosed to the plan fiduciaries.


In DOL Advisory Opinion 97-15A,(50) Frost National Bank (Frost) serves as trustee to various employee pension benefit plans (the Plans). As trustee of the Plans, Frost's duties include recordkeeping on individual accounts, loan administration, employee communications and making certain mutual fund families available for investment by the Plans. Frost reviews each mutual fund family periodically and reserves the right to add or remove mutual fund families. Frost also advises some plans on which of these mutual funds should be offered; for other plans, Frost does not make recommendations.

Frost sought an opinion on whether payment of certain fees by a mutual fund in which a plan has invested violates ERISA Section 406(b)(1), barring a fiduciary from dealing with plan assets for its own account, and Section 406(b)(3), barring a fiduciary from receiving consideration from a party dealing with a plan in a transaction involving plan assets.

Whether or not Frost makes specific investment recommendations, before a Plan enters into the arrangement, the terms of Frost's fee arrangements with the mutual fund families are fully disclosed to the Plan. In addition, Frost's trustee agreement with a Plan will be structured so that fees received by Frost attributable to the Plan's investment in a mutual fund will be used to benefit the Plan. Under the particular agreement with each Plan, Frost will offset such fees, on a dollar-for-dollar basis, against the trustee fee that the Plan is obligated to pay Frost or against the recordkeeping fee that the Plan is obligated to pay to a third-party recordkeeper; or Frost will credit the Plan directly with the fees it receives based on the investment of Plan assets in the mutual fund. The trustee agreement will provide that, to the extent Frost receives fees from mutual funds in connection with a Plan's investments in excess of the fee that the Plan owes to Frost, the Plan will be entitled to the excess amount.

In the DOL's view, advising that plan assets be invested in mutual funds that pay additional fees to the advising fiduciary generally violates ERISA Section 406(b)(1). But in light of the full disclosure and the fees transfer to the Plans, to the extent a Plan's legal obligation to Frost is extinguished by the offset, the DOL concluded that Frost would not be dealing with the Plan's assets in its own interest or for its own account in violation of ERISA Section 406(b)(1).

With respect to Plans for which Frost does not provide investment advice, the Plan fiduciary (and, in some instances, the participants) will select the mutual funds in which to invest Plan assets from among those made available by Frost. Generally, if a trustee acts pursuant to a direction in accordance with ERISA Section 403(a)(1) or 404(c), and does not exercise any authority or control to cause a plan to invest in a mutual fund that pays a fee to the trustee in connection with the Plan's investment, the trustee would not be dealing with the Plan assets for its own interest or its own account in violation of ERISA Section 406(b)(1).

Similarly, it is generally the DOL's view that, if a trustee acts pursuant to a direction in accordance with ERISA Section 403(a)(1) or 404(c), and does not exercise any authority or control to cause a Plan to invest in a mutual fund, the mere receipt by the trustee of a fee or other compensation from the fund in connection with such investment would not, in and of itself, violate ERISA Section 406(b)(3). However, because Frost reserves the right to add or remove available mutual fund families, complications arise. The DOL could not conclude that Frost would not exercise any discretionary authority or control to cause the Plans to invest in mutual funds that pay a fee or other compensation.

Because Frost's trustee agreements with the Plans are structured so that any fees attributable to the Plans' investments in mutual funds are used to benefit the Plans (either as a dollar-for-dollar offset against the fees the Plans would be obligated to pay to Frost for its services or as amounts credited directly to the Plans), in the DOL's view, Frost would not be dealing with the Plans' assets in its own interest or for its own account or receiving payments for its own personal account in violation of ERISA Section 406(b)(1) or (3).


DOL Advisory Opinion 97-16A(51) offers a similar situation. Aetna Life Insurance and Annuity Company (ALIAC) offered similar administrative functions, including Aetna mutual funds,Aetna Life Insurance annuities and unrelated funds. ALIAC, like Frost, selected the funds to offer. ALIAC received fees from the unrelated mutual funds and from the Aetna organizations. These arrangements are fully disclosed to the plans. However, unlike Frost, ALAIC:

1. Did not offer advice to plans on which investments they should offer. 2. Received fees from related Aetna parties. 3. Did not pass through to the plans any fees it received.

If ALIAC deletes a fund and a plan fiduciary rejects the proposed deletion or substitution of a fund, ALIAC is not authorized to make the proposed deletion or substitution effective with respect to that particular plan. In such circumstances, on written notice of termination, the plan fiduciary is afforded an additional 60 days to convert the plan to another service provider. In most cases, ALIAC would seek to avoid terminating the agreement and losing a customer by negotiating to address the concerns of a plan fiduciary that has rejected a proposed modification to the unrelated funds menu. If the issue could not be resolved, ALIAC would attempt to give a plan fiduciary more time to convert to a new service provider.

ALIAC sought an advisory letter that ERISA Section 406(b)(3), barring fiduciaries from benefiting from others who transact with a plan, is not violated by the receipt of fees from the unrelated funds. The opinion letter specifically states it does not address the status of fees from related Aetna entities.

The DOL letter relies on the Frost letter and expands its scope. The DOL has taken the position (in Advisory Opinion 97-15A, above) that if a fiduciary does not exercise any authority or control to cause a plan to invest in a mutual fund, the mere receipt by the fiduciary of a fee or other compensation from the mutual fund in connection with the plan's investment would not, in and of itself, violate ERISA Section 406(b)(3). The DOL seems to ignore significant facts, such as Frost's passthrough of the fees to the Plans, leading to the conclusion that passthrough of the fees apparently will not be required.

DOL Advisory Opinion 97-16A first examines whether the receipt of such fees by ALIAC violates ERISA Section 406(b)(3) if ALIAC is a fiduciary as to the investing plans. ALIAC argues that the circumstances under which it provides recordkeeping and administrative services to plans would not cause it to be a fiduciary, absent the fact that Aetna Life Insurance Company (ALIC), an affiliate under common control with ALIAC, may be considered a fiduciary of the plans because it provides investment management services for plan assets invested in an ALIC separate account.

The DOL analysis notes that ERISA Section 3(21)(A) provides that a person is a fiduciary with respect to a plan to the extent he (1) exercises any discretionary authority or control respecting management of the plan or exercises any authority or control respecting management or disposition of its assets, (2) renders investment advice for a fee or other compensation (direct or indirect) with respect to any moneys or other property of the plan, or has any authority or responsibility to do so, or (3) has any discretionary authority or responsibility in plan administration. That section also provides that neither an investment company registered under the Investment Companies Act nor its investment adviser or principal underwriter are fiduciaries or parties in interest to a plan solely by reason of the plan's investment in the investment company's securities.

The DOL also cites Interpretive Bulletin 75-8(52) for additional guidance on the types of functions that make a person a fiduciary to a plan. In particular, Q&A D-2 states that a person who performs purely ministerial functions (e.g., preparation of employee communications material, government reports and reports concerning participants' benefits) within a framework of policies, interpretations, rules, practices and procedures made by other persons, is not a fiduciary, because such person does not have or exercise discretionary authority or control regarding the management of the plan or its assets.

Under these provisions, the DOL concludes that the question of whether ALIAC is an ERISA "fiduciary" is inherently factual and depends on the particular actions or functions ALIAC performs on behalf of the plans. Because the only discretion is ALIAC's ability to delete or substitute the unrelated funds it makes available to all plans using its services and because the plane' fiduciary has the right to accept or reject such funds, ALIAC is not a fiduciary.

The DOL letter also addresses ALIC, stating that:

You have assumed that ALIC, an affiliate under common control with ALIAC, is a fiduciary with respect to the plans by virtue of exercising authority or control over plan assets invested in separate accounts maintained by ALIC. There is nothing, however, in your submission to indicate that ALIAC, is in a position to (or in fact does) exercise any authority or control over those assets. Accordingly, it does not appear that ALIAC would be considered a fiduciary merely as a result of its affiliation with ALIC.

Both letters conclude by stating the general standards of fiduciary conduct under ERISA Section 404(a)(1), requiring that the responsible plan fiduciaries must act prudently and solely in the interest of participants and beneficiaries both in deciding whether to enter into, or continue, the above-described arrangement and trustee agreement, and in determining the investment options and whether the fees involved in the arrangements are reasonable. The DOL reminds plan fiduciaries to obtain sufficient information on any fees or other compensation that recordkeepers receive for the plans' investments in each mutual fund and to periodically monitor the actions taken by the recordkeepers in the performance of their duties, to assure, among other things, that any fee offsets to which the plans are enticed are calculated and applied correctly.

(21) Notice 97-2, IRB 1997-2, 22.

(22) Sec. 401(k)(3)(A)(ii) and 401(m)(2)(A), as amended by Small Business Job Protection Act of 1996 Section 1433(c), effective for plan years after 1986.

(23) These rules are also discussed in Schneider and Doolittle, "Small Business Job Protection Act Adds Simplicity (and Complexity)," 28 The Tax Adviser 372 (June 1997), p. 374.

(24) Rev. Proc. 97-9, IRB 1997-2, 55.

(25) Rev. Proc. 96-55, 1996-2 CB 387.

(26) Rev. Rul. 94-76, 1994-2 CB 46.

(27) Rev. Proc. 89-9, 1989-1 CB 780.

(28) Rev. Proc. 89-13, 1989-1 CB 801.

(29) Rev. Proc. 90-20, 1990-1 CB 495.

(30) Rev. Proc. 91-41, 1991-2 CB 697.

(31) Rev. Proc. 91-66, 1991-2 CB 870.

(32) Rev. Proc. 93-39, 1993-2 CB 513.

(33) Rev. Proc. 96-6, 1996-1 CB 525.

(34) Ben A. Scott v. Administrative Committee of the Allstate Agents Pension Plan 113 F3d 1193 (11th Cir. 1997), rev'g and rem'g MD Fla., 1995.

(35) Notice 88-131, 1988-2 CB 546.

(36) Rev. Proc. 89-65, 1989-2 CB 786.

(37) Donald R. Kurz v. Philadelphia Electric Co., 96 F3d 1544 (3d Cir. 1996)

(38) Donald R. Kurz v. Philadelphia Electric Co., 994 F2d 136 (3d Cir. 1993), cert. denied.

(39) IRS Letter Ruling 9727026 (4/7/97).

(40) Rev. Rul. 96-47, IRB 1996-40, 7.

(41) IRS Letter Ruling 9633041 (5/21/96).

(42) Citing Rev. Ruls. 83-57, 1983-1 CB 92 and 69-190, 1969-1 CB 131.

(43) TD 8581 (12/22/94).

(44) IRS Letter Ruling 9726032 (4/1/97).

(45) IRS Letter Ruling 9706017 (11/14/96).

(46) Rev. Rul. 79-336, 1979-2 CB 187.

(47) Rev. Rul. 80-129, 1980-1 CB 86.

(48) Vera Mae Hopkins v. AT&T Global Information Solutions Co., 105 F3d 153 (4th Cir. 1997), aff'g 914 F Supp 1362 (DC W. Va. 1996).

(49) 61 Fed. Reg. 49279 (9/19/96).

(50) Pension and Welfare Benefits Administration (PWBA) Opinion Letter 97-15A (5/22/97).

(51) PWBA Opinion Letter 97-16A (5/22/97).

(52) Interpretive Bulletin 75-8, 29 CFR 2509.75-8.


* The Eleventh Circuit ruled that a plan administrator that followed IRS procedures for retroactively amending plans to comply with certain nondiscrimination provisions could thereby retroactively reduce accrued benefits.

* In Letter Ruling 9727026, an employer's cash payment to restore losses resulting from a plan's failure to invest elective deferrals and matching contributions according to the participants' instructions was not a contribution for Secs. 404 and 4972 purposes, was not an annual addition under Sec, 415 and did not adversely affect the plan's qualification under Sec. 401(a)(4).

* A recent Third Circuit decision examined whether a plan administrator had breached its ERISA fiduciary duty by denying or failing to disclose, when asked by prospective retirees, that the employer was "seriously considering" plan changes.
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Title Annotation:part 2
Author:Soscia, Elizabeth
Publication:The Tax Adviser
Date:Dec 1, 1997
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