treatment of former employees

[Guest Charlie Stevens]

I thought that I once saw a revenue ruling regarding the treatment by a qualified retirement plan of former employees. That is, former employees could be treated no worse than active employees. Thus, if the employer paid administrative expenses on behalf of active employees, it could not charge the accounts of former employees (to encourage the former employees to withdraw their money). Does anyone remember the number of this revenue ruling? Is my memory correct that it was, in fact, a revenue ruling?

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Charlie Stevens

Michael Best & Friedrich LLP

[Guest Charlie Stevens]

Mike,

Thanks for your response. This is exactly what I had remembered and was looking for. I don't know why I couldn't find it. In response to LCarusi, I do think that charging former employees but not charging active employees could be problematic on the basis that the former employees would be urged to leave the plan on an "involuntary" basis. Does anyone else agree with this?

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Charlie Stevens

Michael Best & Friedrich LLP

[MWeddell]

I'd guess that you are recalling Revenue Ruling 96-47

[LCARUSI]

Question to Mike Weddell or Charlie Stevens:

In light of 96-47, do you think the arrangement as described (sponsor paying expenses only for active participants) is invalid?

[david shipp]

As Charlie alludes to, the issue here is whether "a significant detriment is imposed under the plan on any participant who does not consent to a distribution." This comes from 1.411(a)-11©(2) which indicates that a participants consent to distribution is invalid if a "significant detriment" is imposed on a decision to leave the money in the plan.

The QJSA Exam Guidelines (which also cover 411(a)(11)) discuss the issue of significant deteriment and state that disparate treatment between former participants and participants may result in a significant detriment to former participants. The example given of a significant detriment describes a plan that allows participants the option of an immediate distribution on termination of employment, but requires those who decide to defer to wait until age 65 to receive their benefits (i.e., no interim elections to withdraw permitted.)

I realize that this is not directly on point, but I think that a good case could be made that charging expenses to former employees but not current employees does create disparate treatment between the two groups. I also realize that a number of plans are already operated in this manner. My recommendation to clients, however, is NOT to adopt this practice since it not clearly acceptable.

[MWeddell]

Answering the question posed by LCarusi:

I agree with the others that charging former employees for the true cost of administering their accounts but not charging active employees is "problematic" and not "clearly acceptable." However, I don't think it's invalid and I'd still recommend it to plan sponsors considering the idea. Resolving the issue is enough of a judgment call that (1) I really don't disagree with those who resolve the issue differently than I and (2) I'd inform the client that there is some compliance risk with this position.

That's my conclusion; the rest of this lengthy post is just explaining my position.

If the client's practice of charging expenses only to former employees and not actives is in the plan document and the client already has an IRS determination letter, then there's not much risk in continuing the practice. Rev. Ruling 96-47 indicates that even if the IRS were to come out with another revenue ruling like 96-47 the plan sponsor won't have to change how the plan operates until the first day of the plan year after the new revenue ruling came out.

Suppose that the client doesn't already have a determination letter on the practice of charging administrative costs to former employees only. I'd still recommend that the client may do so if it fits the client's objectives. Here's a more complete history of the IRS treatment of the topic:

- At the late spring ALI-ABA meetings in Washington DC in 1993 and 1994, IRS officials discuss the significant detriment issue including opining that the practice of paying costs for actives and not former employees violates the regulation. Hence, key IRS officials are aware of the issue at this point but haven't issued anything formal.

- In audit guidelines in Announcement 95-33, the IRS discusses the significant detriment issue in writing, says what constitutes a significant detriment is a facts and circumstances determination, and gives 3 examples of what is a significant detriment and 1 example of something that is not a significant detriment. The audit guidelines don't mention paying expenses only for active employees.

- Rev. Ruling 96-47 is issued, complete with a Pres. Clinton press conference. It only addresses requiring former employees to be in a money market fund when actives get to choose among a broad range of investment options. Other possible examples of significant detriments are not mentioned.

- In comments before a 10/5/1996 ALI-ABA meeting, a key IRS official discusses Rev. Ruling 96-47, which are reported in CCH's Pension Plan Guide, para 26,629. Alan Tawshunsky suggested that charging an administrative fee to terminated participants but not active participants wouldn't be a significant detriment as long as the fee was a reasonable allocation of the plan's costs.

- In Dec. 1998, the IRS revised the cash-out regulations but didn't tinker at all with the significant detriment language.

So what inference do we draw from that history? I say that given the IRS' silence on whether charging administrative costs to former employees and not active employees is a significant detriment in light of the fact that the IRS knows this is a fairly common practice, go ahead and do it. More analytically, one factor mentioned in Announcement 95-33 is whether the employer has a valid business reason for the disparate treatment between former participants and active participants. Wanting to subsidize costs only for active employees strikes me as a valid business reason.

[This message has been edited by MWeddell (edited 04-21-99).]

[david shipp]

Thanks to MWeddell for a well-reasoned explanation of his position. This is a gray area and one that is subject to different interpretations. The valid business reason factor gives sponsors the best "cover" if they choose to go this route.

It is obviously the plan sponsor's ultimate decision and they need to decide whether the business risk is worth the benefit. I don't think this is an issue that one would resign an account over if the client chooses not to adopt a recommendation that expenses not be charged in this manner.