Demutualization Compensation as Plan Asset

[Guest Steve C]

I believe that the demutualization award should be treated as a plan asset (and considered as investment return) to the extent that it derives from an annuity contract included in plan assets.

[Guest Jeff Kropp]

Assume that an insurance company demutualizes (i.e., converts from a mutual

life insurance company to a stock company).

In exchange for relinquishing their voting rights, policyholders receive stock or cash). If a tax-qualified annuity benefit plan (contributory)is funded through an annuity contract that is in the name of the sponsor-employer, is the demutualization stock or cash a "plan asset". There is no formal DOL or IRS guidance on this issue, but any thoughts are appreciated.

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[Kirk Maldonado]

Jeff Kropp:

There are at least two articles on this topic. (I think one of them was in Compensation Planning Journal, and it was worth reading, although I seem to recall that the author definitely had some strong views on the topic.) You can find citations to them in some prior message threads (on BenefitsLink).

[pjkoehler]

The article in the Tax Management Compensation Planning Journal to which Kirk refers is "Insurance Company Demutualization Awards and Welfare Benefit Plans" by Alden J. Bianchi, Esq. I'm sorry I don't have the specific edition and volume, but I'll be glad to fax it to you if you email me your fax number. I think it's a 1998 or 1999 edition.

The author makes a reasonable argument based on the analysis that policyholders of mutual life insurance companies have both "membership" (or proprietary) rights and "indemnity" (or contractual) rights. He argues that while demutualization awards are paid in exchange for the policyholder's "membership" rights, its indemnity rights, which he asserts are the extent of the "plan assets," are unaffected. Therefore, he concludes that, logically, since demutualization leaves the benefit structure of the plan intact, the demutualization award could be retained by the policyholder as a corporate asset, regardless of whether or not the plan was contributory. He recognizes that this does not appear to be the government position (to the extent one can be discerned) and that such a position probably needs to be modified on general equitable principles. He ends up concluding that the safest approach is to prorate the award in the ratio of employee contributions to total contributions, with that amount being treated as a plan asset and the remainder a corporate asset. The most expeditious approach to handling the plan asset portion of the award is to deposit the funds in a VEBA (unless the amount can be applied in less than 90 days) for the purpose of declaring a premium holiday for all the current participants, until the award is exhausted.

[Guest Jeff Kropp]

Thanks.

In my hypo, the plan is a pension plan that uses an annuity contract to fund pension benefits. Most authors that have written on this subject conclude that the DOL views (or will view) the demutualization compensation attributable to the contract as a "plan asset" that cannot inure to the benefit of an employer (regardless of whether the employer holds the annuity contract in its own name). Since the exception to ERISA's trust requirement no longer applies to stock held by a qualified plan, the stock should probably be held in a trust-for the exclusive benefit of participants-to be sold as needed to pay benefits or reinvested elsewhere. Though I have not read the article, it most likely relies on a few welfare plan cases dealing with how to treat dividends or rebates issued by insurance contracts. Though I understand the argument as applied to pension plans, it seems like a risky approach for sponsors of pension plans to take, in the absence of clear IRS/DOL guidance on the issue, given the potential risks (breach of fiduciary duty, prohibited transaction, disqualification of plan, or participant/DOL lawsuit).

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[pjkoehler]

Jeff, I agree that given the current absence of guidance, the prudent approach is to treat the entire demutualization award as a plan asset. However, someday the DOL should have to distinguish the holding in Jacobson v. Hughes Aircraft, 119 S.Ct. 755 (1999). There a contributory defined benefit plan was overfunded by about $1 billion, Hughes ceased making contributions in 1987, but the mandatory employee contributions continued to be withheld from employee paychecks and contributed to the plan. In 1989 the plan was amended by adding an early retirement incentive benefit for certain employees. In 1991 Hughes froze the plan and Hughes spunoff a noncontributory plan, funded by a portion of the excess assets. The plaintiffs claimed that, as contributing employees under the frozen plan, they had a right to a portion of the excess assets in the form of enhanced benefits. The Supreme Court, however, held that participants in a contributory defined benefit plan have no right to any portion of excess assets accumulated in the plan. The Court reasoned that the participants held an interest only as to their accrued benefits, regardless of the level of overfunding. How is it then, that the DOL can logically argue that participants in a noncontributory pension plan have any right to have any portion of a demutualization award?

[This message has been edited by PJK (edited 06-28-2000).]

[Guest Jeff Kropp]

The difference between the Hughes case and my hypo is that in Hughes, the employer was not taking the surplus out of the plan/trust for its own corporate purposes-the company was just setting up a different benefit structure with the surplus.

Participants may not have a right to surplus partly attributable to their own contributions, but neither does the company (with the exception of a plan termination, I guess).

What about the argument that state insurance laws regulating a demutualization (and the allocation of proceeds between employers and employes) are not preempted by ERISA?

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[pjkoehler]

In Hughes, the plaintiffs' chief objection was that the new noncontributory plan benefitted participants who never made employee contributions to the frozen plan and that Hughes was, therefore, using "their[plaintiffs'] money" to achieve a corporate purpose related to the establishment a new pension benefit plan, and to obtain substantial savings by satisfing its funding obligations thereto by transferring "frozen plan" assets. If an employer can establish a new noncontributory plan for one class of employees, and offset its funding obligations by transferring assets from a contributory plan that covers a separate group of employees, it achieves a financial benefit in direct proportion to the assets transferred. But that is of no moment, according to the Supreme Court, so long as the transferor plan's benefit structure is left intact. It can be argued that treating a demutualization award that is paid in exchange for membership rights in an erstwhile mutual life insurance company as a corporate asset, without affecting the benefit structure of the plan for which the policy is the funding vehicle, stands on the same footing.

As far as state insurance laws, it can be argued that a state law, even if codified in the state insurance code, which purports to determine whether or not a demutualization award is a "plan asset" of an employee benefit plan, is not a law that "regulates insurance," and, therefore, isn't saved from preemption under ERISA Sec. 514(B)(2)(A).

[This message has been edited by PJK (edited 06-28-2000).]