6. Investment Considerations for Retirement Plans

Question 1

Suitability of investment types

Answer 1

-ERISA 404 (c) plans usually have stock, bond and cash equivalent options (3 investment alternatives and trade 1/3 months considered broad range and control)
- Pension plans require diversification especially for employer in defined benefit plan, who assumes all risk

Question 2

Time horizon and risk

Answer 2

Should consider time horizon and level of risk, eg:
-should assess reputation and financial strength of Guaranteed Investment Contract (GIC)
- should consider higher yielding bonds as opposed to muni bonds that have a lower yield due to tax free status, but not necessary in tax shelter

Question 3

Prudent Person Standard of Care

Answer 3

As a fiduciary, must act with care, skill, prudence and diligence in the interest of plan’s participants and beneficiaries when:
-Providing benefits to participants and their beneficiaries (diversify investments and minimize risk), and
-Defraying reasonable expenses of administering the plan.

Question 4

Indicia of Ownership

Answer 4

Except as authorized by the Secretary of Labor by regulations, no fiduciary may maintain the indicia of ownership of any assets of a plan outside of the jurisdiction of the district courts of the United States.

Question 5

Control Over Assets

Answer 5

A pension plan which allows participants/beneficiaries control over assets will not consider that person a fiduciary, and fiduciary is not liable for participant’s actions

In case of a SIMPLE plan, participant/beneficiary shall be considered as exercising control when:
- election of initial investment
- rollover to another IRA
-1 year after SIMPLE IRA is establish

Question 6

Plan Terminations

Answer 6

Fiduciary’s duty is discharged in a terminated pension plan/single employer plan when there is an election to establish/maintain qualified replacement plan/increase benefits

Question 7

Liability for Breach of Fiduciary Duty

Answer 7

Any fiduciary who breaches any responsibilities shall be liable to make good losses resulting from breach. May be removed from role for violation. Not liable for breaches before/after fiduciary duty.

Question 8

Prohibited transactions between plan and party in interest

Answer 8

• sale/exchange/leasing of any property
• lending of money/extension of credit
• furnishing of goods, services or facilities
• transfer to use/benefit any assets of the plan
• acquisition of employer security or real property of employer in violation of section 1107 of Title 29.

Question 9

Prohibited transactions between plan and fiduciary

Answer 9

• deal with assets in own interest/account
• act in transaction involving the plan adversely to plan/participants/beneficiaries’ interest
• receive consideration in personal account for plan dealings/transactions

Question 10

Prohibited Transfer of Real/Personal Property

Answer 10

Title 29 section 1106:
A transfer of real or personal property by a party in interest to a plan shall be treated as a sale or exchange if the property is subject to a mortgage/ similar lien which the plan assumes/is subject to a mortgage/similar lien which a party in interest placed on the property within the 10-year period ending on the date of the transfer.

Question 11

Exemptions from Prohibited Transactions

Answer 11

Secretary of Labor may grant exemption of subsection 1108 if:
-administratively feasible
- in interest of plans and its beneficiaries/participants
- protective of beneficiaries/participants rights

Must publish notice, require adequate notice and affords opportunity for a hearing

Question 12

When is LI used in a qualified plan

Answer 12

• when substantial # of employees have unmet LI need either for family protection or estate liquidity
• when there are gaps and limitations in other company plans providing death benefits such as section79 group-term LI plans, NQ deferred comp plans and split dollar plans
  -when overfunded in a closely held business/professional corporation, and addition of incidental LI benefit/change to fully insured funding may permit future deductible contributions
  -when HCE are subject to estate taxes on death benefits: LI death benefits can be structured to avoid taxes or provide funds to pay estate taxes
• additional option for investing plan accounts, eg profit sharing /401(k) plan/DC plans
  -extremely secure funding vehicle for a plan

Question 13

Pros to LI in qualified plan

Answer 13

-Tax treatment of LI provides overall cost advantage compared with individual life policies provided by employer/personally owned
- one of safest available investments
- pure insurance portion (death proceeds-policy cash value) is not subject to income tax /effective means of transferring wealth
-fully insured plan is exempt from min funding standards and actuarial certification requirement of Code section 412, reducing administrative cost and complexity of DB plan, also allows higher deductible plan contributions than regular trusteed plan

Question 14

Cons to LI in qualified plan

Answer 14

Rate of return on cash value may be low. Policy expenses and commissions may be more than comparable investments

Question 15

Insurance Coverage

Answer 15

all plan participants under a nondiscriminatory formula related to the retirement benefit/ plan contribution formula. Insurance coverage can be conditioned on taking a medical exam as long as it does not result in discrimination in favor of HCEs

Question 16

Incidental Test

Answer 16

Incidental so long as cost is <25% of total cost of plan/meets either of the following:
- DB: patient’s insured death benefit <= 100x expected monthly benefit
- DC: aggregate premiums paid over entire life of plan for participant’s issued death benefit are less than:
-50%- ordinary LI
-25%- term ins
-25%- universal

Question 17

LI in DB plans

Answer 17

Adds to the limit on DC and allows greater tax-deferred funding as cost of LI can be added to contribution and deducted:
- combination plan- appropriate for <25 employees: whole life and side/conversion fund
- envelope funding approach: separate group life insurance policy is purchased
- fully insured plan: exclusively funded by life insurance or annuity contracts- only used as an option for overfunded plans:
-funded exclusively by the purchase of individual insurance contracts
-provide for level annual (or more frequent) premiums extending to retirement age
-paid without lapse
-No rights under the contract have been subject to a security interest
- no outstanding policy loans

Question 18

The Retirement Equity Act of 1984

Answer 18

owner and beneficiary of life insurance in a qualified plan must be the trustee.

Question 19

LI in DC plans

Answer 19

part of each participant’s account is used to purchase insurance on the participant’s life: amount must be kept within incidental percentage limits. This plan can provide that insurance
- purchases are voluntary by participants
- provided automatically as a plan benefit,
- provided at the plan administrator’s option (on a nondiscriminatory basis)

Employers in profit sharing plans for more than 2 years allow in-service cash distributions prior to termination of employment, which can be used to purchase any life insurance as specified in plan.

Question 20

Economic value of pure life insurance coverage on a participant’s life

Answer 20

Taxed annually to the participant at levels specified by the IRS- lower of: (a) the IRS Table 2001 costs or (b) the life insurance company’s actual term rates for standard risks (limited).

Any amount actually contributed to the plan by the participant is subtracted from taxable annual economic benefit amount except in the case of Keogh

Question 21

Taxation of an Insured Death Benefit

Answer 21

• pure insurance element: tax-free
• total of costs paid by participant: tax free
• remainder/qualified plan distribution taxed accordingly- included in estate for federal tax purposes, but may be possible to partially exclude if decedent has no incidents of ownership

Question 22

Economic Advantage of LI in plan

Answer 22

deductibility of tax with plan-provided insurance potentially results in a measurable net tax benefit

Question 23

Annuity

Answer 23

contract between insurance company and individual that guarantees lifetime income to the person in which the contract is based in return for a lump sum or periodic payment to the insurance company, commonly used to fund 403(b) plans

Question 24

Fixed annuity

Answer 24

All funds placed in general account and have guaranteed return. Payout is based on value of account and life expectancy based on mortality tables. Risk likes in loss of purchasing power due to inflation

Question 25

Variable annuity

Answer 25

Money invested in portfolio of equity securities, which has a better chance of outpacing inflation, but also carries greater risk. Contributions are placed in a separate account that is not part of the insurance company’s general account and are not subject to insurer’s creditors.

Question 26

Single life annuity

Answer 26

set monthly payment for life

Question 27

Life/Period certain Annuity

Answer 27

Annuity payments for life, but if you die before end of period certain (10-20 years), then payments will go to beneficiary

Question 28

Joint and Survivor Annuity

Answer 28

• 50% survivor benefit: pays survivor 50% of original annuity after death
• 100% survivor benefit, continues benefit to survivor @ same level after death
  -no inflation protection and little flexibility in altering

Question 29

Tax treatment of distributions

Answer 29

• if qualified plan payout in the form of an annuity, then ordinary income
• if purchased outside of a tax advantaged retirement plan, then withdrawals will be assumed to be gain first/taxable. Once all gain is removed, then withdrawals will be basis and not taxed again
  (taxable withdrawals made before 59.5 may be subject to 10% penalty, unless due to death, disability, as a series of substantially periodic payments/through annuitization using commercial annuity)

-if purchased before 8/1982, may be allowed to withdraw basis first

Question 30

Exclusion ratio Formula

Answer 30

Investment in contract/expected return

Question 31

Inclusion ration Formula

Answer 31

1-Exclusion ratio

Question 32

Pete died recently and held a profit-sharing account balance of $300,000. As part of Pete’s account allocation, he maintained a universal life insurance policy with a death benefit of $100,000. The cash value of the policy is $20,000 and Pete had paid total P.S. 58 costs of $3,000.

What is the current tax treatment of a lump-sum distribution of the profit-sharing account and life insurance proceeds?

Answer 32

$317,000 ordinary income and $83,000 tax-free.

The $300,000 account balance plus the life insurance cash value, less the P.S. 58 costs paid of $17,000 is ordinary income. The balance of the life insurance death benefit, $83,000, is tax-free.

Question 33

What is the maximum percentage of qualified plan contributions that may be allocated to ordinary (whole life) life insurance on behalf of a participant in a defined contribution plan to comply with the “incidental” regulations for life insurance in a qualified plan?

Answer 33

no more than 50% of contributions on behalf of a participant may be allocated to ordinary life insurance.

Question 34

Fully Insured Pension Plans

Answer 34

-funded exclusively by life insurance or annuity contracts
- trust is not used to hold the plan assets
-high interest rates of the late 1970s lured many pension investors away
-option for overfunded plans.

Question 35

If ordinary (whole life) life insurance is used in a defined benefit plan, what is the maximum death benefit the life insurance may provide without violating the “incidental” test for life insurance in a qualified plan?

Answer 35

no more than 100 times the expected monthly pension benefit (100 times limit)

Question 36

In a qualified plan, such as a Section 401(k) plan, under which a participant has investment allocation control over the assets in their account, what is the minimum number of investment alternatives that must be offered according to ERISA regulations?

Answer 36

ERISA dictates that the account holder be given control over the assets in his or her account and provide at least three investment alternatives.