Enforce the Exclusive Benefit Provision for Pension Plans
D. Larry Crumbley and William M. VanDenburgh, Louisiana State University,
look at the exclusive benefit provision for pension plans.
Document Type: Viewpoint
Tax Analysts Document Number: Doc 2002-12124 (6 original pages)
Tax Analysts Electronic Citation: 2002 TNT 98-55
Citations: (20 May 2002)
=============== SUMMARY ===============
D. Larry Crumbley Ph.D., CPA, is the KPMG Endowed Professor of Accounting at
Professor Crumbley has authored numerous articles in tax, law, and
accounting journals. Mr. VanDenburgh has also contributed to many tax and
accounting journals.
=============== FULL TEXT ===============
Enforce the Exclusive Benefit
Provision for Pension Plans
By D. Larry Crumbley and
William M. VanDenburgh
[1] The
[2] Within these general confines great variations exist. Companies can
implement plans for maximum tax advantages. For example, the portion of the
companies' stock invested in these plans can have a unique dividend advantage.
Dividends that are paid on these shares are typically deductible by the company
(unlike ordinary dividends that are not deductible). Further, there is no cash
outflow when stock is used to fund a plan.
[3] Congress is assessing whether substantial retirement plan reforms are
necessitated. Many proposals would add more hoops that retirement plans must
jump through as a knee-jerk reaction to the Enron fiasco. For example, Sen. Jon
Corzine, D-N.J., is proposing to restrict employees from investing more than 20
percent of their 401(k) money into a single stock. However, the prudent
investor standard is already in place and should be enforced, rather than
Congress adding more complexity to the already complex pension area.
Regulating Retirement Plans
[4] Administrative controls over retirement plans are supposed to occur
through oversight by the Treasury Department and the Department of Labor
(Internal Revenue Code of 1986 and Employee Retirement Income Security Act
[ERISA] of 1974). A recent JCT report, however, noted that, "As a
practical matter, the IRS rarely disqualifies a plan." 1 For
any plan to qualify for preferential tax treatment, it must be for the "exclusive
benefit" 2 of employees. In 1998, the Department of Labor
in regard to a pension plan noted:
The Department is providing no opinion in this proposed exemption as to whether
particular investments or investment strategies would be considered
"socially responsible" in nature. In this regard, the Department
notes that the Internal Revenue Service (IRS) has taken the view that
investment strategies for qualified retirement plans may raise questions with
regard to the exclusive benefit rule under section 401(a) of the Code if, among
other things, the safeguards and diversity that a prudent investor would adhere
to are not present. 3 [See, for example, IRS Rev. Rul. 73-532,
1973-2 C.B. 128]
[5] An examination of the above referenced IRS revenue ruling, which is still
current, reveals that the prudent investor standard has likely been overlooked
and/or forgotten in many retirement plans. In other words, retirement plans
that are predominately invested in company stock potentially fail to meet this
standard in many situations.
[6] With the current flurry of debate over pension reform, an effective
solution may likely be contained within the administrative rules of the
Internal Revenue Service already in place. The answer resides in better
enforcement and expansion of existing rules. While the personal losses incurred
by Enron employees are tragic, the overall success of privately funded
retirement planning should be respected and encouraged by any forthcoming
legislatively mandated changes. The national economic stakes are immense, as
reflected in table 1. 4
====================================================================
Table 1:
Value of
Plan Assets
Value as of
Plan Type
(in trillions)
--------------------------------------------------------------------
Defined Benefit
Plans
$2.06
Defined
Contribution Plans
$2.53
Individuals' IRAs
and Keoghs
$2.65
====================================================================
[7] During the U.S. Chamber of Commerce meeting in late February 2002, Treasury
Secretary Paul O'Neill declared the administration's policy in broad terms as:
The President has called for protections so that employees have as much access
to the company shares in their 401(k) as corporate officers have to their own
shares in the company.
Government has no business telling Americans where
they can and can't invest their money. And government can't ensure that no one
ever makes a bad investment decision. What we can do, and should do, is make
every effort to ensure that Americans have the skills to evaluate their savings
and investment choices. 5
====================================================================
Table 2:
Revenue Rulings Relevant to Prudent Investing
Revenue
Cumulative
Ruling
Bulletin
Subject
--------------------------------------------------------------------
73-532
1973-2 C.B. 128 "Investment of trust
funds"
73-380
1973-2 C.B. 124 "Loan of trust's assets to
employer corporation"
73-282
1973-2 C.B. 123 "Trust funds loaned to
related
corporation"
72-389
1972-2 C.B. 220 "A profit-sharing plan
... under
section 401 of the code"
70-536
1970-2 C.B. 120 "Supplemental unemloyment
benefit trust"
69-494
1969-2 C.B. 88 "Stock or securities of
the
employer corporation"
====================================================================
[8] Some in Congress have divergent views on the need for pension reform. Rep.
Charles Rangel, D.-N.Y., has even stated that this matter "cannot wait
until all the hearings and task forces" have completed their work. 6
The president has established a task force consisting of representatives of the
Labor, Treasury, and Commerce Departments to investigate the Enron affair. 7
Prudent Investing Standard
[9] A search of IRS revenue rulings with the term "safeguards and diversity"
discovered the rulings listed in Table 2 that are relevant to retirement plan
holdings:
[10] While these rulings are dated, their methodology was referred to as
recently as 1998 by the Department of Labor as underlying investments of plan
assets. 8 These statements are in one sense timeless in that they
deal with the concept that diversifying one's investment assets eliminates many
of the risks of investing. Specifically, one can replace company-specific risk
with general market risk when an investor's stock portfolio reaches
approximately 40 equally rated securities. Because the code affords highly
favorable treatment to retirement plans, the government has a vested interest
in these plans' performance in terms of future governmental revenue and social
expenditures. A prudent investment standard requires that diversification
occur. Importantly, the revenue rulings also require that plans meet any state
fiduciary requirements.
[11] Revenue Ruling 69-494 deals with the requirements that must be met if a
plan is to invest in the employer's stock. Trustees are allowed to invest in
employer stock under certain conditions. A highly relevant quote is:
The safeguards and diversity that a prudent investor would adhere to must be
present. However, the requirement set forth in item (2) with respect to a fair
return is not applicable to obligatory investments in employer securities in
the case of a stock bonus plan. See Rev. Rul. 69-65, C.B. 1969-1, 114. Upon
compliance with these requisites, if the trust instrument and local law permit
investments in the stock or securities of the employer, such investments are
not deemed to be inconsistent with the purposes of section 401(a) of the Code.
[12] While not setting a limit on the amount that can be invested in employer
stock, the revenue ruling could be interpreted as requiring a certain level of
investment diversification. Revenue Ruling 69-494 also states:
In such matters the trustee should be guided by the trust instrument, local
law, and his own judgment as a reasonably prudent investor.
[13] As a recent example, a former Enron retirement plan trustee, Ms. Olson,
sold over $6 million of her Enron stock since 1996, but took no action in
regard to the Enron stock that comprised 63 percent of Enron's 401(k) plan,
$1.3 billion out of $2.1 billion. 9 Some claimed that Ms. Olson even
failed "to review whether Enron stock continued to be a prudent
investment." She also missed four trustee meetings in the prior year. 10
James Prentice, another ex-trustee of that plan, sold nearly $1 million in
Enron stock. In November 2002, he sold another 50,000 shares for $1 a share.
Only in November did Enron's former trustees start to analyze whether Enron was
a prudent investment. 11
[14] Within this atmosphere it took until
[15] Revenue Ruling 73-532 disallows trustees to invest in assets that are
"speculative, hazardous, adventurous" even though the trust documents
allow for these types of investments. These provisions of the trust were found
to be "more than an exculpatory clause" and therefore were not for
"the exclusive benefit of the employees." Adequately secured loans of
plan assets back to the employer have even been disallowed under section 401
due to the exclusive benefit clause -- "safeguards and diversity"
(see Revenue Ruling 72-389).
[16] Lucent's 401(k) plan trustees are currently under court proceedings for
supposedly not adhering to the prudent investor standard. This is considered a
landmark case with "the charge: by not restricting or eliminating the
company's stock in the plaintiffs' 401(k) plans, Lucent officials cost the
plaintiffs millions of dollars as the stock price fell from $37 a share to less
than its current $6 a share." 14
Advising Diversification?
[17] Some firms have asserted that they have not offered their employees any
type of investment advice due to potential liability concerns. ERISA
potentially holds companies liable for investment advice given to employees. 15
Near the end of 2000, Rep. John Boehner, R-Ohio, introduced legislation to
alleviate this concern (avoid liability if potential conflict of interest were
disclosed). The bill passed the House and is now awaiting action in the Senate.
However, the AFL-CIO views this legislation in a different context. It noted,
"Enron is a story of conflicts of interest." 16 A plan
holding the employer's stock faces a Catch-22: The company potentially can be
liable if it advises diversification and the stock does well or if does not
advise diversification and the company stock does poorly.
[18] Some firms, even with the potential for liability, advise their
employees on the inherent risk of inadequate diversification. The Vanguard
Group advises employees on the risk of inadequate diversification if requested
by employers. Texas Instruments, whose 401(k) plan is three-fourths invested in
itself, is intensifying its message on diversification. 17 Firms
also "target communications" to participants that are not diversified
and some set limits to amounts that can be invested in the employer's stock. 18
[19] How risky is it to advise diversification? Is diversification not
considered a key fiduciary standard that trustees must meet? Clearly, more
investor education is needed. Approximately 33 percent of employees' assets are
invested in their employer's stock, according to a study by the Employee Benefit
Research Institute (for 401(k) plans that offered company stock). In another
study, John Hancock Financial Services noted that numerous investors perceive
their company stock as less risky than a diversified portfolio and that bond
funds are risk free. 19
JCT Background Statement
[20] The current debate on retirement plans has resulted in Congress
becoming keenly interested in the topic. In response, the Joint Committee of
Taxation on
====================================================================
Table 3:
Tax Advantage of Company Stock
Percent
Total
Value in
Estimated
of Plan Company Tax
Savings
Company (in millions)
Stock (in millions)
--------------------------------------------------------------------
Abbott
Laboratories $ 6,200
82.00% $ 28.10
Anheuser-Busch
2,800
83.00 14.50
Bank of
Ford Motor
17,062
49.70 90.20
Marsh &
McLennan 2,000
61.00 10.00
McDonald's
2,445
74.30 4.20
Pfizer
7,623 82.40
23.40
Procter &
Gamble 11,851
91.50 127.00
SBC
16,899 38.10
56.20
Verizon
19,100
51.00 30.50
Source: WSJ,
1 Ellen E. Shultz and
Theo Francis, "Companies Cash In
on Tax Breaks From
Employee Retirement Plans," WSJ.com,
Jan. 31, 2002.
====================================================================
[21] Interestingly, but not surprising, the report did not address the prudent
investment standard as interpreted by the revenue rulings in table 2. This
standard would appear to be highly applicable.
Enron's Retirement Plan Collapse
[22] A significant number of relevant issues are raised by the collapse of
Enron's retirement plan. If the prudent investment standard had been followed
and/or enforced, much of the resulting damages to pension assets could have
been severely limited from the onset. As the Department of Labor reported:
Many Enron employees lost 70-90% of their retirement assets after the company
indicated that it would re-state profit reports. The Labor Department's Pension
and Welfare Benefits Administration is reviewing Enron's benefits plans, the
rules that govern them, and steps that were taken by the company shortly before
its collapse to temporarily freeze trading of 401(k) plan assets. This action
is being closely coordinated with other government agencies investigating
Enron. 22
[23] Enron had three retirement plans (defined benefit pension plan, 401(k)
plan, and employee stock ownership plan (ESOP)). 23 The Wall
Street Journal reported that Enron had combined its pension plan and ESOP.
These "floor-offset" arrangements are not unique and are permissible
(Hewlett-Packard and Airborne, for example, also have these arrangements).
Enron employees were to receive the higher benefits of the two plans. However,
Enron locked in the value of the ESOP when its stock was trading higher
(potentially illegal). The IRS may have even given a "determination letter"
for this maneuver. Enron's 2000 SEC filing reported that its ESOP had $116
million in assets and that its pension assets were $858 million (which included
the ESOP). At the time Enron reported that the plan was overfunded by
$116 million. 24 In addition, by combining a defined benefit plan
and ESOP, the government in effect became an insurer (through PBGC) of a highly
complex deal. A defined benefit plan is limited to investing no more than 10
percent in the employer stock to protect government interests.
[24] Enron's collapse caught most people by surprise. The S&P Outlook
as late as October 24, 2001, highlighted Enron as a stock that warranted
purchase consideration. S&P made the following points:
[25] One potentially disregarded aspect is that the
employees of Enron could have elected to diversify to a much greater extent
than they did. The Enron 401(k) plan offered several investment options ranging
from Fidelity's Magellan Fund to a Schwab account that allowed individuals to
self-direct their holdings. 25 However, apparently there was stated
and unstated pressure to remain loyal to the company by investing in its
shares, even as top management was selling large portions of their own
holdings.
Cagey Tax Advantages of Company Stock
[26] The investment of more than half of the 401(k) assets in Enron's
underlying stock is not unique. The table on the previous page reveals that
retirement plans can have significant investments in company stock and that
there are significant tax advantages.
[27] These tax advantages can occur thanks to several tax- planning tactics.
As the JCT report stated: 26
Special tax benefits also apply to ESOPs. For example, the employer may deduct
dividends paid on stock held by an ESOP if the dividends are used to repay a
loan, are distributed to plan participants, or if they are reinvested in the
ESOP by plan participants.
[28] One method to obtain this tax deduction is to "graft" a 401(k)
plan into an ESOP, thereby creating a KSOP (hybrid retirement plan). In 1998,
more than 900 companies created KSOPs (based on IRS filings). In May 2000, the
tax law was changed to facilitate this type of planning 27 (likely
the result of special interest influence).
[29] Further, The Wall Street Journal observed that in 2000, Abbott
Laboratories contributed $86 million to its retirement plan, but merely paying
$72 million in dividends to the plan resulted in tax savings of approximately
$28 million. Its KSOP owns a staggering 6 percent of the company (a sizable
insider block of stock). Pfizer paid $60 million in dividends to its company
plan, resulting in tax savings of around $23.4 million. To achieve maximum
advantages some plans are even structured with preferred shares that pay higher
dividend rates. For example, Proctor & Gamble's retirement preferred shares
pay a dividend of $2.06 as opposed to its regular common shares dividend of
$1.40. ESOPs also have the ability, unlike other retirement plans, to take on
debt, allowing a company a deduction for interest and principal payments.
Contributions to an employer's retirement plan also are not subject to the
employer's share of social security taxes. 28
[30] These massive tax savings are in addition to regular deductions a
company receives for contributing funds to their retirement plans. Clearly, tax
laws concerning pensions need simplification and compliance needs to be verified
and assured through an appropriate level of enforcement. Currently, over a
dozen separate retirement plans are allowed under the code. Each has a separate
set of intricate rules. The reality is that few, if any, including the people
at IRS, fully understand the multifaceted retirement provisions (much less
comply with them). The IRS has gone from 111,000 full-time employees in 1995 to
approximately 100,000 in 2002. Its audit rate fell to less than 0.58 percent in
2001 (it was 1.6 percent in 1999). 29 As Rep. Lloyd Doggett,
D-Texas, stated in regard to the IRS's corporate tax shelter amnesty program,
the "all carrot and no stick approach reflects its continued indifference
to corporate tax shelters and havens." Currently, Enron is contemplating
whether or not to avail itself of this short- term program. 30
Debatable Professionalism
[31] Imagine the billable hours accounting firms obtain from retirement
plans. First they provide consulting services. Then they do tax filings.
Finally, as an added bonus they annually "audit" their creations.
Arthur Andersen received a total of $52 million from Enron in 2000. The audit
fee was $25 million and an additional $27 million was paid for nonaudit
services (including tax and consulting services). 31 Perhaps, former
SEC Chairman Arthur Levitt's campaign to limit consulting was not only in the
best interest of shareholders, but also accountants. Accountants demand and
receive a premium price in large part because they have been perceived to be
"neutral, independent, and objective." As James D. Cox, professor of
law at Duke University, stated in regard to limiting consulting:
There are a lot of investors out there, including financial institutions, who
believe this is a good idea. [Prior to Enron] We lulled ourselves into a
complacent state thinking that accountants who know their client from
performing nonaudit services can better perform the audit function. I think
that's a mantra that after Enron is going to fall on deaf ears. 32
[32] No wonder Paul Streckfus, in a recent letter to the editor of Tax Notes,
observed that "the reality is that most of us practicing tax today have
long since compromised our integrity." 33
Conclusion
[33] Overall, what message does the Enron retirement fiasco send? Clearly,
it is not the IRS's stated policy that a "trustee should be guided by . .
. his own judgment as a reasonably prudent investor." 34 All
share some blame in the Enron debacle, including the political process and
individual plan participants. Clearly, basic and sound business practices need
not only be called for, but actually followed. Enron is a salient reminder.
[34] In the current environment the question is not whether another
retirement plan will fail, but only when. Business failures are inevitable;
however, the answer clearly is not to pass another layer of complicated rules
that few will understand, much less abide by. The exclusive benefit restriction
should be enforced now without waiting for Congress to reform 401(k) plans out
of existence. The economic stakes are too high for typical legislative tax
action consisting of more complexity that inevitably leads to even more
creative tax strategies.
FOOTNOTES
1 Joint Committee On Taxation, "Background Information Relating
to the Investment of Retirement Plan Assets in Employer Stock," JCX-1-02,
Jan. 11, 2002, p. 3.
2 Section 401(a).
3 63 Federal Register, no. 59, May 18, 1998, http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?IPaddress=&dbname
=1998_register&docid=98-13145-filed, p. 27331.
4 JCT, note 1 supra (based on Federal Reserve Board
Governors Data), at 18.
5 http://www.treas.gov/press/releases/po1033.htm.
6 Alvin D. Lurie, "Elegy for an Elephant (Enron) and
Remembrance of Cases Past," Tax Notes, Feb. 11, 2002, p. 771.
7 Kathy Chen, "Government Seeks Ways to Strengthen
Retirement Funds Following Enron Woes," WSJ.com, Jan. 17, 2002.
8 Note 3, supra.
9 Kathy Chen, "Regulators Reach Pact to Replace Trustees of
Enron's Pension Plans," WSJ.com, Feb. 13, 2002.
10 Kathy Chen, "Labor Acts to Replace Trustees of Enron's
Retirement Program," WSJ.com, Feb. 11, 2002.
11 Kathy Chen, "Enron's 401(k) Chief Sold Shares, Netting
Personal Gain of $900,000," WSJ.com, Feb. 8, 2002.
12 http://www.dol.gov/opa/media/press/opa/OPA2002089.htm.
13 Albert B. Crenshaw, "U.S. to Seek Retirement Plan Control
at Enron," www.washingtonpost.com, Feb. 11, 2002.
14 Russ Banham, "Dear Prudence," CFO, December
2001, p. 54.
15 James K. Glassman, "Diversify, Diversify,
Diversify," WSJ.com, Jan. 18, 2002.
16 Kathy Chen, "Fight Looms Over Changes to Pension Laws as
Both Sides Begin Massive Lobbying Push," WSJ.com, Jan. 22, 2002.
17 Kathy Chen, "Pension Allocations Are Adjusted After
Fallout From Enron Debacle," WSJ.com, Jan. 29, 2002.
18 Note 14 supra, at 60.
19 Glassman, note 15 supra.
20 JCT, note 1 supra, at 1-18.
21 The "404(c) safe harbor."
22 http://www.dol.gov/opa/media/press/opa/OPA2001459.htm.
23 Kathy Chen, "Labor Acts to Replace Trustees of Enron's
Retirement Program," WSJ.com, Feb. 11, 2002.
24 Ellen E. Schultz, "U.S. Taxpayers May Have to Pay Enron
Workers' Pension Benefits," WSJ.com, Feb. 27, 2002.
25 Glassman, note 15 supra.
26 JCT, note 1 supra, at 4.
27 Schultz and Francis, note 26 supra.
28 Id.
29 World News, The Wall Street Journal, Mar. 1, 2002, p.
A1.
30 John D. McKinnon, "Enron May Use IRS Amnesty Program to
Seek Relief From Tax Shelter Fines," WSJ.com, Feb. 28, 2002.
31 Deborah Solomon, "Shareholders Seek to Limit Roles of
Accounting Firms," WSJ.com, Jan. 25, 2002.
32 Id.
33 Paul Streckfus, "How to Avoid Future Enron-Andersen
Situations," Tax Notes, Feb. 25, 2002, p. 1057.
34 Rev. Rul. 69-494, 1969-2 C.B. 88.
END OF FOOTNOTES
Code Section: Section 401(k) -- Cash or
Deferred Arrangements
Geographic Identifier:
Subject Area: Benefits and pensions
Corporate taxation
Individual income taxation
Legislative tax issues
Tax policy issues
Tax system administration issues
Magazine Citation: Tax Notes,
Cross Reference:
Author: Crumbley, D. Larry; VanDenburgh,
William M.
Institutional Author: