CHAPTER OBJECTIVES

When you have finished this chapter, you should be able to

• Identify the major classes of employee benefits that employers provide to their employees, and describe the tax treatment of these benefits
• Explain the statutory requirements that qualified retirement programs must meet
• Identify and explain the characteristics of the funding alternatives available to employers with respect to qualified retirement plans
• Explain the nature of the business-continuation exposure facing business owners and describe the measures used to address this exposure
• Explain the nature of the key-person exposure facing a business organization and describe the measures used to address this exposure
• Explain the purpose and operation of nonqualified deferred-compensation programs and describe the characteristics that distinguish them from qualified programs

In addition to the uses we have examined for individuals, life and health insurance is used extensively in the business world. In previous chapters, we discussed the various types of life and health insurance policies and how they could be used to meet the personal risks faced by individuals. This chapter will discuss the ways businesses use life and health insurance to meet their objectives.

Businesses use life and health insurance for two general purposes. First, most businesses make some insurance available to their employees. It is common for an employer to offer an employee some life insurance, health insurance, or retirement benefits in the employment setting. In many cases, the employer pays a part of the cost. This may be viewed as another form of compensation since it benefits the employee. These arrangements fall under the broad classification of employee benefits.

In addition to using life and health insurance arrangements in employee benefits, employers may use them to protect against risks faced by the business. These may involve loss to the business from a key employee's death or disability. Businesses may use life insurance to arrange the continuation of the business following the owner's death.

EMPLOYEE BENEFITS GENERALLY

There is no uniform definition of what constitutes employee benefits. Under a broad definition, employee benefits include almost any benefit provided to employees by an employer other than wages and salary for work performed. This definition includes the employer's share of legally required payments for employee security, such as workers compensation, unemployment compensation, and Social Security. In addition to insurance benefits, this broad definition would include things, such as vacation benefits, subsidized parking, child care assistance programs, tuition benefits, and employee discounts on the firm's products. Using this definition, it is estimated that U.S. employers spend roughly 40 percent of payroll on employee benefits. A more narrow definition focuses on those benefits offered voluntarily by the employer.¹ The main components of benefits are those programs designed to assist the employee with his or her personal risks of premature death, disability, superannuation, and unemployment.

Regardless of the definition, employee benefits represent a significant part of the compensation of many employees. Medical expense coverage for most employees and their dependents is obtained through an employer-sponsored health insurance plan. More than half of all employees are covered by employer-sponsored retirement plans, and about half of all employees are covered by life insurance offered by their employer. Although an employer is less likely to offer private disability insurance, an estimated one of every four employees is covered by employer-sponsored long-term disability plans.

There are several reasons for the prevalence of employer-sponsored insurance benefits. First, employees may find it advantageous to accept insurance as part of their compensation. As described in Chapters 12 and 21, this is because wages are taxable income to the employee, whereas some insurance benefits are not. In addition, most life and health insurance provided by employers is part of a group insurance contract, which tends to be less expensive than individual insurance. Some of the reasons for this include lower underwriting expenses and administrative costs, as well as reduced costs from adverse selection. In addition to employees finding insurance benefits to be an attractive form of compensation, employers may have other objectives for offering employee benefits. Some plans are established in the hope they will improve employee morale and motivation. Plans may be designed to address certain specific goals, such as reducing employee turnover or encouraging early retirement.

Levels of benefits vary by type of industry and number of employees. Employee benefits are more likely to be offered by large employers than by smaller employers. In addition, employers typically differentiate between full-time and part-time employees in the design of their plans. Often, full-time employees are eligible for a variety of benefits for which part-time employees are ineligible. Elimination periods for participation may be imposed, so seasonal and short-term employees are eliminated from the various plans.

The design of an employer's plan must consider the employer's objectives and employee's needs, the various options available, and their cost. Typically, the employer will want to consider how its employee benefit plan compares with other firms with which it competes for employees. In addition, the employer must decide how the plan will be financed (whether through insurance or some other mechanism) and who will administer the plan. Finally, the employer must communicate the plan to employees if it is to have the intended impact. Frequently, the employer will retain a consultant to assist in this process. The specific benefits offered by employers under various life, health, and retirement plans were described in previous chapters. In this chapter, we will discuss other considerations that employers find important when designing their benefit plans.

GROUP LIFE AND HEALTH INSURANCE AS EMPLOYEE BENEFITS

Group life and group health insurance are widely used as part of the compensation package to workers. In part, the growth of group life and health has been encouraged by collective bargaining and the demands of unions. However, a more important impetus has probably been the favorable tax treatment of contributions made by the employer for such coverage. We have noted that the employer's contribution to the cost of health insurance, including disability income and medical expense coverage, is deductible as an expense by the employer and is not taxable to the employee. This favorable tax treatment results in a net saving to the employees since, in the absence of such treatment, the coverage would have to be purchased with after-tax income.

Group Term Life Insurance

The most common life insurance benefit offered to employees is group term life insurance. Internal Revenue Code (IRC) Section 79 exempts the premium paid by an employer on the first $50,000 of group term life insurance from the taxable income of employees. As with group health insurance, the premium for such coverage is deductible by the employer as a business expense but is not taxable to the employee as income. The coverage must be provided on a nondiscriminatory basis.

A group term life insurance plan is considered nondiscriminatory if it does not discriminate in favor of key employees as to eligibility and amount of benefits. A plan is nondiscriminatory if it benefits 70 percent or more of all employees; if at least 85 percent of all employees who are plan participants are not key employees; or if the plan benefits employees who qualify under a classification established by the employer and found by the IRS not to discriminate in favor of key employees.²

The requirement that the group term insurance benefits not discriminate can be satisfied if the insurance amount bears a uniform relationship to total compensation of the persons covered. This means that a formula that provides life insurance equal to, say, two times the individual's annual salary is nondiscriminatory even though it produces a higher amount of life insurance for more highly compensated individuals.

Group term life insurance need not be limited to $50,000 per employee; higher amounts may be provided, but only the first $50,000 is granted favorable tax treatment. For each $1000 of coverage in excess of $50,000, the employee must include as income an amount that represents the taxable value of the employer-paid premium. The taxable value of group term life insurance in excess of $50,000 is not the amount paid by the employer but an imputed cost contained in IRS regulations.³

Group Ordinary Life Insurance

As its title suggests, group ordinary life insurance is group permanent insurance with an accumulating cash value. The premium for the insurance is divided into two parts. Usually, the employer pays that part of the premium that represents the cost of group term insurance and that is deductible under Section 79. (The premium part that qualifies for deduction is established by an IRS table.) The employee pays the remainder of the premium, which represents the policy's cash value element. If the employer pays the entire premium, the employee is taxed on the premium's nonterm portion.

Group Paid-Up Life Insurance

Group paid-up life is designed to provide a limited amount of permanent insurance to employees at retirement. This is usually achieved through the purchase of paid-up units of single-premium whole-life insurance during the employee's working years in combination with decreasing term insurance. The whole-life units are purchased by the employee's contribution. As the amount of paid-up whole-life increases, the employee's contribution usually reduces. At retirement, the employee may withdraw the cash value or leave the policy in force for the remainder of his or her life.

Group Universal Life

Group universal life is similar in most respects to individual universal life and differs primarily in the same ways that other forms of group life differ from individual contracts. Coverage is usually written without evidence of insurability and is usually subject to lower administrative costs than individually written universal life. There is no tax advantage in employer funding, and premiums are generally paid by employees.

Survivor Income Benefit Insurance

Survivor income benefit insurance (SIBI) is life insurance payable to dependents as a monthly benefit rather than in a lump sum. The coverage is unique because the beneficiary's status determines the benefit payment. For example, the monthly benefit to a surviving spouse terminates if the spouse remarries. Otherwise, benefit payments continue until the spouse reaches a specified age (usually 65) or until he or she dies. SIBI benefits are payable to children until they reach a specified age, usually age 19 or until age 23 if attending school on a full-time basis. The child's benefit terminates if the child dies or marries. SIBI may be written as a rider to another form of group life insurance, or it may be written as a separate contract.

Retired Lives Reserve

Usually, the employer's deductible contribution for group term insurance for employees terminates when the employee retires. Retired lives reserve is a mechanism for funding the continuation of yearly renewable term after the employee's retirement. The employer makes contributions to a trust fund during the employee's working years in an amount sufficient to fund the cost of term insurance after the worker retires. Since the Tax Reform Act of 1984, retired employees are taxed on the value of term life insurance exceeding $50,000, the same as active employees.

FUNDING ISSUES

The alternatives available to an employer for financing its life and health benefits for employees range from a fully insured plan to a fully self-funded plan, with many variations in between. Throughout this text, we have examined the proper role of insurance in an individual's risk management plan. Recall that four alternatives are available for dealing with a pure risk faced by an individual or firm: transfer, retention, avoidance, and loss control. The factors that influence the choice of each alternative were discussed in Chapter 3. We noted that insurance tends to be an expensive mechanism for treating risk since it involves expenses beyond the payment for losses (insurer marketing expenses, premium taxes, insurer profit, etc.). When the risk is characterized by a high frequency and low severity and, therefore, relatively predictable expenses, insurance is unlikely to be as cost-effective. Retention, on the other hand, is likely to be appropriate when expenses are predictable.

These same considerations will affect an employer's choice of funding mechanism for its employee benefit plans. When losses tend to be unpredictable and there is a potential for large severity losses that would adversely affect the firm, self-funding is unlikely to be an attractive option. However, when losses are stable and relatively predictable, self-funding may be attractive. In addition to these general considerations, specific tax and other legal considerations may affect the choice of funding vehicle. Finally, if an employer decides to self-fund, it must decide whether to administer the plan itself or to retain an outside administrator to make benefit determinations.

Because of potential loss severity, historically only large employers self-insured their medical expense plans. Some smaller employers obtained employee health insurance under programs that involved partial self-funding, such as a retrospective rating plan (discussed in Chapter 7) or a minimum premium plan (MPP). Under an MPP, the employer retains liability for small claims and pays these directly. The insurer pays claims only above the stated level. Because most states level premium taxes only on premiums the insurer receives, the MPP arrangement avoids taxes on a significant part of the benefit costs, those paid directly by the employer. As health care costs have increased, smaller employers have increasingly engaged in more extensive self-funding arrangements while capping their exposure with stop-loss insurance.

Stop-loss insurance puts a limit on the amount of loss the employer is required to fund. One common form of stop-loss insurance is aggregate stop-loss. With aggregate stop-loss insurance, the employer agrees to pay all claims up to an agreed limit for the year, and the insurer pays for all the claims beyond the limit. In a sense, the stop-loss limit acts as an annual deductible, and the policy caps the employer's loss exposure for the year. The employer self-funds losses within the limit but is protected if losses exceed the limit. Frequently, the stop-loss limit is set at 120 to 140 percent of the employer's expected losses. Stop-loss policies are increasingly being made available to small employers and have fueled a dramatic growth in self-funding among this employer group. An alternative form of stop-loss insurance, specific stop-loss, caps the amount of claims for one individual. When the claims of one employee or dependent exceed the stop-loss limit, any excess is covered by the insurer. The use of stop-loss insurance by small employers has grown in response to the increased interest of small employers in self-funding their medical expense benefits.

The reasons for the greater interest in self-funding medical expense plans are numerous. Self-funded plans are exempt from state insurance laws, thanks to a preemption in the Employee Retirement Income Security Act of 1974 (ERISA). An employer can avoid state mandated benefits by self-funding. Federal and state laws that require guaranteed issue and impose rate limitations also tend to increase premiums. Although these reforms make insurance more available and less expensive for those firms who employees have health problems, they tend to increase the cost for other firms with younger, healthier employees. These other firms might find it more attractive to escape the insured market and avoid the mandated subsidy of the poorer risks under health insurance reform. Self-funded employers can avoid paying premium taxes and a new ACA-mandated fee on health insurers. For these reasons, interest in self-funding has increased since the ACA was enacted.

With the exception of large employers, most employers that decide to self-fund their medical expense benefits will seek the assistance of an outside administrator. Administering a medical expense plan requires expertise, and the employer is often uninterested in developing and maintaining internal expertise. In addition, some employers are concerned that internal administration creates the possibility for conflict between the employer and employee over benefit decision. A third-party administrator (TPA) is often retained to make benefit determinations, pay benefits, assist in plan design, and administer the plan. The administrator may be an insurer or an independent TPA. When the employer arranges stop-loss insurance, it is common for the insurer to be the administrator. When the plan is fully self-funded, the contract between the administrator and employer is often called an administrative-services-only (ASO) agreement, recognizing that no insurance is being provided.

In the area of disability income, most employers offer sick leave plans to employees and pay the benefits out of corporate assets. For obvious reasons, it is less likely for an employer to self-fund life insurance and long-term disability insurance. The potential severity in both areas would preclude self-funding except in the case of very large employers.

Funding through a 501(c)(9) Trust

An employer who self-funds certain employee benefits may establish a 501(c)(9) trust vehicle. IRC Section 501(c)(9) allows employers to establish a voluntary employees' beneficiary association (VEBA) and to use the trust to fund certain members' benefits. Benefits that may be funded through a 501(c)(9) trust include those payable because of death, medical expenses, disability, legal expenses, and unemployment. Retirement and deferred-compensation benefits may not be funded through this vehicle. These funds may be used to prefund retiree life insurance or medical benefits subject to special rules.⁴

Certain additional requirements apply. Membership in the trust is limited to employees, former employees who are retired, disabled, or laid-off, and their dependents. Benefits must not discriminate in favor of highly compensated individuals although benefits may be based on a uniform percentage of compensation. If the plan requires contributions, membership in the trust must be voluntary on the part of employees.

In any year, trust contributions are limited to the sum of (1) direct benefit costs for that year, (2) additional amounts necessary to fund benefits that were incurred but have not yet been paid, and (3) administrative costs. Excess contributions may not be deducted by the employer and may result in adverse tax consequences.

PENSIONS

Although private pension plans in the United States have been in existence since the late 1800s, their greatest growth has taken place since World War II. In 1940, about 4 million people, fewer than 20 percent of all employees in government and industry, were covered by private pensions. By 2012, more than 100 million persons were enrolled in employer-sponsored retirement plans, including 84 percent of full-time workers at firms with more than 100 employees.

Pension plans are established by employers, and sometimes jointly by unions and employers, to provide individual workers with a retirement income that will supplement Social Security retirement benefits. The plan may be set up for the firm's employees, or it may be a multi-employer plan, serving workers from several unrelated firms.

Legislation Affecting Pension Plans

Three major pieces of legislation stand out in the history of pensions in the United States: the ERISA, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), and the Pension Protection Act of 2006 (PPA-2006). In addition, several other acts establish conditions that must be observed by an employer in establishing retirement plans for their employees.⁵

Employee Retirement Income Security Act of 1974 Any discussion of private pension plans in the United States must begin with the Employee Retirement Income Security Act of 1974 (ERISA),⁶ which embodied the most sweeping overhaul of private pensions in the country's history. The act was passed in response to a growing concern over the soundness and equity of the pension system. Although few pension plans had failed, many instances had occurred in which workers lost the benefits they had been counting on for retirement.⁷ The funding provisions of many plans were unsound, and the vesting requirements, under which an employee's right to the pension was established, were often severe. To correct these and other deficiencies in the existing pension system, Congress passed ERISA to establish standards for pension programs that would provide a better guarantee to the workers they covered.

ERISA's goal was to increase the rate of national participation in pension plans, prevent loss of benefits by persons who terminate employment before retirement, establish minimum standards for funding and vesting, and provide for the overall control of new and existing pension plans. Although the law does not require an employer to establish or maintain a pension plan, if such a plan exists, it must conform to the law's provisions. ERISA prescribes which employees must be included in a plan, establishes minimum vesting requirements, specifies the amounts that must be contributed, and sets forth minimum funding requirements. The act also requires extensive reporting and disclosure information about pension and welfare programs, their operations, and their financial conditions to the Secretary of Labor, the Internal Revenue Service (IRS), and those covered by the plan and their beneficiaries.

Tax Equity and Fiscal Responsibility Act of 1982 The second major law affecting pension plans was the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). With respect to qualified retirement programs, TEFRA had two basic objectives: to require more equal treatment of highly compensated employees and rank-and-file workers and to make noncorporate retirement plans and corporate plans more similar. To achieve these two goals, Congress modified the rules for corporate pension plans and Keogh plans. The maximum limits for contributions to corporate plans were reduced, and the limits for individual plans were increased. In addition, corporate and individual plans were subjected to new rules with respect to top-heavy plans, that is, plans that discriminate in favor of stockholders, key employees, or highly paid executives.

Pension Protection Act of 2006 The Pension Protection Act (PPA-2006) was aimed primarily at strengthening the funding requirements for defined benefit plans and the Pension Benefit Guarantee Corporation (PBGC), which insured them, following the termination of several large pension plans with insufficient assets. The law also contained provisions aimed at expanding benefits, however. For example, the PPA increased the limits on annual contributions, benefits, and employer deductions. It accelerated the vesting requirements for some plans, created an option for employers to automatically enroll employees in a 401(k) plan (with the ability of the employee to opt out), and created a new DB(k) alternative (a cross between a defined benefit and a defined contribution plan) for employers with 500 or fewer employees. The PPA also created a new Saver's Credit for low-income individuals.⁸

Title VII of Civil Rights Act of 1964 In addition to the IRC requirements, pension plans are subject to laws relating to employment practices, and the U.S. Supreme Court has ruled that the pension plan design may violate the equal employment provisions of the Civil Rights Act of 1964. In a 1978 case, the court ruled that when benefits to men and women under a pension plan are equal, it is illegal for an employer to require higher contributions to the plan by women than by men.⁹ In another case, the Supreme Court ruled that when men and women make equal contributions to a pension plan (or when equal contributions are made by the employer on their behalf), women cannot receive a smaller monthly benefit than men, either directly from the plan or under an annuity purchased by an insurer selected by the employer.¹⁰ The net effect of the Supreme Court's decisions is that a retirement plan cannot pay women lower retirement benefits and cannot require women to make higher contributions because of their generally longer life expectancy.

Qualification Requirements

For a plan to be qualified by the IRS, it must conform to certain standards specified in the tax code. In general, to be qualified, the plan must meet the following nine standards:

1. The plan must be designed for the exclusive benefit of employees and their beneficiaries. Officers and stockholders who are bona fide employees may participate in the plan.
2. Contributions and benefit formulas cannot be designed to discriminate in favor of officers, stockholders, or highly compensated employees.
3. The plan must be in writing, and the plan's written description must set forth all the provisions necessary for qualification.
4. The plan must be communicated to the employees. Plan administrators must furnish participants with a written description summarizing the major provisions and clearly describing their rights and obligations.
5. The plan must provide for nondiversion of contributions, making it impossible for the employer to divert or recapture contributions made until all the plan's liabilities have been satisfied.
6. The plan must provide for definite contributions by the employer or a definite benefit to the worker at the time of retirement.¹¹
7. The plan must be permanent, and while modifications in the plan over time are permitted, the employer cannot terminate the plan except for business necessity.
8. Vesting must be provided. (Vesting was discussed in Chapter 18.)
9. Life insurance benefits may be included in the plan only on an incidental basis.¹²

Prior to ERISA, many plans provided that employees were ineligible to participate in the pension plan until they had been employed by the firm for long time periods. The obvious intent was to reduce the employer's cost by eliminating benefits for persons involved in the firm's labor turnover. ERISA set standards for participation in qualified pension plans, requiring that all employees with one year of service who had reached age 25 be included in the plan, and that years of service after age 22 be counted for vesting purposes. The Retirement Equity Act of 1984 reduced the age at which employees must be allowed to participate to 21, and the Tax Reform Act of 1984 required that years of service after age 18 be considered for vesting purposes.¹³

Top-Heavy Plans The most far-reaching feature of TEFRA in the area of retirement programs was a new set of rules applicable to so-called top-heavy plans, those plans that do not provide what Congress considered a sufficient portion of their benefits to rank-and-file workers. If a plan is top-heavy, it must satisfy several special requirements designed to ensure that it provides a benefits floor to non-key employees. In particular, top-heavy plans are subject to special minimum vesting provisions and minimum benefits or contributions for non-key employees.

In general, a top-heavy plan is one that provides a disproportionate share of its benefits to key employees (owners and certain other highly compensated employees).¹⁴ More specifically, a pension plan is top-heavy if more than 60 percent of the accumulated account balances or 60 percent of the present value of all accrued benefits are for key employees. The top-heavy test for any plan year is usually made as of the preceding plan year's last day. Benefits derived from employer contributions and employee contributions (voluntary and mandatory) are considered in determining the present value of accumulated accrued benefits under a defined benefit plan and the sum of the account balances under a defined contribution plan. In addition, the account balances and present value of the accrued benefits generally include amounts distributed to the participant during the year prior to the determination date. The proportion of the benefits that are vested is of no significance in determining whether a plan is top-heavy.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) modified the top-heavy plan rules in an effort to simplify the rules and reduce the number of plans that are deemed to be top-heavy. Under EGTRRA, a 401(k) plan that uses a safe-harbor design will not be deemed to be top-heavy. A safe-harbor design is one in which the employer (1) provides nonelective contribution of 3 percent of compensation for all employees or (2) matches employee contributions dollar for dollar up to 3 percent of compensation and matches 50 percent of employee contributions for the next 2 percent of salary. EGTRRA simplified the definition of key employee, specifying that an employee will be a key employee only if he or she meets one of the criteria for the current year, and eliminated the prior requirement that the plan look back to the preceding four years. The PPA-2006 made these changes permanent.

Top-heavy plans are required to provide minimum contributions for non-key employees. For defined contribution plans, the minimum annual contribution is 3 percent of the employee's compensation. In defined benefit plans, it is the contribution necessary to provide a life annuity at the plan's normal retirement age equal to 2 percent of the employee's average annual compensation during the five highest-paid years of employment, multiplied by the number of years employed by the firm. However, the minimum benefit need not exceed 20 percent of such average annual compensation.

Top-heavy plans are required to use one of two alternative vesting schedules: 100 percent vesting after 3 years of service or a 6-year graded vesting schedule (20 percent after 2 years plus 20 percent per year thereafter).

Funding Pensions

The term funding refers to the preparation an employer makes for provision of the health benefits under the plan. In a funded plan, monies are set aside in advance of the date that they are payable, normally as the liability for the benefits accrues. ERISA required full funding for currently accrued liabilities (i.e., benefits earned by employees during the year, including the increase in prior benefits because of additional service). If total assets were less than total liabilities, an unfunded liability existed. This liability could arise in a defined benefit plan because of benefits awarded to workers for service before the plan's adoption, investment earnings below expectations, or changes in actuarial assumptions. Unfunded liabilities were required to be amortized over a period that could be as high as 30 years. Penalties for failing to meet funding requirements were significant.

Starting in 2001, declines in the stock market and decreases in interest rates led to large unfunded liabilities in many plans. Several large pension plan terminations between 2003 and 2005, particularly in the automobile, steel, and airline industries, highlighted the deterioration in funding status that had occurred and led to increased concerns about pension plan funding. In 2006, the Congress enacted the PPA-2006, the principal purpose of which was to strengthen funding requirements in defined benefit plans. It did this by changing the requirements that applied to asset valuation, liability valuation, and amortization of the unfunded liability. It created a new category of high-risk plan subject to additional requirements, and restricted benefit increases in underfunded plans.¹⁵ More recently, when low interest rates that followed the recent financial crisis led to increased pension plan deficits and required employer contributions, Congress relaxed the PPA-2006 rules, first in the Pension Relief Act of 2010 (PRA-2010) and again in the 2012 Moving Ahead for Progress in the 21^st Century (MAP-21). PPA-2006 and the subsequent changes are discussed below.

Liability Valuation PPA-2006 specified the mortality and interest rate assumptions to be used in calculating the plan's liabilities. The interest assumption is based on a 24-month average of high-quality corporate bond rates.¹⁶ The interest rate assumptions were phased in over three years beginning in 2007. The IRS is charged with specifying a current mortality table in regulations, and the mortality table must be updated at least every 10 years. Employers may petition the IRS to use a plan-specific mortality table.

As interest rates fell in recent years, so did the 24-month average. Because plan liabilities increase as the discount rate falls, more plans were underfunded. Plan sponsors argued the low interest rates were a temporary result of Federal Reserve activity, and lobbied Congress to permit higher rates. MAP-21 was the response. The law attempts to stabilize the discount rate by basing them on historical rates over a longer period of time. Specifically, the discount rates promulgated by the IRS must fall within a corridor around 25-year average rates. (Technically, the IRS uses the uses the average of the 24-month average rates over the past 25 years.) The corridor started at plus or minus 10 percent in 2012 and will increase by 5 percent each year until it reaches plus or minus 30 percent for 2016 and later. As the size of the corridor increases, the impact of this relief will diminish.

Amortization Rules Prior to PPA-2006, unfunded liabilities were allowed to be amortized over a period of up to 30 years. PPA-2006 required unfunded liabilities to be amortized over 7 years.¹⁷ PRA-2010 provided temporary relief to plan sponsors, permitting them to amortize funding shortfalls over a longer period, with two options available, thus reducing the required contribution. Under the 15-year option, the plan sponsor could elect to amortize the deficit in level annual installments over fifteen years. Under the two plus seven year option, a plan sponsor continues to amortize the funding shortfall over a seven-year period. However, the seven-year amortization period would begin two years later. During the two-year delay, the employer was required to pay interest on the funding shortfall. Plan sponsors could elect this funding relief for only two plan years between 2008 and 2011, and certain conditions applied. The ability to elect this relief expired at the end of the 2011 plan year.

At-Risk Plans Plans are deemed to be at risk if they are below 80 percent funded under normal assumptions or are below 70 percent funded using special at risk assumptions. At risk plans are subject to even stricter funding requirements. The at-risk plan rules apply only to firms with more than 500 participants in the plan.¹⁸

Benefit Restrictions Plans that are less than 60 percent funded have restrictions on their ability to award “shut-down” benefits (e.g., for a factory closing) and other unpredictable contingent benefits. Plans that are less than 80 percent funded may not amend the plan to increase benefits. Either of these limitations may be avoided if the employer makes a prescribed additional contribution. In addition, plans that are less than 60 percent funded must cease future benefit accruals.¹⁹ Additional restrictions apply to plans with funding below 80 percent or 60 percent.

Trusts and Insurance Companies

Two principal funding agency types are used for pension plans: trustees and insurance companies. In 2006, more than 25 percent of the assets of employer-sponsored pension plans were managed by life insurers. In either case, the employer's contributions are paid to the funding agency, where they accumulate with investment earnings until they are paid to the pension plan participant. The use of two or more agencies for the funding of a single pension plan is called split funding. Usually, split funding takes the form of partial funding through insurance, with another part of the employer's contribution paid to a trustee for investment in equities.

Trust Fund Plans Under a trust fund plan, the employer usually retains a consulting actuary to determine the contributions necessary to fund the plan's specified benefits. Contributions by the employer (and by employees in a contributory plan) are paid to a trustee, usually a bank or trust company, that holds and invests the contributions and pays benefits according to the trust agreement terms and the pension plan provisions. The funds are invested in various instruments, including some issued by insurance companies. Since the 1970s, many trust fund plans have invested in instruments called guaranteed investment contracts, (GICs), issued by insurance companies. GICs are similar to the certificates of deposit (CDs) issued by commercial banks; they are generally issued for a fixed and fairly short period, such as 2 to 5 years, and bear a guaranteed rate of interest.

Although a trustee holds the assets, trust fund plans are self-insured by the employer, who is responsible for the benefits payments under the plan. The trustee makes no guarantee as to the adequacy of the employer's contributions to meet the obligations under the plan.

Insured Plans For insured plans, the funding agency is an insurance company. Although funding through insurers once provided little flexibility, insurers now offer many approaches for funding pension plans.

Individual Policies Individual cash value life insurance and annuity policies are sometimes used by smaller employers as funding devices. When individual contracts fund a pension plan, the employer's (and employee's) contributions are paid to an individual policy pension trust, a trustee who arranges for the purchase of the individual policies, serves as a custodian, and pays the premiums. The cash values that accumulate provide the retirement benefits under the policy settlement options.

Group Permanent Plans Group permanent life insurance, which consists of cash value life insurance written on a group basis, may be used as a funding vehicle for a pension plan. When group permanent life insurance funds a pension plan, the amount of life insurance is usually set at $1000 per $10 of annuity benefits.

Group Deferred Annuities When a group deferred annuity plan is chosen, the annual contributions are used to purchase a deferred annuity for each employee each year. Under the defined benefit and defined contribution plans, a paid-up unit of benefit is purchased with each year's contribution. Thus, with the defined contribution plan, the annual contribution is used to purchase a single-premium deferred annuity, payable to the employee at retirement. A defined benefit plan might purchase an annuity equal to 2 percent of the employee's current income over a period of, say, 30 years, and the cumulative value of such annuities would equal 60 percent of the employee's average earnings.

Unallocated Funding Instruments Individual policy pension trust programs, group permanent life insurance, and group deferred annuities are collectively referred to as allocated funding instruments because employer contributions are specifically allocated to the individual participants. A second approach to funding pension benefits through life insurance involves unallocated funding instruments, in which funds paid to the insurer are not allocated to individual plan participants but reside in an aggregated pool until they are required for the benefits payment. Unallocated funding instruments used by insurers for pension funding include deposit administration plans, immediate participation guarantee plans, and separate accounts. Under a deposit administration plan, a single fund is established by the insurer for all participants under a pension plan. Contributions are not allocated to specific workers until retirement, when a withdrawal is made from the fund to purchase a single-premium immediate annuity sufficient to provide the retirement benefits due the employee. Many insurers guarantee a minimum return on the account and annuity purchase rates for some initial period.

Immediate participation guarantee (IPG) plans are a variation of the deposit administration plan in which the gains or losses from mortality or the account investment are segregated from the rest of the insurer's operations, giving the employer an “immediate participation” in the favorable (or unfavorable) experience of the plan. There is no guaranteed rate of interest credited to the fund; instead, the fund receives its share of the actual investment earnings of the company. In addition, annuities are usually not purchased for retiring workers as under the basic deposit administration plan; instead, annuity payments are made directly out of the IPG fund. Deposit administration plans and IPG plans were created by insurers to compete with trusteed plans. By permitting the plan sponsor to directly and immediately participate in mortality gains and losses, the plans represent a type of partial self-insurance by the plan sponsor. The appeal of these plans to pension sponsors is indicated by their accounting for much of the pension assets in insurance company general accounts.

Given the success insurers had achieved in marketing deposit administration and IPG plans, and the acceptance the plans had received in the market, the industry was stunned in 1993 when the U.S. Supreme Court ruled the sale of these plans made insurance companies fiduciaries under ERISA. The decision that rocked the insurance industry, John Hancock Mutual Life Insurance Co. v. Harris Trust & Savings Bank (Harris Trust), held that some of the general account assets of insurers selling deposit administration and IPG plans were pension plan assets, subject to ERISA's fiduciary requirements.²⁰ The decision was shocking because insurers had considered themselves exempt from ERISA's fiduciary standards since the law's inception, based on an interpretative bulletin published by the U.S. Department of Labor in 1975.²¹

Under ERISA, a person is a fiduciary with respect to an employee benefit plan “to the extent that he exercises any discretionary authority or control respecting management of disposition of such plan or its assets.”²² Although insurance companies do exercise discretionary control over plan assets they manage, Congress included a provision in ERISA exempting insurers from fiduciary responsibilities with respect to certain types of contracts sold to pension plans. ERISA provides that if an insurance company issues a “guaranteed benefit policy” to a pension plan, the plan's assets are deemed to include the policy but not any of the insurer's general assets.²³

In its decision, the Court held that a contract qualifies as a “guaranteed benefit policy” only to the extent that it allocates the investment risk to the insurer. Accordingly, deposit administration and IPG plans did not qualify for exemption from ERISA under the “guaranteed benefit policy” exclusion. This, in turn, meant insurers with such plans in their portfolio were fiduciaries with respect to the funds associated with those assets.

The significance of the Harris Trust decision rests on the duties imposed on fiduciaries under ERISA and the potential conflicts between those duties and an insurance company's responsibilities to other policyholders and stockholders. The obligations imposed on a fiduciary under ERISA are stringent and demanding. They require the fiduciary to act for the exclusive benefit of plan participants, an obligation that an organization, such as an insurance company, with other customers and stockholders, would find difficult to meet. Indeed, since Harris Trust applied retroactively, a major concern was the possibility that insurers might be subject to litigation for violating the ERISA fiduciary responsibilities in any transaction after 1974.

In response to the Harris Trust decision, Congress amended ERISA to clarify the application of ERISA to insurance company general accounts. Congress enacted legislation directing the Department of Labor to publish regulations that would retroactively provide limited relief to insurers from lawsuits alleging breach of past fiduciary duties. As issued, the regulations apply to contracts issued before December 31, 1998. Contracts issued after that date that are not “guaranteed benefit policies” make a life insurer a fiduciary under ERISA.

As a consequence of the Harris Trust decision, insurers have made adjustments in the deposit administration and IPG plans by amending these plans to include annuity rate guarantees and a guaranteed return. Another alternative, discussed next, has been to shift deposit administration and IPG plans into separate accounts.

Separate Accounts One type of arrangement that was not jeopardized by the Harris Trust decision was the separate account. A separate account is a fund held by an insurance company apart from its general assets, to be used for investment of pension assets in equities. These accounts are “separate” in that the funds are not commingled with the insurer's other funds, but contributions from a particular pension plan are usually commingled with those of other plans. Separate accounts were designed by insurers to compete with trusted plans, which always had the advantage of investing in equities. They are permitted under special legislation enacted by the states in the 1960s. One likely result of the Harris Trust decision is a shift in emphases by insurers and an increase in the use of separate accounts for pension funding.

ERISA PENSION PLAN TERMINATION INSURANCE

In addition to the other provisions designed to increase the security of benefits under pension plans, ERISA established the Pension Benefit Guarantee Corporation (PBGC) within the Department of Labor. All employers with defined benefit pension plans are required to insure their plan's benefits with the PBGC, paying a premium that varies with the nature of the plan and its funding status. The PBGC is intended to be self-financing, with revenues made up of premiums, assets acquired from terminated plans, recoveries from sponsors of terminated plans, and earnings on invested assets.

The benefits of a covered pension are guaranteed up to 100 percent of the average wages of the worker during his or her five highest-earning years, subject to a dollar maximum. The dollar maximum was originally set at $750 per month but varies with the Social Security taxable wage base.²⁴ By 2013, the maximum coverage per employee had increased to $4789.77 per month for an individual age 65.

The PBGC has had a history of funding issues resulting in changes to funding or termination requirements, the most recent being the provisions of MAP-21, which increased PBGC premiums. Earlier attempts to address funding problems included the Single Employer Pension Plan Amendments Act of 1986 (SEPPAA) provisions in the 1994 General Agreement on Tariffs and Trade (GATT), the Deficit Reduction Act of 2005, and the PPA-2006.

Although the original provisions of ERISA that established the PBGC permitted voluntary termination of any single-employer pension plan on the grounds of business necessity, SEPPAA strengthened the provisions regarding terminations. Under the SEPPAA provisions, terminations in which the plan assets are insufficient to pay accumulated non-forfeitable benefits, or distress terminations, are permitted only if the sponsor can prove financial distress. Standard terminations, in which the plan assets are sufficient to pay benefits due, may still be done for business necessity. If a plan is terminated with insufficient assets, the employer must reimburse the PBGC for the deficiency. This contingent employer liability is limited to 30 percent of the employer's net worth plus 75 percent of the remaining liability. The PBGC must permit the employer to pay the additional 75 percent under commercially reasonable terms. The SEPPAA makes provision for the PBGC to appoint a trustee to collect additional payments from the employer over future years. The payments collected are paid to the plan beneficiaries along with the assets from the plan.

In 1994, motivated by increasing concern about the financial condition of the PBGC, Congress enacted a pension reform package that strengthened the funding requirements for private pension plans. Over the years, the PBGC had accumulated a deficit of $2.9 billion from pension plans that terminated with insufficient funding. Features of the 1994 law, which was enacted as part of the GATT, were intended to reduce underfunding by requiring companies to use more conservative mortality and interest assumptions when valuing plan liabilities and to accelerate contributions to underfunded plans.²⁵ The results were dramatic. In 1996, after more than 20 years of continuous deficits, the PBGC reported a modest surplus. The surplus continued to increase until 2000, when it reached $9.7 billion. The improvement resulted from the 36 percent increase in premiums for covered plans, the absence of major pension failures, and unusually strong investment income during a bull market. In 2001, owing to the failure of several major plans, the surplus fell to $7.7 billion.

Stock market declines and lower interest rates in the period from 2001 to 2003 led to another period of concern about the funding status of pension plans and PBGC's fiscal condition. The PBGC 2001 surplus declined to a deficit of $11.2 billion as of Sept. 30, 2003. National Steel, LTV Steel, and Bethlehem Steel were permitted by bankruptcy judges to terminate their plans. The PBGC was forced to assume unfunded liabilities of $7.1 billion for these three plans. In March 2003, the PBGC took over the pension plan for US Airways pilots, with a deficit of $2.5 billion. (Given benefit limitations, only $600 million of the deficit was covered by the PBGC.) By the end of 2003, the defined benefit funding problem was being compared to the S&L crisis of the 1980s, with projected taxpayer costs of more than $100 billion. By the end of fiscal year 2004, the PBGC deficit had soared to $23.3 billion. In 2005, the largest pension default in PBGC history occurred when the United Airlines pension plan terminated with $9.8 billion in unfunded liabilities.

Given this backdrop, it is easy to understand why the Congress was focused on the PBGC and pension plan funding requirements. The Deficit Reduction Act of 2005 (DRA-2005) increased PBGC premiums and indexed them for inflation beginning in 2007, based on changes to the Social Security taxable wage base. By 2012, premiums for single-employer plans had increased to $35. In addition to the fixed per participant premium, less than fully-funded plans were required to pay a variable rate premium (which existed prior to the DRA-2005) of $9 per $1000 of unfunded vested benefits. Finally, the DRA-2005 created a special per participant premium to be assessed on underfunded plans that terminate in a distress termination or an involuntary termination by the PBGC. Further legislation in 2006, PPA-2006 (which was discussed earlier), was primarily aimed at strengthening the funding requirements for defined benefit pension plans.

MAP-21, which, as discussed earlier, provided some funding relief for pension plans, also increased PBGC premiums in response to new concerns about the PBGC's long-term solvency. Single-employer premiums are scheduled to increase from $35 per participant in 2012 to $42 in 2013 and $49 in 2014, with indexing in future years. The variable rate premium will be indexed for inflation and increase an additional $4 in 2013 and $5 in 2014. The variable rate premium will be capped at $400 per participant in 2013, adjusted for inflation in future years

ACCOUNTING FOR DEFINED BENEFIT PLANS

An additional issue for defined benefit pension plans (and for plans that cover postretirement health care costs) involves the accounting rules. Accounting rules provide considerable flexibility to firms in accounting for pension and postretirement benefits. Assumptions must be made on future salary increases, mortality, return on the plan's investments, and the discount rate used to calculate the present value of benefits. In 2004, the Securities and Exchange Commission (SEC) announced it was going to look at whether companies were using this flexibility to manipulate reported earnings when calculating their costs for pensions and retiree health benefits.

In 2005, the Financial Accounting Standards Board (FASB), which establishes financial reporting requirements for publicly held companies, announced it was going to examine accounting for pensions and other postretirement benefits, with the goal of making information more useful and transparent for investors.²⁶ The FASB announced a two-phase project. The first phase would incorporate information about the funded status of a company's plan directly on the firm's balance sheet. (It was previously required to be disclosed only in footnotes.) The second phase would address how to account for these plans in earnings, how to measure the obligation, and whether more guidance should be provided regarding assumptions.

The first phase of the project was addressed by the FASB's issuance of the Statement of Financial Accounting Standards No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, (SFAS 158). Effective for financial statements as of December 31, 2006, SFAS 158 requires employers to recognize on their balance sheets the overfunded or underfunded positions of their pension and other postretirement plans.

PLAN DE-RISKING AND LONGEVITY RISK TRANSFER

The combined effects of the PPA-2006 funding requirements and SFAS 158 have increased focus on the financial impact of defined-benefit plans. Recent low interest rates forced some employers to recognize large unfunded positions on their balance sheets. The combination of the size and the volatility as interest rates change has led to efforts to “derisk” plans. The traditional means of derisking is to freeze the plan to new entrants and, perhaps, freeze benefits for current participants. Other derisking strategies include liability-driven investing (LDI) and risk transfer.

LDI refers to an investment strategy that attempts to better match assets and liabilities, thus reducing the volatility from movements in interest rates. At one time, pension plans held large amounts of equities, but movements in equity values may not track with plan liabilities, which are determined by interest rates. Because this asset-liability mismatch can create volatility in plan funding status, many plans have decreased their investment in equities.

Plans are also transferring risk to third parties. Risk may be transferred to plan participants through lump-sum distributions, to an insurer by purchasing annuities, and to the capital markets through longevity-based financial instruments. A number of plans offered lump sum distributions to retirees and/or terminated vested participants in 2012, including Ford, General Motors, the NY Times, Sears, and J.C. Penney. Risk transfer arrangements to insurers fall into two categories. In a “buy-out”, the pension plan transfers all or a portion of the plan liabilities to the insurer, typically by purchasing a group annuity contract. The insurer assumes the obligations that have been transferred, and the employer's obligation is extinguished. The U.S. had two large pension buy-outs in 2012—General Motors and Verizon—resulting in Prudential assuming the obligations to a combined 150,000 individuals. In a “buy-in”, the plan purchases an annuity from an insurer but retains liability for the ultimate payment to annuitants should the insurer default. Buy-ins are more common in Europe, where some countries require plan participants and the regulator to consent to a buy-out. The buy-in can be a transitional step toward a buy-out after the necessary approvals have been obtained.

Less commonly, pension plans may use a financial instrument, such as a longevity swap or longevity bond, to transfer the longevity risk. In a longevity swap, the plan pays a fixed premium to a swap counterparty based on assumed mortality, and the swap counterparty pays an amount to the plan based on the difference between actual and assumed mortality. This protects the plan if mortality is lower than expected. In 2011, Rolls Royce transferred $4.7 billion in longevity risk to Deutsche Bank through a longevity swap, and Deutsche Bank then transferred pieces of the risk to a group of insurance and reinsurance companies. Insurers and reinsurers may also transfer longevity risk to the capital markets. To date, however, investor interest in longevity risk has been limited. In 2010, a group of banks and insurers formed the Life and Longevity Markets Association (LLMA) to “promote a liquid traded market in longevity and mortality-related risk.”

The benefits to plan sponsors from plan de-risking are clear, but some experts worry about the impact on plan participants. When a plan sponsor de-risks its plan by offering a lump-sum payout to participants or transacting with an insurer, the risk is transferred, not eliminated. The insurer, individual, or in the case of capital markets transactions, the investor, holds the longevity risk. Some commentators have questioned the ability of individuals to wisely invest the lump sums they receive or to understand longevity risk and the value of a life annuity. Others have raised concerns about pension buy-outs, pointing to the lack of PBGC protection on the annuities purchased. While state guaranty funds would cover the annuitant if the insurer failed, the limits may be lower than the PBGC protection. The capacity of state guaranty funds has also been questioned, given the potentially massive sums involved. In 2013, the ERISA Advisory Council of the Department of Labor announced it would study private sector pension plan de-risking and participant protections.

Financial regulators are also looking at issues related to longevity risk. The NAIC is considering the need for an explicit longevity risk capital charge in its risk-based capital formula. In 2012, the Joint Forum, an international group of banking, insurance, and securities regulators based in Basel, Switzerland, announced it was examining the potential for contagion between insurers, banks, and securities firms as the market for longevity swaps and bonds grows.

Given the aging population, longevity risk is an important issue for pension plans and for society. It is likely there will continue to be innovation and insurers and capital markets will play an increasingly important role.

CAFETERIA EMPLOYEE BENEFIT PLANS

A cafeteria plan is an employee benefit plan that meets the design conditions outlined in IRC Section 125. In it, employees have the right to choose from among a range of benefits. Cafeteria plans have become popular because they permit employees to select the benefits that are most appropriate to their needs.

The normal approach to a cafeteria plan is a program that grants employees credits that may be used to “buy” benefits. Credits can be based on salary, years of service, or a combination of factors but cannot discriminate in favor of key employees. The employee then selects benefits most appropriate to his or her need from the choices offered, which can include most nontaxable benefits, such as group term life insurance, health insurance, dependent care, adoption assistance, or a health savings account. Long-term care (LTC) may not be offered as a qualified benefit under a cafeteria plan, but distributions from an HSA may be used to pay eligible long-term care insurance premiums or qualified LTC services. The employer may permit the employee to take some or all of the credit in the form of additional cash compensation (but not as taxable benefits).²⁷ Section 401(k) cash or deferred profit-sharing or stock-bonus plans can be included in the list of choices. Other deferred compensation plans, such as pensions, must be provided separately from the flexible program.

In some cases, flexible benefits are funded directly through salary reduction; employees can reduce their salaries by a certain amount and use the money tax-free to pay for certain benefits. Such arrangements, while technically cafeteria plans, are called flexible spending accounts.

As in the case of other qualified employee benefits, a cafeteria plan may not discriminate in favor of highly compensated participants as to benefits or contributions. Under a restriction added by the Tax Reform Act of 1984, key employees will be taxed on otherwise nontaxable benefits in any year for which the qualified benefits for key employees exceed 25 percent of such benefits for all employees under the plan.²⁸

SOME SPECIALIZED USES OF LIFE INSURANCE IN BUSINESS

In addition to providing protection to employees under the fringe benefit programs and funding retirement benefits, life insurance serves several other functions in the business firm. They include funding business purchase agreements, protecting the firm against the loss of a key employee, and providing additional compensation to executives and other valuable employees.

Business Continuation Insurance

The death or disability of the business owner, a partnership member, or a stockholder of a closed corporation may create serious problems for that business. If it is a sole proprietorship, it may be necessary to liquidate and sell the specific assets rather than the going concern. Any value based on goodwill or earnings may be wiped out. In the case of a partnership, the executor of the deceased partner's estate may find it necessary to sell the estate's interest at the best offer obtainable from surviving partners. Finally, in the case of a corporation, the corporation will continue, but either the heirs of the deceased stockholder may not desire to continue their ownership or the remaining stockholders may not wish to share ownership and control with the heirs.

The ideal solution to those problems is to make arrangements for the sale of the individual's interest in the business prior to death through a buy-and-sell agreement under whose terms each owner agrees that his or her share of the business is to be sold to the remaining owners at death, and each owner agrees to buy the deceased owner's shares. In a proprietorship, the parties to the purchase agreement may be the owner and an employee or the owner and a competitor. The buy-and-sell agreement should contain a formula for setting the value of the business at the time of the sale, thus eliminating later difficulties regarding the value.

It is possible to have a business purchase agreement without a funding arrangement. The partners may have sufficient cash or liquid assets to enable a survivor to purchase the interest of the decedent for cash. But this would be an unusual situation, particularly in a growing business where the partners have been plowing back the profits. The most satisfactory method of funding is to purchase business life insurance on the owners' lives. The purchaser (the partners, partnership, stockholders, or the corporation) would pay the premiums and receive the policy's proceeds on the life of the party whose interest in the business is to be purchased.²⁹

The funding's operational aspects may vary, depending on the circumstances. Under the arrangement known as a cross-purchase plan, each partner or stockholder carries enough life insurance on the lives of the others to permit the purchase of a proportionate share of the deceased member's interest. For example, if Abner, Baker, and Cole own one-third of a business each valued at $300,000, Abner would buy $50,000 in life insurance on Baker and $50,000 on Cole, Baker would buy $50,000 on Abner and Cole, and Cole would buy $50,000 on Abner and Baker. If one partner dies, the remaining two will receive sufficient proceeds from their policies to permit them to purchase the decedent's interest.

As an alternative, the firm could purchase each owner's policy. Under this arrangement, known as the entity plan, the firm owns the policies and is the beneficiary. Premiums paid by the firm are not a deductible expense, but the policy proceeds are exempt from income taxation. Under the entity plan, the partnership or corporation purchases the deceased owner's interest, and the survivors's interest is increased proportionately.³⁰

Key-Person Insurance

One of the most valuable assets of any business is the skill of its employees. Since every employee contributes to the business' success, the death of any employee is a loss to the firm. The extent of this loss varies with the individual's part in the firm's success. Those employees who make a critical contribution to this success are key employees, and sometimes the risk of their loss may be sufficient to warrant key-person insurance protection. The key person may be a crucial factor in sales, production, finance, management, or some combination of these functions. In some cases, the key worker may be the owner; in others, he or she will be a partner, an employee, or a stockholder. Whatever the case, when the death of an individual associated with the business might cause a financial loss through imperiled credit, loss of leadership, lower profits, or reduced ability to secure new business, the firm has an insurable interest in that individual.

One of the most difficult aspects of insuring key personnel is determining their value. The valuation may be based on an estimate of the probable income loss that might result from the employee's death or an estimate of the additional expenses of obtaining a replacement. In the last analysis, the value will be an educated guess, based on a combination of factors.

Split-Dollar Plan

Split-dollar insurance is an arrangement by which an employer and employee share the insurance policy cost on the life of the latter. The two parties usually enter into an agreement under which the employer agrees to pay that portion of each annual premium equal to the increase in the cash value resulting from such premium payment. The employee pays the premium's balance. The employer is usually the policy owner and is a beneficiary to the extent of the cash value. The employee's spouse or other personal beneficiary is designated as beneficiary to the extent of the balance of any death proceeds. Under the basic split-dollar plan, the employer may not change the the beneficiary designation section dealing with the insured's personal beneficiary without the insured's consent.

Split-dollar insurance is intended to give the employee an incentive to remain with the firm. It permits the employee to obtain additional life insurance with a minimum outlay of personal funds, and because it is permanent insurance, it can be continued beyond retirement age. One drawback to the basic split-dollar plan is that the amount payable to the insured's personal beneficiary decreases yearly as the policy's cash value and the employer's interest increase. However, with participating policies, this drawback can be partially offset by using dividends to purchase one-year term insurance (the fifth dividend option). A split-dollar plan can be characterized in one of three ways. First, it may be viewed as a loan. Under this view, the employer's policy payment is viewed as an employee loan, which reqires imputed interest. The employer receives taxable interest income and a deduction for employee compensation, while the employee receives additional compensation equal to the imputed interest and is entitled a deduction for interest (subject to limitations). Under the second characterization (the traditional view of split-dollar plans), the employer is the policy owner, and the employee receives imputed compensation equal to the insurance value, reduced by premium payments he or she makes to the plan. Under the third view, the employer pays the policy premiums but does not acquire policy ownership. In this case, the entire premium the employer pays is viewed as employee compensation.³¹

Deferred Compensation

Deferred compensation is an arrangement in which the employer agrees to make future payments to an employee after retirement or make future payments to the employee's spouse if the worker should die before retiring. Such an arrangement usually results from the employer's desire to retain the services and loyalty of key personnel. The employee derives a benefit since some income is deferred until a time when the tax burden is usually lower. The employee incurs no federal income tax liability prior to retirement under an orthodox deferred compensation agreement because the employer's mere promise to pay, not represented by notes or secured in any way, is not regarded as the receipt of income by a cash-basis taxpayer.

Employers often find it advisable to obtain a life insurance policy on the life of the employee to fund the deferred-compensation agreement. If the employee lives to retirement age, the employer will use the policy's cash surrender value to make monthly payments to the retiree. The employer may not deduct the premiums paid for the insurance, and the cash value is taxable when received to the extent that it represents a return over the premiums paid. If the employee dies before retirement, the proceeds of the life insurance policy provide the funds paid to the employee's dependents. The death proceeds, which are received by the employer upon the employee's death, are not taxable as income. Amounts paid to the employee or surviving dependents are a deductible expense to the firm if reasonable in amount. Sums payable to the employee are fully taxable when received, and sums the employer pays to the employee's surviving dependents if the employee dies are also taxable income.

Corporate-Owned Life Insurance

Corporate-owned life insurance (COLI) is life insurance a corporation purchases on the life of an employee, with the corporation as the beneficiary. It was originally used to cover the corporation's loss from a key employee's death or to fund deferred executive compensation benefits. As discussed in Chapter 12, death benefits paid to a beneficiary under a life insurance contract are not subject to federal income tax, and taxation occurs on the increase in the cash value. Because of these tax advantages, the Internal Revenue Code (IRC) prohibits a business from deducting premiums paid for life insurance on employees when the business is also the policy's beneficiary. Prior to 1996, however, a corporation could take out a loan against the cash value and deduct the interest payments. In essence, the company was funding a tax-free benefit with tax-deductible contributions, a concept known as tax arbitrage. In 1996, the IRS attempted to disallow these deductions, arguing that the plans lacked economic substance. Courts have tended to support the IRS position.³²

In 2002, it became public that some corporations had been purchasing life insurance on the lives of rank-and-file employees without their knowledge. This became known, derisively, as janitor insurance or dead peasant insurance. The company would often continue the coverage even after the employee had ceased working for the employer.³³

The concept of insurable interest became a key issue in the ensuing debate. Regulations can vary by state. Some states give companies an insurable interest in any employee; others require there be a financial interest as would be the case with a key employee. Everyone agreed that, at a minimum, employees should be notified or provide permission for an employer to insure their lives.

The PPA-2006 established requirements for COLI policies to preserve the income tax exemption for death benefits. The company must issue policies only on highly compensated employees (the top 35 percent) and directors, provide a written notice to employees and obtain their written consent, and file an annual return disclosing the number of employees, number of employees insured under COLI policies, and the total amount of insurance involved. Failure to meet these requirements would cause the death benefits to be taxable to the employer.

SUMMARY

Our discussion of life and health insurance and pensions in the business firm has been limited. These are technical fields, and require management decisions with long-range implications. The tax aspects of the business life and health area and of qualified pension plans call for the advice of competent tax and legal technicians. No attempt has been made to deal with all facets of these complicated areas, but the student should have a better appreciation of the intricacies and a foundation for further study.

IMPORTANT CONCEPTS TO REMEMBER

employee benefits

group life insurance

group health insurance

group term life insurance

employee death benefit

group ordinary life

group paid-up life insurance

group universal life insurance

survivor income benefit insurance (SIBI)

retired lives reserve

stop-loss insurance

aggregate stop-loss insurance

flexible spending account

501(c)(9) trusts

split funding

group deferred annuity

Tax Equity and Fiscal Responsibility Act (TEFRA)

top-heavy plan

trust fund plan

guaranteed investment contract (GIC)

insured plan

deposit administration plan

Pension Protection Act

immediate participation guarantee plan

separate account

Pension Benefit Guarantee Corporation (PBGC)

cafeteria plan

allocated funding instrument

unallocated funding instrument

cross-purchase plan

deferred compensation

key-person life insurance

entity plan

split-dollar insurance

QUESTIONS FOR REVIEW

1. Identify and briefly describe the employee benefits discussed in the chapter for which the tax code provides favorable tax treatment.

2. Explain the advantages granted to employees under the tax laws governing the following:

1. Health insurance plans for which the employer pays the premium.
2. Contributions made by an employer for life insurance on the lives of employees.

3. Identify and briefly explain the requirements for a pension plan to be “qualified” under ERISA. What are the advantages of qualification?

4. Identify and explain the differences in the funding agencies an employer may use for funding a qualified pension plan.

5. What is the basic difference between allocated funding instruments and unallocated funding instruments? Identify the funding instruments that fall into each category.

6. The PBGC guarantees insured plan participants against a loss of benefits that can result from funding deficiencies. How can funding deficiencies arise?

7. In what way does the employer assume a greater element of risk under an immediate participation guarantee pension plan than under a group deferred annuity?

8. Briefly describe the special requirements that apply to a top-heavy plan. Why were these requirements enacted?

9. Briefly outline the provisions of the tax code relating to deductibility of premiums and taxation of policy proceeds in key-person life insurance.

10. In what way(s) does the PBGC protect (a) employees and (b) employers?

QUESTIONS FOR DISCUSSION

1. Many of the decisions relating to pension plans were formerly regarded to be management prerogatives but are dictated by federal regulations. To what extent does ERISA violate the freedom of choice of business managers with respect to pension plans? Is this violation justified?

2. The text notes that the business continuation exposure involves the possibility of the owner's death or disability. From the perspective of other owners, in what ways is the effect of an owner's disability the same as and different from the risk of an owner's death?

3. For what reasons might an organization decide to establish a nonqualified deferred compensation program? Has the number of nonqualified programs increased or decreased since enactment of ERISA? Why?

4. A self-employed chiropractor has three full-time employees and is considering establishing a qualified retirement plan. What are the options with respect to the type of plan that he or she should establish and the features that will be included in the plan?

5. Employee benefits are sometimes referred to as “fringe” benefits, suggesting they represent a form of gratuitous compensation granted by an employer. This view considers pensions as a reward for long and faithful service. The opposing view is employee benefits are a part of a total compensation package and that pension benefits are deferred compensation the employee accepts in lieu of higher current wages. To what extent are the provisions of ERISA consistent with either view?

SUGGESTIONS FOR ADDITIONAL READING

Allen, Everett T., Joseph J. Melone, Jerry S. Rosenbloom, and Dennis F. Mahoney. Retirement Plans, 11th ed. New York: McGraw-Hill, 2013.

Beam, Burton T., Jr., John J. McFadden, and Karen Stefano. Employee Benefits, Brookfield, Wis.: Dearborn Real Estate Education, 2012.

Crosson, Cynthia. Emerging Trends in Life Reinsurance: Non-Tradtional Players Enter Global Longevity Risk Transfer Market. Reinsurance News, March 2012.

Employee Benefit Research Institute, Fundamentals of Employee Benefits, 6th edition, 2009. www.ebri.org

McFadden, John. Qualified Retirement Plans. Bryn Mawr, Pa.: The American College, 2007.

Obersteadt, Ann Managing Longevity Risk, NAIC Center for Insurance Policy and Research Newsletter, April 2013.

Rosenbloom, ed. The Handbook of Employee Benefits, 7th ed.. New York: McGraw-Hill, 2011.

WEB SITES TO EXPLORE

American Benefits Council	www.americanbenefitscouncil.org
BLS National Compensation Survey	www.bls.gov/ncs/ebs/benefits
Employee Benefit Research Institute	www.ebri.org
Employee Benefits Security Administration	www.dol.gov/ebsa
Employee Benefits Survey	www.bls.gov/ncs/ebs
International Foundation	www.ifebp.org
Pension Benefit Guarantee Corporation	www.pbgc.gov

¹The U.S. Department of Labor Bureau of Labor Statistics conducts an annual survey of employers to measure the availability and participation in various types of employee benefits. The survey encompasses a broad array of benefits. See, e,g., Bureau of Labor Statistics, Employee Benefits Survey, 2012.

²If a group term insurance plan discriminates in favor of key employees, the key employees are taxed on the value of the benefits, but the benefits remain tax exempt to other workers.

³In 2001, the IRS issued new rules regarding the tax treatment of life insurance under qualified plans and released a new table for the imputed cost of life insurance in such plans. The 2001 table replaces the previous P. S. 58 rates, which were somewhat higher than the new rates.

⁴At one time, many large employers promised to provide health care coverage to their employees during retirement. Many companies, however, dropped their retiree health care benefits as health care costs escalated. In September 2007, General Motors (GM) and the United Auto Workers (UAW) announced an agreement that would transfer GM's retiree health care obligations to a VEBA managed by the UAW. The arrangement was expected to serve as a model for negotiations with Chrysler and Ford.

⁵Other recent legislation includes the Deficit Reduction Act and the Retirement Equity Act of 1984, the Tax Reform Act of 1986, and the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Because the provisions of EGTRRA were temporary, but were made permanent in the Pension Protection Act of 2006, they are discussed with the rest of the PPA.

⁶P.L. 93–406.

⁷A well-publicized example of this occurred when the Studebaker auto factory closed in 1963. Although pensions for workers age 60 and older were paid, pension rights of workers under age 60 (some of which were vested) were lost.

⁸The increased limits for contributions and benefits were originally contained in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), but they were scheduled to expire in 2011. The PPA also contained special provisions for distributions to qualified reservists and public safety employees, a requirement for plans to offer a new Qualified Optional Survivor Annuity, and the ability for nonspousal employees to roll over assets from inherited qualified plans into an IRA. Other provisions related to ESOP diversification, employee benefit statements, simplified top-heavy testing rules, long-term care insurance riders to annuities and life insurance, and corporate-owned life insurance.

⁹City of Los Angeles Department of Water and Power v. Manhart (435 U.S. 702).

¹⁰Norris v. Arizona Governing Committee for Tax Deferred Annuity and Deferred Compensation Plans. This 1983 ruling on defined contribution plans was limited to future retirees to avoid the risk of bankrupting pension plans nationwide if retroactivity were invoked.

¹¹Employers who do not want to commit to a defined contribution rate or a defined benefit at retirement may establish a qualified profit-sharing plan under which the contributions may (but need not) vary with the profits of the firm.

¹²Life insurance is considered incidental if the cost of the life insurance is less than 25 percent of the cost of providing all benefits under the plan. Under a defined benefit plan, the requirement is that life insurance benefits not exceed 100 times the expected monthly retirement benefit. Under a defined contribution plan, less than 50 percent of the total contributions may go toward the purchase of ordinary life insurance. See Rev. Rul. 68–453, 1968-2 CB 163.

¹³Part-time employees who work fewer than 1000 hours a year need not be included in the plan. Plans with immediate vesting may require three years of employment as a prerequisite to participation.

¹⁴A key employee is defined as any plan participant employee who at any time during the current plan year was (1) an officer earning over $145,000 (in 2007), (2) a 5 percent owner, or (3) a 1 percent owner earning over $150,000.

¹⁵Interestingly, an earlier law, the Pension Funding Equity Act of 2004 (PFEA-2004), responded to the concerns by weakening the funding requirements. As unfunded liabilities increased, required contributions from fund sponsors increased. These increased contributions came at a time when companies were recovering from a downturn in the economy. The PFEA-2004 provided relief from the increased contributions during the 2004 and 2005 plan years by increasing the interest rate that could be assumed when calculating plan liabilities, thus reducing the required contribution. Additional reductions were permitted for the airline and steel industries.

¹⁶The rates will use three segments of the yield curve, with a different rate applicable to liabilities payable in the first 5 years, the next 15 years, and periods after that.

¹⁷Commercial airlines are permitted to amortize unfunded liabilities over 10 years, or 17 years if they have frozen benefit accruals.

¹⁸The 80 percent test phases in over four years, starting at 65 percent in 2008, then increasing to 70 percent in 2009, 75 percent in 2010, and 80 percent in 2011 and later. Under the special at-risk assumptions, liabilities must be calculated assuming all participants who could elect a benefit in the next 10 years elect the benefit at the earliest possible time, with the most valuable option. This stipulation provides greater recognition of subsidized early retirement benefits offered by many plans.

¹⁹The Worker, Retiree, and Employer Recovery Act of 2008 and the PRA-2010 temporarily relaxed this requirement, allowing plans to look back to their funding status in the previous plan year to determine whether the 60 percent funding requirement was met for purposes of freezing benefit accruals. This relief expired in 2010.

²⁰John Hancock Mutual Life Insurance Co. v. Harris Trust & Savings Bank, 114 S. Ct. 517 (1993).

²¹Interpretive Bulletin, 75-2, 29CFR 2509.75-2 (1975).

²²29 U.S.C. Section 1002 (21)(A).

²³29 U.S.C. Section 1101(b)(2)(B); ERISA Section 401(b)(2).

²⁴The original $750 limit is increased by the same percentage as the Social Security table wage base increases over the 1974 wage base of $13,200.

²⁵Employers were to use the 1983 Group Annuity Mortality Table (GAM 83) to calculate life expectancies of plan participants, and the Treasury Department was required to develop a new mortality table to be used beginning in 2000. With respect to the interest rate assumptions, employers were previously required to use an interest rate between 90 percent and 110 percent of the four-year weighted average rate for 30-year treasury bonds. The top of that range gradually fell to 105 percent in 1999.

²⁶Although the SEC has the statutory authority to establish financial accounting and reporting standards for publicly held companies, its policy has been to rely on the FASB, a private-sector organization.

²⁷Originally, participants under cafeteria plans were offered a choice from a wide range of nontaxable benefits, taxable benefits, and cash. Since 1988, cafeteria plans may include only cash or nontaxable benefits, such as coverage under group health insurance, group term life insurance, or other qualified benefits.

²⁸IRC Section 125(b)(2).

²⁹Although this discussion describes the need and solution in the event of death, the same problems apply to disability. Business continuation disability policies are available that pay a lump-sum benefit for use in purchasing a disabled owner's interest. Another approach would be to provide sufficient disability income insurance for the firm to continue the income of the disabled owner, partner, or stockholder without imposing a financial burden on the firm itself.

³⁰A stock retirement agreement is a contract between stock-holders and the corporation by which the corporation agrees to purchase the stock in the corporation owned by an employee on the employee's death. The corporation may then hold or cancel the stock. A stockholders' buy-sell agreement is an agreement for the purchase and sale between stockholders, under which survivors agree to buy the stock of a deceased shareholder.

³¹National Underwriter, Taxline. vol. 2001, no. 2 (February 2001).

³²See, e.g., Dow Chemical v. United States, 435 F. 3d 594 (6th Cir. 2006), in which the court disallowed interest deductions. Dow has appealed the case to the Supreme Court.

³³For example, it has been reported that between 1993 and 1995, Walmart purchased life insurance on 350,000 employees. In December 2006, Walmart agreed to pay $5.1 million to settle a class-action lawsuit brought by former employees in Oklahoma. Under Oklahoma law, if a named beneficiary has no insurable interest, the estate of the deceased may claim the benefits under the policy (BestWire, December 7, 2006).