The QSERP: gaming the nondiscrimination rules to provide larger qualified benefits for executives.

• Author: Carolan, Mark E.
• Position: Qualified supplemental executive retirement plan

1. INTRODUCTION II. BACKGROUND A. Defined Benefit Retirement Plan Overview B. Background on the Evolution of Retirement Plan Regulation C. The Current Nondiscrimination Requirements 1. Amount Limits on Pay and Benefits 2. Nondiscrimination Testing i. A Permitted Level of Discrimination ii. Increasing the Discrimination Permitted in a Qualified Plan iii. Integrated Plans and Permitted Disparity iv. Nondiscriminatory Plan Amendments 3. Penalties for Discriminatory Plans D. Supplemental Executive Retirement Plans (SERPs) E. The "Qualified" Supplemental Executive Retirement Plan (QSERP) F. Section 409A III. ANALYSIS A. The Problematic Status of the Current Nondiscrimination Rules for Plan Amendments B. The QSERP Runs Contrary to the Purpose of ERISA and Executive Compensation Laws IV. RECOMMENDATIONS A. The Internal Revenue Service Must Become More Aggressive Toward Plan Amendments 1. Expand the Resources to Monitor Plan Amendments 2. Impose Heightened Standards on Employers Submitting Amendments for IRS Approval B. Interpret or Amend [section] 409A to Explicitly Prevent QSERPs V. CONCLUSION I. Introduction

   Retirement-plan regulation must walk a fine line. On one hand, the federal government wishes to incentivize private retirement benefits since they promote the general worker welfare, (1) so the government provides incentives for employers to provide retirement plans. (2) On the other hand, to ensure that these benefits promote the general worker welfare, the Federal Government imposes complex and strict regulations on these plans. (3) Section 401(a)(4) of the Internal Revenue Code illustrates one particular policy underlying these regulations--qualified benefits cannot discriminate in favor of highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). (4) To this end, the Internal Revenue Service (IRS) and the U.S. Department of the Treasury (Treasury) have issued numerous complex requirements to ensure that qualified plan benefits do not discriminate in favor of HCEs. (5)

   Employers still can enjoy great flexibility in how they choose to compensate their employees, but the government incentives granted to an employer are for providing a qualified benefit plan to promote the general worker's welfare. (6) If an employer wishes to discriminate in its benefits, it can forego the government incentives and provide a nonqualified benefit plan. (7) The nondiscrimination rules seek to ensure that discriminatory plans do not enjoy qualified status.

   However, strategic manipulation of the rules can actually allow an employer to discriminate in its qualified benefit plan, and even transfer benefits from a nonqualified plan into a qualified plan. A Qualified Supplemental Executive Retirement Plan (QSERP) uses loopholes in the nondiscrimination rules to allow discriminatory nonqualified benefits to gain the preferential qualified treatment. (8) Despite being contrary to [section] 401(a)(4) of the Code, the QSERP is not explicitly illegal. (9) In the end, this practice allows executive benefits greater security and preferential tax treatment at the expense of the rank-and-file workers and taxpayers, who subsidize this strategy. (10) Given the current scrutiny of executive compensation (11) and the poor funding status of retirement plans, (12) there is no reason the government should continue to allow these manipulative techniques to be legal.

   This Note demonstrates how employers execute the QSERP under the current nondiscrimination rules, and further explains why this practice violates fundamental principles of ERISA and [section] 401(a)(4) of the Code. Part II of this Note provides a background on retirement plan regulation and explains how the nondiscrimination rules and the IRS allow the QSERP to exist. Part III demonstrates the problematic status of testing plan amendments for nondiscrimination and demonstrates that the QSERP violates numerous principles of retirement plan regulation. Finally, Part IV provides two potential solutions to the QSERP problem: either the IRS should change its policy towards the approval of plan amendments, or Congress should pass an amendment to [section] 409A explicitly barring the QSERP.

2. BACKGROUND

   A QSERP strategically manipulates pension laws to place executive benefits into a tax-qualified retirement plan. (13) To understand how the QSERP works, it is necessary to provide an overview of defined benefit retirement plans, a background on the Employee Retirement Income Security Act (ERISA), and the nondiscrimination regulations that apply to defined benefit retirement plans. The QSERP is complex and technical, but simple examples will help explain how it works.

   1. Defined Benefit Retirement Plan Overview

      A defined benefit retirement plan provides a determinable benefit to the recipient upon retirement. (14) The plan has a formula that uses a participant's work information to determine how much of a benefit that person receives. (15) Usually the plan rewards long employee service by tying the percentage received upon retirement to the number of years of service. (16)

      For example, a plan may offer three percent of an employee's final salary per year for every year that employee has worked for the employer. under that plan, if a person had 30 years of service upon retiring, that person would receive 90 % (30 years x 3%) of their final salary as a life annuity. This is particularly advantageous for employees because they know they will receive a retirement benefit for the rest of their lives after they retire.

      While advantageous to employees, these plans pose significant risks if not properly managed by the employers. (17) For example, an employer must ensure that it always has sufficient assets to pay for the accumulated benefits owed to retirees. (18) If an employer does not properly invest and allocate assets to their retirement plan, the beneficiaries under the plan could lose their primary means of retirement support.

   2. Background on the Evolution of Retirement Plan Regulation

      The federal government started to provide preferred tax treatment for retirement plans in 1921. (19) The Revenue Act of 1921 treated contributions to a stock bonus or profit sharing trust established to maintain a retirement plan as tax exempt. (20) This legislation had little documented history, but it appeared that its focus was to match the timing of the employee receipt to the taxation period. (21) The idea was not to subsidize a private pension plan, but simply to tax earnings when paid to employees, not when set aside into a retirement trust. (22)

      By the 1970s, the tax incentives for employers to contribute to retirement plans became much more directed at promoting worker welfare. ERISA states that "the continued well-being and retirement income security of millions of workers, retirees, and their dependents are directly affected by [retirement] plans." (23) As a result, these plans "are afforded preferential Federal tax treatment." (24) The tax subsidy promoted the general welfare by giving employers an incentive to provide retirement plans for all of their workers.

      However, the preferential tax treatment was not unconditional. Prior to ERISA, private pensions were subject to a variety of major risks simply due to a hands-off regulatory approach. (25) Agency risks caused plan managers to mishandle, misuse, and sometimes steal plan assets. (26) Forfeiture risks caused some employees to lose their retirement benefits simply because of lopsided plan provisions. (27) Default risk caused some plans to deplete their assets, so employers could no longer pay out the benefits promised to retirees. (28) Finally, there was a discrimination risk that only executives and officers could participate in the tax advantaged plan, which undermined the social purpose of the tax subsidy. (29) ERISA implemented a number of ways to address these concerns. It requires plan managers to be fiduciaries, (30) which greatly reduces the agency risk. It requires minimum coverage (31) and vesting standards, (32) which address forfeiture risk. ERISA imposes minimum funding standards (33) to prevent risk of default by requiring a plan to maintain a specified minimum allocation of assets in a fund toward future benefits. Finally, Congress also enacted several nondiscrimination provisions (34) to ensure the benefits do not favor highly compensated employees.

      The nondiscrimination regulation of private retirement plans began with the Revenue Act of 1942. (35) These first rules were very broad and simple--often easy to manipulate. (36) As Congress investigated pensions in the 1970s, it discovered that, essentially, employers were able to negotiate with the IRS districts as to what "was and was not discrimination in a pension plan." (37) In response, Congress wanted to "[tighten] the rules to insure a broader coverage of low paid workers." (38) As a result, ERISA's nondiscrimination requirements were very technical and based mostly on objective standards. (39) This trend continued when Congress passed the Tax Reform Act of 1986. (40)

   3. The Current Nondiscrimination Requirements

      In the pension context, the concern with discrimination is that the retirement plan favors highly compensated employees over the average rank-and-file workers. Consequently, the regulations have a number of ways to promote equity in retirement benefits. However, the QSERP strategically manipulated the nondiscrimination regulations to provide larger qualified benefits to executives rather than the rank-and-file workers. (41) To provide a foundation for understanding the QSERP, this Note provides an overview of the HCE nondiscrimination regulations.

      1. Amount Limits on Pay and Benefits

         A few sections of the Internal Revenue Code cap the amount of compensation used to determine the benefit under a defined benefit plan. (42) Section 401(a)(17) caps the compensation for determining a qualified benefit for 2008 at $230,000. (43) This...