Evolution of Employee Benefits As Provided through the Internal Revenue Code

Evolution of Employee Benefits As Provided
through the Internal Revenue Code
Professor Kathryn J. Kennedy
Testimony before the
President’s Advisory Panel on Federal Tax Reform
March 16, 2005
INTERNAL REVENUE CODE

Provides enormous tax savings for employees and employers when certain
employee benefits are provided:
 Pension & profit sharing benefits
 Health and dental benefits
 Other welfare benefits (e.g., disability, dependent care)

Pension and profit sharing plans provide tax-deferred benefits for employees,
whereas health benefits provide tax-free benefits and other welfare benefits
provide tax-free benefits with maximum caps (e.g., $5,250 for educational
assistance, $5,000 for dependent care)

Why are employee benefits offered by employers?




To compete for workers who look for benefits, especially health and retirement, as
a condition for employment
To promote economic security by insuring against certain risks and to raise living
standards
To add economic stability by securing the income and welfare of employees and
their families
To encourage employee savings which contributes to capital formation and
economic productivity
2
ERISA: Additional Layer of Regulation

ERISA is a federal labor statute passed in 1974 to regulate employee benefit
plans
 Imposes substantive rules for pension/profit sharing plans
 Amended portions of IRC §401(a)
 Exempts governmental and church plans

Since 1974, ERISA and the Code have been amended over 30 times to
expand and narrow the scope of employee benefit plans, resulting in:
 A patchwork of conflicting public policy concerns
 Increased administrative and legal costs in providing benefits
 Undue complexity for employers in deciding to adopt plans
 Confusion for employees in understanding plan choices

Due to the complexity of administering pension/profit sharing plans and the
difficulty in making timely amendments due to changes in the law
 IRS has adopted a correction program known as Employee Plans
Correction Resolution System (EPCRS) for employers to correct defects
3
Code’s Original Retirement Plan Models

Pension versus Profit Sharing Model
 Pension plans are designed to provide retirement benefits and thus
restrictions imposed on withdrawals, types of distributions (e.g., joint &
survivor annuities for married participants), accrued benefits rules,
minimum funding requirements
 Profit sharing plans are designed as capital accumulation plans and
thus less restrictions imposed on the use of the monies

Defined Benefit versus Defined Contribution Plan Model
 Defined Benefit Plans are always pension plans, in which benefits are
calculated according to a formula (e.g., percentage of pay and related to
service)
 Defined Contribution Plans can be designed as either a pension plan or
profit sharing plan, in which contributions are allocated to individual
accounts
4
Choice of Retirement Benefits Confusing under Code


Choices Vary by Type of Employer

Taxable Employers can choose §401(a) Qualified Plans and §409A Nonqualified
Plans, which can be either Defined Benefit or Defined Contribution Plans
 Employees can make pre-tax deferrals under a §401(k) profit sharing plan
 Employees can make pre-tax deferrals under §409A nonqualified plan (but
these are unsecured and unfunded)

For Certain Other Employers, the Code offers alternatives:
 Tax-Exempt §501(c)(3) Employers and Public School Systems may offer
§403(b) Tax Deferred Annuities
 Government and Tax-Exempt Employers may offer eligible §457(b) and
ineligible §457(f) Deferred Compensation Plans
 Small Employers may offer SIMPLE Plans under §408
For Individuals: Choices are solely Defined Contribution Plans



IRA under §219 – deductible & nondeductible depending on pay
Nondeductible Roth IRAs under §408A
Spousal IRAs under §219
5
Shift from Defined Benefit Model to Defined
Contribution Model Provides a Variety of Choices

In 1974, Typical Plan Model – Noncontributory Defined Benefit Plan – fairly
simplistic in plan design
 Number of Defined Benefit Plans peaked in 1983 at 175,143 declining to a
total of 56,405 in 1998

In 2005, Typical Plan – Contributory Defined Contribution Plan Model
 Number of Defined Contribution Plans in 1998 at 673,626, almost half
offering employees a deductible §401(k) feature ($14,000 in 2005)
 Variety of different choices
 Money purchase & target benefit (which are pension plans) and profit
sharing or stock bonus (which are profit sharing plans)
 Types of tax-deferred features: §401(k); §403(b); §457(b)
 Small employers: SIMPLE IRAs
 Individuals: IRAs, Roth IRAs, Rollover IRAs, and Spousal IRAs
6
Example of Confusion Facing Small Employers
Adopt §401(k) Plan
Adopt SIMPLE IRA Plan
Pre-tax Contribution
Amount
$14,000 in 2005
$10,000 in 2005
Catch-Up Amounts
$4,000 in 2005
$2,000 in 2005
Employer Matching
May be matching and/or nonelective
Either a full match on elective contributions
up to 3% of pay or 2% nonelective
contribution
Matching not limited to 3% and match may be
less than full dollar for dollar; no limit on
nonelective contributions
Yes
Nonelective contributions limited to 2% of
pay
Vesting schedule may be added
Full vesting of employer contribution
May be required
Not Required
Plan Loads
Permitted
Not permitted
Other Plans
May adopt other qualified plans
May not sponsor any other SIMPLE plan or
qualified plan
Pooling of Plan Assets
May pool §401(k) contributions into a single
trust invested by trustee
Individual assets within IRAs invested by
employees
Eligibility
Eligibility may exclude employees with less
than 1,000 hours of service
Eligibility must include employee who earns
$5,000 or more during calendar year
Protects benefits from creditors
Not applicable
Form 5500 annual filing
No Form 5500 filing
Nonelective Contributions
Discrimination Testing
Vesting
Top Heavy Contributions
ERISA Applicability
Required Return
No
Cost of Employee Benefits For Employers/Employees

Retirement benefits continue to be the dominant type of benefit that
employees receive




Of all benefit dollars, 47% provide retirement benefits (virtually
unchanged from 1970)
Major growth has occurred in health benefits, which has increased
from 21% of all benefit dollars in 1970 to 30% in 1999
Employers have increased the relative proportion of compensation
spent on employee benefits between 1970 to 1999 (wages and
salaries decreased 4% while spending on benefits increased 4% )
Workers are spending proportionately more on both retirement and
health benefits


Retirement income accounted for 25% of personal spending in 1970,
compared to 46% in 1999 – reflective of the demographics
Health benefits accounted for 9% of personal spending in 1970,
compared 27% in 1999
8
Need for Simplification of Defined Contribution
Plans

Although Defined Contribution Plans can be designed as pension or
profit sharing plans, EGTRRA ’01 eliminated the disparity in the
maximum employer contribution levels for Defined Contribution
pension versus profit sharing plans

As a result, employer adopting new plans will choose the flexibility of a
profit sharing plan

Suggestions
 Provide a single type of Defined Contribution Plan – a new Savings Plan
with the same flexibility as permitted under profit sharing plans, thereby
eliminating the restrictions under Defined Contribution pension plans
 Provide a single §401(k) tax-free feature regardless of type of employer –
eliminating alternatives and §403(b) and §457(b) features
 Make choices between a Qualified §401(k) and SIMPLE IRA simpler for
small businesses
9
Health Benefits Provided under the Code

Employment-based health plans provide coverage to nearly two-thirds of
nonelderly individuals in the US

Health Benefits are ranked as the most important by workers

For Code purposes:
 Health insurance premiums paid by the employer are deductible by
employers and completely tax-free to the employee (IRC §105)
 Flexible spending accounts (FSA under §125) permit employees to pay
for health care expenses (e.g., deductibles and coinsurance) with pretax dollars
 Self-employed individuals may deduct 100% of the amount paid for
health insurance
 Individuals without employment-based health coverage may deduct total
health care expenses only to the extent they exceed 7.5% of adjusted
gross income
10
Skyrocketing Health Care Costs

Health care costs have increased 59% over the past 5 years,
leaving all employers with the dilemma of how to pay for such costs

Cost drivers: demographic aging population, costs of prescription
drugs, research and technology, and medical malpractice premiums

Employers have adopted a number of approaches:
 Shift more costs to employees
 Foster greater consumerism among employees regarding
choices
 Adopt disease management, wellness programs, non-smoking
plans
11
Congressional Initiatives

Health Care FSAs (Flexible Spending Accounts): Pre-tax employee deferrals under a §125
cafeteria plan to fund deductibles/coinsurance
 “Use it or lose it” feature forfeits unused amounts at year end

Irrevocability of elections make it difficult to adjust mid-year

Period of coverage extends 12 months

HRAs (Health Reimbursement Accounts under Rev. Rul. 2002-41): Employer funded
accounts to reimburse employees for medical expenses
 Can be, but need not be, coordinated with a High Deductible Health Plan (HDHP)

MSAs (Archer Medical Savings Accounts under IRC §220): 1996 Temporary Initiative for
small employers ≤ 50 employees

HSAs (Health Savings Accounts under IRC §223): 2004 initiative requires employers to
provide HDHP coverage, with pre-tax employee and/or employer deferrals to pay for
deductibles and coinsurance on a tax-favored basis
 Employees with the least discretionary income have the least to defer under the HSA
and will not be covered under the HDHP until the deductible kicks in
12
Concluding Thoughts

Pension Benefits
 Simplification of the Code’s Defined Contribution Plan model could
easily be made
 Making employer choices simpler
 Reducing administrative costs
 Unfortunately the Code’s Defined Benefit Plan model is out of date
 Public policy concerns
 Since Defined Contribution models shift mortality and investment risk to
employees, greater education is necessary

Health Benefits
 Reform existing Code provisions or dramatically change the Code’s
models to help curb costs
 Importance of consumer education regarding health care choices
 Incentives to adopt disease management, wellness, and similar
programs?
13
Additional References

EBRI Research Highlights: Retirement Benefits
Special Report SR-42 (June 2003), available at
http://www.ebri.org/ibpdfs/0603ib.pdf

EBRI Research Highlights: Health Data
Issue Brief #229 (January 2001), available at
http://www.ebri.org/ibpdfs/0101ib.pdf
14