What’s the Impact of 2016 IRS Retirement Plan Limits?

The IRS just announced the 2016 retirement plan benefit limits, and there are virtually no changes from 2015. What does it all mean for employer-sponsored retirement plans? Below is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2015 2016
415 maximum DC plan annual addition $53,000 $53,000
Maximum 401(k) annual deferral $18,000 $18,000
Maximum 50+ catch-up contribution $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $210,000
Highly compensated employee (HCE) threshold $120,000 $120,000
401(a)(17) compensation limit $265,000 $265,000
Social Security Taxable Wage Base $118,500 $118,500

 

Changes affecting both DB and DC plans

  • Qualified compensation limit remains at $265,000. A flat qualified compensation limit could have several consequences. These include:
    • More compensation counted towards SERP excess benefits if a participant’s total compensation (above the threshold) increases in 2016.
    • Lower-than-expected qualified pension plan accruals for participants whose pay is capped at the 401(a)(17) limit and were hoping for an increase.
  • HCE compensation threshold remains at $120,000. For calendar year plans, this will first affect 2017 HCE designations because $120,000 will be the threshold for the 2016 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
    • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
    • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit remains at $53,000 and the 401(k) deferral limit remains at $18,000. Although neither of these limits has increased to allow higher contributions, it should make administering the plan a little easier in 2016 since there are no adjustments to communicate or deal with. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $35,000 from profit sharing ($53K – $18K) if they maximize their DC plan deductions.
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $59,000 ($53K + $6K).

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) remains at $210,000. This limit remained unchanged for a third straight year, which may constrain individuals with very large DB benefits (e.g., shareholders in a professional firm cash balance plan) who were looking forward to increasing their DB plan contributions/deductions.
  • Social Security Taxable Wage Base remains at $118,500. When this limit increases, it can have the effect of reducing benefit accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base. When the wage based remains unchanged (like this year), it means that these individuals’ accruals may be higher-than-expected if their total compensation (above the wage base) continues to increase.

 

First pensions, now OPEB – New GASB 74 & 75 will transform OPEB reporting

Public sector employers, get ready! The Governmental Accounting Standards Board (GASB) has officially approved new accounting statements for Other Post-Employment Benefit plans (OPEB; retiree medical). Here’s what the recent GASB announcement confirms:

  • Final provisions will closely mirror GASB 67/68 pension accounting. The official statements won’t be released until late June, but last summer’s OPEB exposure draft included similar provisions such as:
    • The unfunded liability will now go on the balance sheet.
    • The liability discount rate will be based on a projection of how long dedicated assets (plus future contributions) will cover current plan members’ future benefit payments.
    • OPEB expense will recognize asset and liability changes over a shorter time period.
    • Goodbye ARC! Funding and accounting are officially separated, so plans and employers should consider developing a new OPEB funding policy.
  • Expanded note disclosures and RSI are required, including sensitivity of results to a +/-1% change in the discount rate and medical trend assumptions.
  • Effective dates:
    • GASB 74 Plan accounting is first effective for reporting periods beginning after June 15, 2016 (e.g., fiscal years beginning July 1, 2016 or January 1, 2017).
    • GASB 75 Employer accounting is first effective for reporting periods beginning after June 15, 2017 (e.g., fiscal years beginning July 1, 2017 or January 1, 2018).

Although the implementation dates are almost 3 years away, employers should take action now to prepare. Some questions to ask include:

  1. How can I develop and implement an OPEB funding policy over the next few years? Prefunding OPEB can help reduce the unfunded balance sheet liability.
  2. What plan benefit adjustments and investment policy changes are available to lower my long-term OPEB liability? Now is the time to review your OPEB management strategies.
  3. What is my strategy to educate stakeholders about OPEB promises and their potential financial impact under the new GASB 74/75 requirements? OPEB is a complex topic that may be unfamiliar to plan members, government decision-makers, and taxpayers.

The new GASB 74/75 statements should help make OPEB promises more understandable and transparent. While there’s still sufficient lead-up time, employers should view this as an opportunity to proactively address an employee benefit which is often unfunded but must be managed prudently.

What’s the Impact of 2015 IRS Retirement Plan Limits?

The IRS just announced the 2015 retirement plan benefit limits and we’re seeing some modest increases from 2014. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $260,000 to $265,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold increases from $115,000 to $120,000. For calendar year plans, this will first affect 2016 HCE designations because $120,000 will be the threshold for the 2015 “lookback” year. Slightly fewer participants will meet the new HCE compensation criteria, which will have two direct outcomes:
  • Plans may see better nondiscrimination testing results (including ADP results) if there are fewer participants at the low end of the HCE range, especially those with big deferrals. It could make a big difference for plans that were close to failing the tests.
  • Fewer HCEs means that there are fewer participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $52,000 to $53,000 and the 401(k) deferral limit increases from $17,500 to $18,000. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. This means that individuals can get up to $35,000 from employer match and profit sharing ($53K – $18K) if they maximize their 401(k) deferrals. Previously, their profit sharing limit would have been $34,500 ($52K – $17.5K).

Public Pension Plan Funding Policy – The Time is Here

“Every state and local government that offers defined-benefit pensions [should] formally adopt a funding policy…,” according to the Government Finance Officers Association (GFOA) best practice recommendations. Guidelines for Funding Defined Benefit Pensions (2013) (CORBA)

SOA and GASB Provide Guidance

Blue Ribbon Panel. Last month, a blue ribbon panel formed by the Society of Actuaries went one step further to endorse risk measures, disclosures and actuarial assumptions as well as guidelines regarding plan governance and benefit changes. These recommendations come at a time when public pensions have come under mounting criticism since the “great recession” and it’s imperative that public plan sponsors be able to demonstrate that their plans are sustainable in the long-term.

GASB 67/68. Furthermore, it’s critical that public sector plan sponsors follow a written funding policy now that GASB 67 and 68 explicitly separate pension funding and pension accounting,. These accounting standards are effective for plan years beginning after June 15, 2013 and June 15, 2014, respectively. For many plan sponsors this means the fiscal years ending June 30, 2014 (!) and June 30, 2015.

Funding Policy Checklist

The place to begin is to gather the facts, actuarially and politically. Here is a checklist of items to assist in providing a basis for developing an effective funding policy:

  1. Assemble a history of plan benefit levels and changes.
  2. Develop a history of contribution levels by members and sponsors.
  3. Compare benefit levels, locally and nationally, to determine appropriateness.
  4. Consider the political history of plan changes.
  5. Identify the politically “hot” topics.
  6. Review legal constraints on plan changes.
  7. Analyze collective bargaining agreements and recent changes.
  8. Calculate the plan’s current funded status.
  9. Determine sustainable funding goals.
  10.  Evaluate options for achieving goals.

Example

We recently assisted a large Midwestern city in developing a comprehensive funding policy that linked future benefit changes to achieving a targeted funding level. In addition, the city Council adopted guidelines for amortization periods and for direct smoothing of actuarially-determined contributions. Indeed, funding policy, investment policy and pension benefit policy must be linked and reinforce one another.

The time is here for every plan sponsor to develop or review their pension plan funding policy to make sure that it is actuarially sound.

What’s the Impact of 2014 IRS Retirement Plan Limits?

The IRS just announced the 2014 retirement plan benefit limits and we’re seeing some modest increases from 2013. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $255,000 to $260,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold remains at $115,000. For calendar year plans, this will first affect 2015 HCE designations because $115,000 will be the threshold for the 2014 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their well-paid employees become classified as HCEs. Eventually, this could have two direct outcomes:
  • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were close to failing the tests.
  • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $51,000 to $52,000 but the individual 401(k) deferral limit remains unchanged at $17,500. A $1,000 increase to the overall DC limit will allow participants to potentially get a little more “bang” out of their DC plan – at least if their employer wants to give them more money.

Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $34,500 from employer profit sharing ($52K – $17.5K). Previously, their profit sharing limit would have been $33,500 ($51K – $17.5K).

What’s the Impact of 2013 IRS Retirement Plan Limits?

The IRS just announced the 2013 retirement plan benefit limits and we’re seeing some modest increases from 2012. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $250,000 to $255,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold remains at $115,000. For calendar year plans, this will first affect 2014 HCE designations because $115,000 will be the threshold for the 2013 “lookback” year. When the HCE compensation threshold doesn’t increase and keep pace with employee salary increases, employers may find that more of their well-paid employees become classified as HCEs. Eventually, this could have two direct outcomes:
  • Plans may see marginally worse nondiscrimination testing results (including ADP results) if there are more HCEs. It could potentially make a big difference for smaller plans that were very close to failing the tests.
  • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • Increase in annual DC 415 limit from $50,000 to $51,000 and 401(k) deferral limit from $17,000 to $17,500. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit isn’t much, but it will allow participants to get a little more “bang” out of their DC plan. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $33,500 from profit sharing ($51K – $17.5K) if they maximize their DC plan deductions. Previously, their profit sharing limit would have been $33,000 ($50K – $17K)

What’s the Impact of 2012 IRS Retirement Plan Limits?

The IRS just announced the 2012 retirement plan benefit limits and we’re finally going to see some (very) modest increases after 3 years of flat rates. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • HCE compensation threshold increases from $110,000 to $115,000. For calendar year plans, this will first affect 2013 HCE designations because $115,000 will be the threshold for the 2012 “lookback” year.  Slightly fewer participants will meet the HCE compensation criteria, which will have two direct outcomes:
  • Plans may see marginally better nondiscrimination testing results (including ADP results) if there are fewer HCEs. It could potentially make a big difference for smaller plans that were very close to failing the tests.
  • Fewer HCEs means that there are fewer participants who must receive 401(k) deferral refunds if the plan fails the ADP test.
  • Qualified compensation limit increases from $245,000 to $250,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.

DC-specific increases and their significance

  • Increase in annual DC 415 limit from $49,000 to $50,000 and 401(k) deferral limit from $16,500 to $17,000. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit isn’t much, but it will allow participants to get a little more “bang” out of their DC plan. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $33,000 from profit sharing ($50K – $17K) if they maximize their DC plan deductions. Previously, their profit sharing limit would have been $32,500 ($49K – $16.5K)

The Value of Tax Deferral

Happy couple

We often hear the question “why should I contribute to a qualified retirement plan if tax rates might go up”?  Good question; here’s why:  you’ll probably end up with more money after tax.  That’s true even if tax rates go up in the future.

How much more you’ll end up with depends on your investment return, the deferral period, and your marginal tax rates at three different times:

  • when you contribute the money,
  • while it’s invested, and
  • when you withdraw it.

The key is that in a taxable account, you lose some of the power of compound interest every time you’re taxed on your contributions and investment earnings.

Let’s start with a simple example, using a 33-1/3% marginal tax rate all the way through.  That’s a bit lower than the 35% top Federal rate, but it makes the math easy.  Suppose you have $3,000 to contribute, and investment earnings average 6%.

Tax deferred account / qualified plan

Contributing your $3,000 to a 401(k) or other qualified plan, you have the whole amount to invest and investment earnings are tax free – but you have to pay tax when you withdraw it.  Leaving it in for, say, 20 years you would have $6,414 after paying your tax:  $3,000 x (1.06 ^ 20) x (1-.3333).

Taxable account

Contributing to a taxable account, you have $2,000 to invest after tax ($3,000 x (1-.3333)) and investment earnings are taxable so your effective investment return is 4% (6% x (1-.3333)).  But then you’re done paying taxes.  After 20 years you would have $4,382:  $2,000 x (1.04 ^ 20).

What if’s:  rising tax rates, capital gains, return, deferral period, Roth

In this simple example, the qualified plan clearly beats the taxable account.  But what if tax rates are higher at withdrawal?  For the $4,382 in the taxable account to beat the qualified plan, the tax rate would have to suddenly jump to 54.5% at withdrawal:  $3,000 x (1.06 ^ 20) x (1-.545) = $4,378.   Any tax increase that happens more gradually would be worse for the taxable account, with no effect on the qualified plan.

What about capital gains?  If the current 15% long term capital gains rate is sustainable and all your investments qualify, your effective return is 5.1% (6% x (1-.15)).  You still start with $2,000 to invest after tax, so after 20 years you would have $5,408:  $2,000 x (1.051 ^ 20).  That’s not bad, but it’s still less than the $6,414 you would have had from a qualified plan.

What about different investment returns and deferral periods?  We’ve used 6% return for 20 years in this simple example, but how does it change for other returns and time periods?  The short answer is that higher investment returns and longer deferral periods favor the qualified plan.  Lower returns and shorter time favor the taxable account.

What about a Roth IRA or 401(k)?  As it turns out, Roth and regular 401(k) results are identical if your marginal tax rates are equal at contribution and withdrawal.  Roth is better if your marginal rate at withdrawal is higher than at contribution time; otherwise a regular 401(k) is better.  And they both blow the taxable account out of the water.

First Look at Proposed GASB Accounting Changes

Over the past couple of years, the GASB (Governmental Accounting Standards Board – they write the public employer accounting rules) has started the process of updating the accounting rules for public employer pension and retiree health plans. They issued an invitation for ideas/comments in 2009 and now we are getting our first sneak peek at the direction that GASB is thinking of going. Their website has been updated with a list of Major Tentative Decisions that could have a HUGE impact on the way retiree benefit costs are accounted for under GASB 27 and GASB 45. The three biggest changes appear to be:

1. Moving the Unfunded Actuarial Accrued Liability (UAAL) onto the balance sheet instead of just showing it in a footnote.

2. Switching from a single liability discount rate (based on expected return of plan assets) to a bifurcated discount rate. Liabilities covered by current assets will still use the old assumption, but unfunded liabilities will be discounted using a “high-quality tax-exempt municipal bond index rate”. The latter rate will likely be much lower than the old discount rate for pension plans (which will increase the liability calculations), but it remains to be seen how the mechanics of this process will actually work.

3. Less smoothing of unexpected asset and liability changes. Currently these unanticipated changes can be spread out and recognized over a period of up to 30 years. It appears the GASB is proposing that this period be shortened to the remaining service period of current employees (probably closer to 10 – 15 years).

The net effect of these proposed changes will likely be that accounting costs for public pension benefits will go WAY up. The impact on retiree health and OPEB liabilities is less clear since they are now usually valued using a very low “risk-free” interest rate. Moving to a (presumably higher) municipal bond index rate will decrease the UAAL, but this could be totally offset by the other proposed methodology changes.

Once we learn more from the GASB in June, we’ll provide additional analysis. For now, Girard Miller at Governing.com has a good summary of the possible ramifications and explores the proposed changes in greater detail. The proposed GASB accounting changes likely wouldn’t go into effect for several years but, as Mr. Miller points out, public plan sponsors should start exploring the potential effects now so that there is adequate time to prepare and develop solutions.

Public Pension Backlash

I have been saying to my colleagues for the past couple of years that the backlash against public employee pensions was on the horizon. Recent newspaper articles and pension studies confirm that the storm is finally here. With many private employees seeing their retirement savings halved during the recession and their employer-sponsored retirement plans cut back, it was only a matter of time before “pension-envy” took over.

However, it seems that the recent press exposure of public pension finances and well-publicized instances of questionable benefit practices has obscured some of the most important questions regarding pension plans – public or private.

  • What is the purpose of a pension plan? Is the current plan serving its purpose or does it need to be adjusted to adapt to changing times?
  • Are current benefit levels in the plan “appropriate”? A “race to the bottom” of employee benefits doesn’t help anyone in the long-term, but I think that it is entirely fair to make targeted adjustments to pension plan benefits so that they are competitive, affordable, and meaningful.
  • How will benefits be financed? This is the question that has been making headlines recently due to the recession’s impact on pension plan trust funds. Stories of pension funds being 30% to 40% underfunded can rile people up, but they rarely capture the complexities of pension plan financing. Pension plans can be a very efficient way to provide meaningful benefits to large groups of employees, but the cost must be transparent and the funding can’t be perpetually deferred to future generations.

One of the most rational voices I have heard in this growing debate has been Gerard Miller at the website www.governing.com. He has many thoughtful articles about pension reform that try to bridge the gap between maintaining unaffordable public pensions and a total dismantling of the system.  I believe that the debate on public pension reform is just getting fired up and we can expect to see it displayed prominently in this year’s mid-term elections. It remains to be seen whether this topic can be discussed objectively or whether it will just devolve into an all-out battle between the “haves” and “have-nots”.