Last year’s tax-law changes stripped some retirement benefits from executives with salaries of $150,000 to $235,840. As a consequence, perhaps unintended, many employees making $66,000 to $150,000 also may see their retirement benefits shaved.
The culprit is the way the new rules interact with the convoluted formulas governing contributions to 401(k) and some other retirement plans.
Exactly who will lose out, and by how much, will vary from employer to employer. The issue is on simmer now, but likely to come to a boil in April, when companies will do their first 1994 analyses of contribution levels and start imposing reductions, if necessary.
But one thing is certain, benefits consultants say: Many of those in the over-$150,000 salary bracket will be offered supplemental plans to replace some or all of their losses. But most of those making less than $150,000 will not.
The new rule affects tax-qualified retirement plans, which get preferential tax treatment in return for following IRS and Department of Labor guidelines on funding and fairness. Employers get immediate tax deductions for their contributions to such plans, while employees pay no taxes until they withdraw the money.
The rule says, in effect, that only the first $150,000 of salary may be considered in figuring benefits from or contributions to such plans. The previous limit was $235,840. The change applies to both defined-benefit plans, which are funded entirely by employers and promise specified levels of pension benefits, and defined-contribution plans, which are funded partly or wholly by employee contributions and specify contribution levels but not payout levels.
For defined-benefit plans, the effect of the rule changes is clear: The maximum salary that may now be used to figure pension benefits is $150,000 a year. That will have the effect of reducing anticipated pension payouts for executives making between $150,000 and $235,840. Both lower-paid and higher-paid employees will be unaffected by the change.
The real murkiness comes in defined-contribution plans, whose byzantine regulations may force some employees who make less than $150,000 to reduce their contributions, while many who make more than $150,000 remain untouched.
In these plans, the group of employees making more than $66,000 a year may not contribute a significantly greater percentage of their combined salaries than the group of employees making less than $66,000. The usual spread is 2 percentage points; the limit is designed to keep high-salaried employees from reaping much greater rewards from the plan than lower-paid workers.
The kick to the under-$150,000 employees comes from federal rules that say the reductions must be made by those who are contributing the highest percentages of their incomes.
Hewitt Associates, a Lincolnshire, Ill.-based benefits-consulting firm, gives the following example of how a $70,000-a-year employee could get socked while higher-paid executives escape unscathed. Executive A last year set aside $8,994, the maximum dollar amount allowed by federal regulations. That was 4.5 percent of his $200,000 income. He plans to contribute $8,994 again this year. But because only $150,000 of his income is now counted for pension purposes, the $8,994 contribution becomes 6 percent of his qualifying salary.
At the same time, Employee B makes $70,000 a year. Last year, she contributed $7,000 to the pension plan, or 10 percent of her salary. She plans to do the same this year.
As it happens, the company has a number of executives who make between $150,000 and $235,840. As with Executive A, their salary caps are lowered to $150,000, which means their percentage contributions rise. The increase in their percentages raises the percentage of the entire over-$66,000 group above acceptable levels.
The company must order cutbacks. Where does the ax fall? On the $70,000 employee, because her 10 percent contribution is the highest in the over-$66,000 group. The fact that she contributes fewer dollars than many higher-paid employees carries no weight.
Meanwhile, the executive making $200,000 is spared. “The government has those employers up against the wall,” says Mary Sales, a consultant in Hewitt’s Philadelphia office. “It’s forcing them to take (pension benefits) away from a potentially large group of employees.”
First impact coming up
Most employers have already notified affected employees about a possible reduction, Sales says. But “the first impact will really be seen in April,” she adds.
For many employees making $150,000 to $235,840, there will be some consolation. About three-quarters of employers in a survey by benefits consultants Towers Perrin said they would offer supplemental pension plans to executives in that group.
But the cuts are coming in funded pension plans, where money is set aside and may not be used for other purposes, and most supplemental coverage will be in unfunded plans, which are essentially promises to pay that could be rescinded at any time, or could evaporate in case of bankruptcy. Because supplemental plans do not qualify for tax advantages, employers find them too expensive to fund.
Quite a few companies are considering setting up “rabbi trusts,” a type of supplemental plan funded by the employer, says Chet Hurwitz, who heads Price Waterhouse’s benefits practice in Philadelphia. This type of trust, invented by a synagogue to provide a pension for its rabbi, provides more security than an unfunded plan, but its assets still could be seized by creditors in bankruptcy proceedings.
But either a rabbi trust or an unfunded pension plan is better than nothing, which is what employees in the $66,000-to-$150,000 bracket are likely to get.
There are so many employees in that salary range that reimbursing them would be a costly and complicated process that most companies wouldn’t want to undertake, says Clyde Beers, who heads Towers Perrin’s consulting practice in Philadelphia.
A major complication is that federal regulations would prevent those employees from being covered by unfunded plans of the type that will be extended to the over-$150,000 crowd, according to many benefits consultants.
Federal pension law says unfunded plans may be offered only to a select group of highly compensated employees. While those terms are not defined in federal law or regulations, their intent is to limit unfunded plans to people with enough power to protect their own interests.
