The Administration’s 2014 budget: provisions affecting retirement benefits

On April 10, 2013 the Administration released its 2014 budget (hereafter, the ‘Budget’).

In this article we review sections of the Administration’s budget that affect company retirement plans: a proposed PBGC premium increase; a $205,000 annual ‘annuity cap’ on tax-favored retirement savings; a 28% ‘deduction cap;’ implementation of the ‘Buffet Rule;’ and Auto-IRAs.

Increase in PBGC premiums

“The Budget gives the Board of Directors of the Pension Benefit Guaranty Corporation (PBGC) discretion to increase premium rates to generate up to an additional $25 billion beginning in 2015. … In order to ensure that these reforms are undertaken responsibly during challenging economic times, the Budget would require a year of study and public comment before any implementation and the gradual phasing in of any premium increases.”

In the context of PBGC premiums, $25 billion (over 10 years) is a lot of money. Changes in last year’s “Moving Ahead for Progress in the 21st Century Act” (MAP-21) legislation raised $9 billion over 10 years. Under those changes (and oversimplifying some), the per capita PBGC premium was increased 40% (from $35 to $49) over the period 2013-2014 and the variable premium was increased 100% (from $9 to $18 per $1,000 of unfunded vested benefits) over the period 2014-2015. We’ll have to see an actual proposal to get the math right, but it looks like the Administration is proposing to triple PBGC premiums.

Exactly what form these increases would take is unclear. (Our article PBGC’s Single Employer Deficit and PBGC Premiums provides background on the PBGC’s financial condition.) PBGC’s proposal calls for premiums that vary based on both the size of a plan’s unfunded vested benefits and the sponsor’s financial condition. Echoing that approach, “[t]he Budget proposes to give the PBGC Board the authority to adjust premiums and directs PBGC to take into account the risks that different sponsors pose to their retirees and to PBGC.”

These three issues: (1) the size of the premium increase, (2) giving discretion to PBGC to set premium policy and (3) linking premiums to the financial condition of the sponsor, are all problematic for plan sponsors.

Prohibit individuals from accumulating an age 62 annuity of over $205,000 in tax-preferred retirement accounts

Under the Budget:

“A taxpayer who has accumulated amounts within the tax-favored retirement system (i.e., IRAs, section 401(a) plans, section 403(b) plans, and funded section 457(b) arrangements maintained by governmental entities) in excess of the amount necessary to provide the maximum annuity permitted for a tax-qualified defined benefit plan under current law (currently an annual benefit of $205,000 payable in the form of a joint and 100% survivor benefit commencing at age 62 …) would be prohibited from making additional contributions or receiving additional accruals under any of those arrangements.”

The Budget estimates that, currently, this benefit would equal an account balance of approximately $3.4 million for a 62 year-old.

Note that the limitation applies to the aggregate of benefits and account balances in the “tax-favored retirement system,” including IRAs and defined benefit plans. The Budget provides some details on how the challenge of administering this limit could be met:

“The limitation would be determined as of the end of a calendar year and would apply to contributions or accruals for the following calendar year.

Plan sponsors and IRA trustees would report each participant’s account balance as of the end of the year as well as the amount of any contribution to that account for the plan year.

For a taxpayer who is under age 62, the accumulated account balance would be converted to an annuity payable at 62, in the form of a 100% joint and survivor benefit using the actuarial assumptions that apply to converting between annuities and lump sums under defined benefit plans.(Note that, currently, this conversion for defined benefit plans may not use an interest rate lower than 5.5% and would artificially “cap” the value of the $205,000 age 62 annuity. It is not clear how this would be reflected in the Administration proposal, because the 5.5% floor on rates would currently limit the age 62 account balance to under $3 million.)

For a taxpayer who is older than age 62, the accumulated account balance would be converted to an annuity payable in the same form, where actuarial equivalence is determined by treating the individual as if he or she was still 62; the maximum permitted accumulation would continue to be adjusted for cost of living increases.

If a taxpayer reached the maximum permitted accumulation, no further contributions or accruals would be permitted, but the taxpayer’s account balance could continue to grow with investment earnings and gains. If a taxpayer’s investment return for a year was less than the rate of return built into the actuarial equivalence calculation, there would be room to make additional contributions.

When the maximum defined benefit level increases as a result of the cost-of-living adjustment, the maximum permitted accumulation will automatically increase.

If a taxpayer received a contribution or an accrual that would result in an accumulation in excess of the maximum permitted amount, the excess would be treated in a manner similar to the treatment of a [401(k)] excess deferral under current law.

If the taxpayer did not withdraw the excess contribution (or excess accrual), then the excess amounts and attributable earnings would be subject to income tax when distributed, without any adjustment for basis.”

For those who want to reduce the tax benefits for retirement savings, capping the total amount in the ‘tax-favored retirement system’ is emerging as the favored approach. A similar proposal has been discussed by some in Congress.

Reduce the value of itemized deductions and other tax preferences to 28% for families with incomes in the highest tax brackets

Currently, a millionaire who contributes to charity or deducts a dollar of mortgage interest enjoys a deduction that is more than twice as generous as that for a middle class family. The Budget would limit the tax rate at which high income taxpayers can reduce their tax liability to a maximum of 28%, a limitation that would affect only the top 3% of families in 2014. This limit would apply to: all itemized deductions; foreign excluded income; tax-exempt interest; employer sponsored health insurance; retirement contributions; and selected above-the line deductions. The proposed limitation would return the deduction rate to the level it was at the end of the Reagan Administration.

The one virtue of the $205,000 ‘annuity cap’ is that it does not apply until the participant has accumulated substantial retirement savings. In contrast, the 28% limit on tax preferences would apply to the ‘first dollar’ of retirement savings.

The Budget would:

“[L]imit the tax rate at which upper-income taxpayers can use itemized deductions and other tax preferences to reduce tax liability to a maximum of 28%. This limitation would reduce the value of the specified exclusions and deductions that would otherwise reduce taxable income in the top three individual income tax rate brackets of 33%, 35%, and 39.6% to 28%. The limit would apply to all itemized deductions, interest on tax-exempt bonds, employer-sponsored health insurance, deductions and income exclusions for employee retirement contributions, and certain above the line deductions. If a deduction or exclusion for contributions to retirement plans or individual retirement arrangements is limited by this proposal, the taxpayer’s basis would be adjusted to reflect the additional tax paid.” (Emphasis added.)

We analyze the impact of a cap on deductions on the value of 401(k) deferrals in our article What would a 28% deduction cap mean for 401(k) tax benefits?

It appears that this 28% ‘deduction cap’ would not apply to defined benefit plans.

Observe the Buffett Rule

“The Budget also puts forward a specific proposal to comply with the Buffett Rule, requiring that wealthy millionaires pay no less than 30% of income – after charitable contributions – in taxes. This proposal will prevent high-income households from using tax preferences, including low tax rates on capital gains and dividends, to reduce their total tax bills to less than what many middle class families pay.”

We mention this proposal because it is likely that this ‘rule’ would prevent ‘wealthy millionaires’ who happen to be participants from getting any tax benefit from, e.g., 401(k) plan savings.

Establishes automatic workplace pensions

“The Budget proposes a system of automatic workplace pensions that will expand access to tens of millions of workers who currently lack pensions. Under the proposal, employers who do not currently offer a retirement plan will be required to enroll their employees in a direct-deposit Individual Retirement Account (IRA) that is compatible with existing direct-deposit payroll systems. Employees may opt out if they choose.”

This proposal has been in every budget of this Administration, and ‘Auto-IRA’ bills have been introduced in the past. Notwithstanding Administration backing, this proposal has never gotten much support in Congress because (1) it imposes a “mandate” on employers and (2) (probably most significantly) it costs a lot in lost revenues.

We note that — if it should ever gain significant support — this proposal would not just affect small employers. It is likely that large employers that, e.g., exclude certain groups or classes of employees (e.g., part time employees) might have to establish Auto-IRA programs for them.

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It’s unclear at this point whether any of these proposals will get anywhere in Congress. Our analysis remains: if Republicans will not agree to new taxes and Democrats will not agree to new spending cuts, then Congress will be gridlocked and nothing will happen. But if the two sides start to seriously work on a ‘Grand Bargain,’ then anything is possible.

We also note that a (much more modest) PBGC premium increase was part of the House Republicans’ budget proposal — so it is possible that a premium increase might move even if Congress is gridlocked on all other issues.

As we discussed in our recent article Entitlement Reform and Retirement Benefits, the next ‘big showdown’ is likely to come in August, when the federal government will hit its borrowing limit.

We will continue to follow these issues.