Retirement Heist

BUYING LIFE INSURANCE on workers is one way many companies informally fund executive deferred compensation. Tapping the regular pension plan is another. Intel, the giant semiconductor chip maker, moved more than $200 million of its deferred-compensation obligations into the regular pension plan in 2005. This move converted an unfunded liability—deferred compensation for the top 3.5 percent to 5 percent or so of its workforce—into a fully funded, regular pension benefit.

When these 12,000 or so highly paid employees and executives at the chip maker get ready to collect their deferred salaries, Intel won’t have to pay them out of cash; the pension plan will pay them.[13]

There was another benefit as well: Intel contributed $187 million to the pension fund to cover the executive obligations. Normally, companies can deduct the cost of deferred compensation only when they actually pay it, often many years after the obligation is incurred. But Intel’s contribution to the pension plan was deductible immediately. Its tax saving: nearly $70 million in the first year.

Meanwhile, the pension contribution enabled Intel to book as much as an extra $136 million of profit over the ten years that began in 2005 (thanks to the pension accounting rules that let companies immediately record noncash income from pension-plan contributions, based on what they expect the assets to earn when invested). The $136 million was Intel’s estimate of the returns on the contribution. The company’s effective guaranteed return on the contribution in the first year: 40.6 percent.

Intel’s move wasn’t illegal, though it had a peculiar result: It turned a pension plan for a company with more than fifty thousand workers primarily into a fund to pay for the deferred compensation of the company’s most highly paid employees, roughly 4 percent of the workforce.

If it were this easy for all employers to just shift executive liabilities into their employee pension plans, they would all have done so long ago. But tax rules put up a roadblock. To get tax breaks, pensions have to be open to a broad group of employees and can’t discriminate in favor of the highly paid.

Benefits consultants, however, found a loophole in the discrimination rules that has enabled a growing number of large companies to shift hundreds of millions of dollars of executive liabilities into rank-and-file pensions. Using complex and proprietary formulas, the consultants determine how much discrimination a pension plan can achieve without technically violating discrimination rules.

The result might be a dollar amount, say, $200 million, which would be allocated to highly paid employees in addition to their regular benefits from the plan. In Intel’s case, the participants got their regular pension, plus an amount of their deferred compensation paid from the pension. These arrangements are often called QSERPs, which stands for “qualified supplemental executive retirement plan.”

The shift doesn’t increase the total amount a person receives; when the executive liability is moved to the pension plan, an equivalent amount of deferred compensation or supplement executive pension is canceled. The goal of the maneuver isn’t to boost executive benefits but to harness the pension plan to pay them. “QSERPs clearly offer a tremendous opportunity for some employers to prefund key executive retirement benefits,” noted Watson Wyatt’s marketing material.

OVERLOADED

Intel and its pension plan were healthy. But companies in financial distress have an incentive to do this, and when they shovel executive obligations into underfunded pension plans, the result can backfire.

In December 2002, Oneida Ltd., a flatware maker in upstate New York, amended its pension to give then chairman and CEO Peter J. Kallett an additional pension of $301,163 a year in retirement. This was in addition to the $116,000 a year he was already eligible for in the regular pension. The company then transferred the liability for that additional amount from his executive pension.

The company made a similar amendment for another executive in April 2004, boosting his pension from less than $33,000 a year to a minimum of $246,353 a year in retirement. The timing wasn’t great. The company was struggling financially, and the pension plan was already significantly underfunded. Two weeks after awarding the pension increase to the second executive, Oneida was supposed to make a mandatory $939,951 contribution to its pension fund. But it didn’t. Instead it froze the pension, which meant that employees would no longer build any benefits. But the freeze didn’t affect executives’ pensions under the QSERP, because these were already set at a certain amount that wouldn’t grow over time anyway. Neither the company nor the plan survived. In 2006, Oneida terminated its pensions in bankruptcy court and transferred the obligations to the PBGC. It also laid off most of its employees. Donald Grogan, who was fifty-two at the time, had worked in manufacturing and shipping at Oneida for twenty-two years before he lost his job. Because the pension plan had been handed over to the PBGC, he had to wait until 2009, when he turned fifty-five, to begin drawing his pension. To make ends meet, he got a truck-driving job with no benefits.

On the other side of the country, a similar drama left Chester Madison with a gutted pension. He had been a middle manager at Consolidated Freightways Corp., a trucking company based in Vancouver, Washington. In late 2001, when the company was clearly in trouble, it transferred most of the retirement IOUs for eight top officers into its pension.

The executives believed this would protect most or all of their supplemental pensions—which could reach $139,000 a year when they retired—because they’d be paid from the pension plan’s trust fund instead of the company’s operating cash.

They also felt more secure knowing that once executive liabilities are transferred into a “qualified” pension plan, they, too, are covered by the PBGC. When consulting firms market these strategies to upper management, that’s a key selling point. By contrast, deferred compensation and supplemental executive pensions are unsecured promises, which creditors can claim if the employer goes under. Many Enron executives learned about this risk the hard way when they lost millions in deferred-compensation savings when the energy giant collapsed in 2001.

CFC executives soon found out how secure they actually were. The company hadn’t been contributing to the pension plan, which was growing steadily weaker. Adding the executive liabilities to the lifeboat swamped it. The plan’s funding went from having about 96 percent of the assets needed to pay promised benefits to having just 79 percent.

The next year, Consolidated filed for bankruptcy, and in 2003 it handed its pension plan over to the PBGC. Consolidated executives lost a chunk of their pensions because the maximum PBGC payout at the time was $44,000 a year at age sixty-five, and is far less at earlier ages and when other factors are applied.

When Chester Madison retired in 2002, after thirty-three years, his pension fell to $20,400 a year from $49,200, which forced him, at age sixty-two, to take a job selling flooring in Sacramento.

Consultants have since devised solutions to reduce risk for the top managers. In 2005, when Hartmarx shifted executive liabilities into the regular pension plan, it also established an unfunded trust to benefit fewer than a dozen executives, including chief financial officer Glenn R. Morgan. A Chapter 11 bankruptcy filing would trigger the funding of the trust, assuring that the executive benefits it had transferred into the regular pension would be paid even if the pension plan failed.

That was a smart move by the Chicago-based maker of high-end men’s suits. In 2009, when its lenders cut off its credit, the company filed for Chapter 11. The company survived: It was acquired by SKNL North America BV, a subsidiary of an Indian textile maker, and renamed HMX. The pension plan didn’t: The new owners had no interest in being saddled with the underfunded pension plan covering thirteen thousand employees and retirees and dumped the plan on the PBGC’s doorstep. At that point, the pension plan was only 47 percent funded.

No one knows how many hundreds of millions of SERP and deferred-compensation obligations have been transferred into employee pension plans since the practice emerged in the 1990s. The Milliman consultant who advised employers to tell only the participating executives about the arrangements was also concerned about the IRS’s reaction. He advised employers that in “dealing with the IRS,” they should ask it for an approval letter, because if the agency later cracks down, its restrictions probably won’t be retroactive.

“At some point in the future, the IRS may well take the position” that supplemental executive pensions moved into a regular pension plan “violate the ‘spirit’ of the nondiscrimination rules,” he wrote. Companies have been able to blow the practice past the IRS because, when they file the amendments, they don’t explicitly note the purpose of the change and include it with a flurry of other technical amendments. In any case, the IRS staff is stretched too thin to scrutinize the dozens of pages of complex calculations companies perform to prove that they don’t discriminate. In contrast with a deduction a freelance worker might take for a home office, the IRS generally accepts an employer’s word that its pension plan doesn’t discriminate. To halt the practice, Congress would have to end the flexibility that companies now have in meeting the IRS nondiscrimination tests, which is something employers have strongly opposed.

And though companies are supposed to disclose details of the compensation of their top officers, they maintain that, because the executives’ benefits are now part of the broad-based plans, they are no longer considered to be executive benefits, so disclosure isn’t required.

DISCRIMINATION 101

These techniques were spawned in the early 1990s, when the IRS issued new rules intended to rein in an employer’s inclination to set up and run retirement plans for the favored few. To get tax breaks that allow them to deduct contributions and have the money grow tax-deferred, companies had to prove that their pensions, profit sharing, and 401(k)s don’t discriminate.

Employer groups hadn’t stood idly by awaiting these new regulations. As they had when FASB crafted new pension and retirement benefits accounting rules, employers and their consultants weighed in, demanding flexibility. They got their wish.

As a result, employers don’t have to actually treat everyone participating in the pension or savings plan the same. They are allowed to have a certain amount of “disparity,” or inequality, as long as they can pass certain tests showing that they weren’t going too far.

The first test is the so-called coverage test, which essentially determines that if 100 percent of the higher-paid executives are going to participate in a plan, then at least 70 percent of the lower-paid must also participate.

Thus, in a perverse way, this anti-discrimination rule makes it legal for employers to exclude 30 percent of their low-paid workers from a particular plan right off the bat.

Even before applying the coverage test, employers generally exclude many part-time workers, independent contractors, and “leased” employees, such as janitorial, security, and cafeteria workers. These categories make up about 25 percent of the U.S. workforce.

The diminished pool of employees “eligible” to participate don’t necessarily get their feet in the plan right away. They must first pass certain hurdles. These might require that they be twenty-one or older, work one thousand hours, or reach December 31 of the year following the year they were employed.

Excluding employees doesn’t just save money: It enables higher-paid employees to receive the maximum benefits. Under IRS rules, the amount higher-paid workers contribute to a 401(k) can’t be greater than a certain percentage of what the lower-paid contribute. But if the lower-paid contribute too little, the contribution gap will be too great, and the higher-paid won’t be allowed to contribute the maximum ($16,500 in 2011). The simplest way of closing the gap is to exclude as many lower-paid workers as possible. In the fast-food, retail, and hotel industries, it’s common for at least half the workforce to be locked out of the savings plans.

Inadvertently, this kind of legal salary discrimination can have a disproportionate impact on women and minorities. For years, Hugo Boss, which makes high-end clothing, excluded the 80 or so workers at its warehouse in Midway, Georgia, from the 401(k) retirement plan that it offered to the 232 employees and managers at its Cleveland headquarters. With their low salaries, the warehouse workers, mostly black women, would have contributed little to their accounts, causing the plan to fail another discrimination test, one that compares the contributions of the low paid and the highly paid. If the gap is too wide, the highly paid can’t contribute the maximum to their accounts ($16,500 in 2011). Ironically, the easiest way to prevent this outcome is to exclude low-paid workers altogether.[14]

Countless studies and surveys lamenting the low participation rates of employees barely making a living wage have portrayed low-income workers as apathetic about saving money. Similar studies also trot out statistics about the low savings rates of blacks and Hispanics, and of women compared with men.

Lorenzo Walker, one of the warehouse workers at Hugo Boss, didn’t fit this stereotype. Walker, in his fifties, was earning only $6.50 an hour but still wanted to save some money for his retirement. He preferred an account like a 401(k), where his contributions would be withheld automatically from his paycheck, perhaps receive a matching contribution from his employer, and grow untaxed. His wife, a nail technician, had no retirement plan. Social Security was going to be the couple’s primary source of income, plus whatever Walker could squirrel away. He’d had a 401(k) at a prior job at a poultry-processing factory and had saved up about $11,000.

So one of the first things he asked when he started his job at Hugo Boss was whether the company had a retirement plan. The company said no. In fact, the company actually did have a 401(k) and the warehouse workers were shut out because their low incomes and savings rates would drag down the tax breaks of higher-income employees.

In 2006, the company agreed to let the employees’ union, Unite Here, set up a separate 401(k) for the warehouse and help run it. In exchange, the company would provide small matching contributions to their plans. The arrangement enabled the warehouse workers to have a 401(k) and receive company contributions, without affecting the Cleveland employees at all.

Many companies have these separate-but-unequal arrangements, with different 401(k)s for lower-paid and higher-income employees, who often get bigger company contributions. IRS rule 401(a)(5) says “a classification shall not be considered discriminatory merely because it is limited to salaries or clerical employees.” In plain English, a company can have a lousy plan covering clericals and a terrific plan for the professionals. “Cadillac plans versus ghetto plans” is what one lawyer called them.[15]

There’s another benefit to excluding low-paid workers from the retirement plans, or segregating them to less generous plans: It makes it easier for plans that executives participate in to pass another required discrimination test, called the “benefits” test. To prove it is nondiscriminatory, the plan must pay the low-paid participants, as a group, at least 70 percent of what the higher-paid get.

GERRYMANDERING

This is where the real creativity comes in. The tests don’t require employers to compare the benefits of individuals; they can compare ratios of the benefits received by groups of highly paid with those of groups of lower-paid employees. Benefits consultants developed software that enabled them to gerrymander employees into hypothetical groups. One might have only highly compensated employees, or HCEs, to use the technical lingo. Another might have only lower-paid employees. Still another group might include only executives and low-paid seasonal workers hired during the holiday.

The goal is to reduce the gap—albeit artificially—between the high-paid and low-paid in each group. To make the benefits of the low-paid, as a group, appear bigger, companies like CenturyTel count Social Security as part of employees’ pensions. Employers might also contribute a small amount to the savings plans of low-paid workers—which makes their percentage of benefits look higher. This helps the plan pass the test, and doesn’t cost the company anything, because the temp workers won’t stick around long enough to vest and forfeit the employer’s contribution.

This works with pensions as well. In 1999, for example, Royal & Sun Alliance Co., with the assistance of PricewaterhouseCoopers, amended its pension to award a small increase to one hundred employees. One employee got a pension increase of an additional $1.92 a month in retirement. This enabled the company to pass the discrimination tests and award eight officers and directors significantly more. The largest payment went to John Winterbauer, the sixty-year-old vice president of human resources, who got an additional $5,300 a month for life, paid out in a lump sum of $792,963.

PricewaterhouseCoopers, which pioneered many of these techniques, has used them on its own workforce. The accounting and benefits consulting giant provides its partners’ contributions to the 401(k) with a 200 percent matching contribution—putting in $2 for every $1 the partners contribute—but only 25 percent for lower-paid workers.

The plan passes the discrimination test in part because new employees joining the plan receive a 200 percent matching contribution in the first month of participation, which is always in December, which is also when the company tests the plan for discrimination. This practice has the effect of making the contributions to the lower-paid, as a group, appear higher, which helps the plan pass the test.

YOUNG AND VESTLESS

Another clever way to pass the discrimination tests is by providing matching contributions. A common scenario is that an employer will chip in fifty cents for every dollar an employee contributes to his 401(k), up to 6 percent of pay. An employee making $50,000 who contributes 6 percent of pay ($3,000) to his 401(k) will get a matching contribution from his employer of $1,500.

Employers say they provide matching contributions to encourage lower-paid and younger employees to participate. That’s true, but a bit disingenuous. If that were the whole story, the contributions would be the employees’ to keep. In reality, lower-paid workers commonly forfeit the employer contribution, because of lengthy vesting requirements, which used to be as long as ten years but now are three years for savings plans and three to five years for pensions.

A company with high turnover can afford to provide a more generous match, since ultimately it won’t pay it all out. Employers use the forfeited matching contributions to make future contributions, which reduces their costs. A 2 percent match will cost only 1 to 1.5 percent, because of forfeitures.

When employees forfeit the employer contributions, they also forfeit the earnings on those amounts. This means that the employer not only gets its contribution back; it also receives tax-free earnings on the money.

The vesting period can be stretched out in other ways. Some plans have required employees to be employed on the fifth anniversary of the day they were hired in order to vest, or on the last day of the fifth year. Wal-Mart employees must work for 1,000 hours in a consecutive twelve-month period to be eligible to participate in the profit-sharing plan. In 2009, 79,339 employees forfeited some of their benefit when they left.

The company then redistributed the money to the remaining employees “based on eligible wages,” meaning that some company contributions originally destined to aid lower-paid employees ended up benefiting longer-service, higher-paid employees.

Employers are perennially seeking to loosen the discrimination rules even further. They scored a big coup with Automatic Enrollment, a provision in the Pension Protection Act that became effective in 2007. This was touted as a way to improve participation. The theory is that poor participation rates are the result of worker apathy and that if they are automatically enrolled, it would solve that problem. It’s hard to see how it will help improve savings rates: Employees can drop out at any time, and they aren’t forced to contribute. At Wal-Mart, 8 percent of the employees who are considered participants in the retirement plan have nothing in their accounts.

What the new rules do, however, is give employers a free pass from the discrimination rules: As long as a plan merely offers automatic enrollment, employers don’t have to worry about passing discrimination tests.