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Sponsor News - June 2013

IRS Audit Trends & Issues

Monday, February 25, 2013
Continuing our series of posts reporting on the recent TE/GE meetings, today we focus on the audit trends and issues that the IRS officials in attendance identified. In addition to providing insight on the IRS’s focus, the list serves as a good compliance checklist for plan sponsors. Are you making these errors? If so, you can (and should) fix them now before the IRS comes knocking.

Areas of Focus. At the outset, it’s helpful to know where the IRS is looking for trouble, so you can have some idea where agents are coming from when you get the dreaded audit letter. The officials at TE/GE gave these insights:

  • Most audits are focused on 3 or 4 particular issues depending on the market segment (i.e., the business of the employer) and the size of the plan (generally less than 100 participants is a small plan while other plans are considered large). The IRS did not give examples of the issues on which they are focusing, but to the extent you or your advisors are aware of other IRS audits in your market segment and for plans of your size, you may be able to identify them.
  • There is no current targeted audit project for governmental plans.
  • 403(b) plans will be an area of focus going forward.
  • With regard to 401(k) audits, there will be a heavy emphasis on internal controls. They mentioned this multiple times, so it’s a good idea to review and document your internal controls now so that you are prepared when the IRS audits.
  • For defined benefit plans, they said they will focus on “issues around [the Pension Protection Act].” They did not elaborate, but presumably this will involve a focus on operational compliance with PPA changes.

Audit Trends. The IRS also identified a few common audit trends. Most of these are unsurprising, but again, serve as a good checklist for plan sponsors.

  • First, they identified the following general trends:
    • Failure to timely amend documents for law changes
    • Failure to follow plan terms
    • Using the incorrect definition of compensation for contribution, benefit calculation, or testing purposes
    • Eligibility compliance issues, such as failing to exclude ineligible employees or include eligible ones
  • On a more specific note, they identified the following as issues that were particularly prevalent in 401(k) plans:
    • Failing to have internal controls (did we mention that they thought this was important?)
    • Increases in plan loan defaults due to administrative errors (see our prior post about doing a quarterly checkup)
    • Failing to make the top heavy minimum contribution in a top heavy plan (this is a bigger issue for smaller plans)
  • In the 403(b) area, they reported that the following issues were common:
    • Deferrals exceeding the 402(g) limit ($17,500 for 2013)
    • Failure to comply with the universal availability rules
    • Contributions in excess of the maximum limits under 415 ($51,000 for 2013)
    • Plan loans that violate the loan rules on maximum loan amounts or maximum repayment periods (and, in some cases, have no documentation at all for the loan)
    • Hardship distributions where insufficient documentation is obtained to demonstrate the hardship.

5 Reasons to Choose a Traditional 401(k) Over a Roth

By David Ning
February 27, 2013 RSS Feed Print
There are many wonderful reasons to invest in a post-tax retirement account such as a Roth IRA. But tax-deferred retirement savings vehicles such as traditional 401(k)s and IRAs that let you put money aside before Uncle Sam gets his share deserve a serious look too. Here are several advantages of saving in a pre-tax retirement account you should take into account before you decide that a Roth IRA is right for you:
There are more obstacles to withdrawing money early. Just because you save doesn't mean you are home free because you can often find an excuse to use the money you've accumulated. When assets are in tax-deferred accounts, there are often penalties involved if you ever need to get the money out.
Even if you comb the details of the law and find a way to withdraw your money penalty-free, you still have to pay a good chunk of taxes on your withdrawal. In a world where temptation is everywhere, these obstacles may help motivate you to leave your money in the account until retirement and turn out to be what your future self appreciates the most.
You can deduct the contributions automatically from your paycheck. Until the Roth 401(k) becomes more popular among employers that offer 401(k)s, the easiest way for most employees to save for retirement is through payroll deductions toward a traditional 401(k). By paying yourself first you don't have a chance to forget about the contributions, nor can you actually spend it because you won't ever touch that money. Having the contribution automatically invested instead of manually hitting send seems like a small convenience, but it’s amazing how much of a difference this simple adjustment can make. Try it, because it works.
Another advantage of having money in a 401(k) is that your assets are better protected. It's just harder for creditors and lawyers to go after assets in your 401(k), so use that to your advantage.
You can move to a lower tax state before you withdraw the money. A seldom talked about strategy when deferring taxes is to move to a no income tax state by the time you retire and have to withdraw from your portfolio. This way, you might be able to skip paying state taxes on your retirement account withdrawals. Moving is a huge decision that involves much more than just the state tax rate, but the option is at least available for those who choose the tax-deferred route.
A Roth IRA conversion is possible during low income years. This maneuver requires careful consideration, so work with a competent accountant who is familiar with the procedure. If you do this correctly, you may be able to avoid paying taxes on your contributions all together in some cases.
Roth IRA conversions are taxed at ordinary tax rates, so you can choose to convert part of your tax-deferred assets in years when your income is low to avoid paying a high tax rate. If you have no other income for the year, part of your conversion will even be converted to a Roth tax free. Next time your income drops, remember to look into this because it could significantly boost your nest egg.
You could pay a lower tax rate in retirement. You avoid paying the top marginal tax rate on every dollar of your contributions to a pre-tax account, but not every dollar of your withdrawals will be taxed at the top rate. Thanks to the progressive tax system, the lower range of income is taxed at a lower rate, and the tax rate moves up as your income increases. That means a portion of your withdrawals will be taxed at the lowest rate, while part of it will be taxed at a higher rate. On the other hand, contributions would have been taxed at your top rate, so don't just try to compare your tax rate during your retirement and working life to determine whether you should choose a tax-deferred account.

A step-by-step guide to selecting vendors

One challenge in advising plans is choosing a "reasonable' agreement among service providers
By Blaine F. Aikin
Mar 3, 2013 @ 12:01 am (Updated 7:54 pm) EST
Advising companies that sponsor a 401(k) plan has become a more popular business model, and though it is a model that can offer benefits and opportunities different from those of a typical advisory business, there are also distinct responsibilities and challenges that must be met.

One of the major roles of a 401(k) plan financial adviser is vendor selection.

The Employee Retirement Income Security Act of 1974 requires plan sponsors to enter into “reasonable” agreements with vendors. As simple and subjective as that may sound, fulfilling this reasonableness obligation entails thorough and well-documented due diligence in the selection of service providers to the plan.

A modified form of ERISA's exclusive-purpose rule serves as a mission statement for service pro-vider selection: Vendors are to be selected based upon their ability to deliver desired benefits for participants and beneficiaries after careful and objective consideration of the costs and capabilities of competing service providers.

That mission statement gives structure to a four-step selection process: (1) define the services (benefits) to be delivered, (2) identify providers capable of delivering the desired services, (3) evaluate the abilities of competing vendors to deliver the services at a fair and reasonable cost, and (4) engage and monitor the top-ranked service provider.

The first step is the most important.

Service provider selections are unlikely to be successful if desired services aren't well-defined and appropriately prioritized according to the benefits that they provide to participants. Without prioritization of services, competing vendors can't be compared properly.

Meeting income needs in retirement is far and away the most important benefit for plan participants, and investment management is clearly the most critical service to address that benefit directly. For this reason, manager selection criteria should attach a high priority to a vendor's ability to offer or support asset classes that promote effective diversification and a strong menu of investment options.

Reliable legal, accounting, trustee/ custodial and record-keeping services are unquestionably necessary, but in these areas, it is most important to set baseline expectations for these services. Variations in capabilities across providers of these services that exceed baseline standards should be considered.

However, the responsible plan fiduciary must evaluate the costs of extra services in terms of possible benefits for participants in order to prioritize them properly.

In the second step, potential service providers can be identified by conducting an informal process of soliciting information from vendors about their capabilities, reviewing published literature about vendors and asking other plan sponsors or respected sources about potential service providers. This pre-qualification process should result in a short list of three to 10 firms likely to be the most capable of delivering the desired services at a competitive price.

The focus of the third step is issuance of a formal request for proposals to the pre-qualified service providers.

The RFP specifies required and preferred services. Each competitor is expected to address the specified services in the proposal and is permitted to note additional capabilities.


Under ERISA 408(b)(2) regulations, which took effect last July and di-rectly address service provider disclosures, plan sponsors must obtain and consider certain information from providers for a service agreement to be deemed reasonable.

Specifically, for each service to be provided, vendors must identify the direct and indirect compensation arrangements involved and indicate whether the vendor intends to act in a fiduciary capacity. Services that are to be delivered by affiliates or contractors must be described, along with compensation arrangements among the parties and potential conflicts of interest.

In addition, the RFP should inquire about the service provider's financial status, insurance coverage, staff turnover, regulatory history, complaint records and experience in serving similar plans. Additionally, the vendor's processes for transitioning business from an existing service provider should be examined.

References from comparable 401(k) plan clients should be required and checked.

RFP submissions should be compared on their ability to deliver desired benefits at a reasonable cost. As a best practice, a scoring system often is used to weigh the relative importance of the services that were prioritized in the first phase and quantitatively compare the capabilities of each service provider.

In the fourth and final step, the responsible plan fiduciary formally engages the selected service pro-vider and puts a performance-monitoring process in place. As part of the contracting process, the service delivery model should be checked against the plan document, the investment policy statement and other governing documents to make sure they are aligned.

At this point, the responsible plan fiduciary should ensure that the entire selection process has been carefully documented. This documentation demonstrates fulfillment of the reasonableness obligation.

To refer to this as the “final” step is something of a misnomer because plan fiduciaries have a continuing obligation to monitor service providers. Vendor relationships should be reviewed periodically as both the plan's service needs and competitive marketplace evolve.
The Labor Department has stated an assumption that “plans normally conduct RFPs from service providers at least once every three to five years.”

This has become an established best practice, though not a hard-and-fast fiduciary obligation.

Selecting service providers is one of the most critical responsibilities of a responsible 401(k) plan fiduciary. An agreement established by a plan fiduciary with a service provider that has not been carefully vetted is inherently unreasonable.

How does your investment committee stack up?

Vanguard | 03/05/2013
Despite the best efforts of investment committees, internal group dynamics can sometimes lead to questionable choices that hamper their fiduciary responsibility of ensuring that their organizations meet their financial obligations, according to a Vanguard survey.

Findings from the survey, conducted by Vanguard Investment Counseling & Research, show that complicating matters further is the relative inexperience of many committee members. The survey of more than 110 committee members across entities—nonprofit organizations as well as defined benefit (DB) and defined contribution (DC) plans—about half of all respondents had committee tenure of five years or less.
Whether you're a new or veteran committee member, you may wonder how your group compares with others in making investment decisions. The survey indicates that committees do many things right, but they also fall into some behavioral patterns that can prove counterproductive.

Make better use of your time

On average, committees spend more time reviewing past investment performance than on deciding strategy, manager selection, or noninvestment issues. Committees for DC plans in particular spent almost 51% of their time on past performance—more than all other issues combined.

"Considering that market performance is an area totally out of one's control, this is not the best use of a committee's time," said Catherine Gordon, principal and head of Vanguard Investment Counseling & Research. "They should be spending more time on areas that they do have control over. For example, you can partly control risk through asset allocation decisions. And you have total control over costs through your choice of investments."

Time spent is based on Vanguard's collective experience, not on survey results.

Committee behavior

About half of our survey respondents acknowledged that their committees tend to seek information that confirms their preconceptions—one of the potential pitfalls discussed in a Vanguard research paper, Group decision-making: Implications for investment committees.
"Confirmation bias can be a real concern for committees, especially if committee members come prepared with opinions and not facts. Decisions can be made solely on how persuasive the member was," Ms. Gordon said. "With about half of our survey respondents indicating that their committees engage in confirmation bias, there is clearly an opportunity to improve decisions by addressing this troublesome bias."

In other ways, the survey respondents seemed to be following some of the best practices outlined in the white paper:

  • Virtually all respondents felt their committees engaged in healthy debate before making decisions.
  • More than 90% felt they were free to question group decisions without fear of criticism.
  • An even greater number felt they used the expertise of all committee members.
  • The majority used an outside consultant, which the paper recommends as one method of bringing diversity of thought, as an outside expert can act as a devil's advocate.

Furthermore, 52% of respondents said their committees had between six and ten members—the ideal range.

"With fewer than five or six members, committees may lack the diversity of thought needed to reach unbiased decisions," Ms. Gordon said. "With more than ten, committees could become unwieldy and inefficient."

Resources to help you

For help with investment committee dynamics, committee members can take advantage of the guidelines in the white paper, along with other resources available on this website:

  • The Nonprofit Fiduciary Resource Center, a convenient one-stop location for forms, tools, and other useful resources for nonprofit investment committees.
  • Evaluating managers: Are we sending the right messages? This recent white paper from Vanguard Investment Counseling & Research highlights the limitations of quantitative approaches in evaluating and choosing investment managers.
  • Vanguard Investment Perspectives, our semiannual journal of recent Vanguard research.

These items are just a few examples of resources available to you. While nothing can guarantee good investment results, our resources can assist you in making sound decisions that can ultimately help your committee reach its objectives.

Small Plan Audit Rules

Rev. O8/01/02; Rev. 03/08/13; E-mail Alert 2013-3
The Department of Labor provides regulations regarding which small plans are exempt from the requirement of having an independent accountant's audit performed. Small plans are generally those that have less than 100 participants at the beginning of a plan year (The DOL Form 5500 instructions provide a detailed definition of “participant” ). Small plans are exempt from the independent audit requirement imposed on larger plans provided certain criteria are met. Plans failing to meet the exemption will have to have an independent accountant's opinion filed along with the annual Form 5500.

Requirements to be exempt from the small plan audit:
At least 95% of the plan assets measured at the beginning of the plan year, (e.g., January 1, 2013 for a calendar year plan) are invested in “qualifying plan assets” (defined below),
Have those assets not defined as qualifying plan assets covered by a surety bond equal to the value of those assets. Note: a 10% bonding requirement up to $500,000 already exists for plans covered by these rules. If the plan includes employer securities, the bond requirement is up to $1,000,000.

Qualifying plan assets are:

  • Qualifying employer securities;
  • Participant loans;
  • Assets held by a regulated financial institution;
  • Shares of a registered mutual fund;
  • Investments and annuity contracts held by insurance companies;
  • Assets held by a registered broker-dealer.

In order for the small plan audit exemption to be available, the DOL requires the following information to be included in the Summary Annual Report:

  • The name of each institution holding the qualifying plan assets and the year end value of them;
  • The name of the surety company covering the nonqualifying assets;
  • A notice that the participants can request a copy of the surety bond; and
  • A notice that the participants should contact the DOL if a copy of the bond is not provided to them.


The DOL provides limited exceptions which allow certain plans with greater than 100 participants to file as a small plan. The following text was taken from the most current Form 5500 instructions:

(1) 80-120 Participant Rule: If the number of participants reported on line 5 is between 80 and 120, and a Form 5500 annual return/report was filed for the prior plan year, you may elect to complete the return/report in the same category (‘‘large plan’’ or ‘‘small plan’’) as was filed for the prior return/report. Thus, if a Form 5500 annual return/report was filed for the 2010 plan year as a small plan, including the Schedule I if applicable, and the number entered on line 5 of the 2011 Form 5500 is 120 or less, you may elect to complete the 2011 Form 5500 and schedules in accordance with the instructions for a small plan, including for eligible filers, filing the Form 5500-SF instead of the Form 5500.
(2) Short Plan Year Rule: If the plan had a short plan year of seven (7) months or less for either the prior plan year or the plan year being reported on the 2011 Form 5500, an election can be made to defer filing the accountant’s report in accordance with 29 CFR 2520.104-50. If such an election was made for the prior plan year, the 2011 Form 5500 must be completed following the requirements for a large plan,
including the attachment of the Schedule H and the accountant’s reports, regardless of the number of participants entered in Part II, line 5”

Recommendations for actions:

  • If an audit will be required, don't wait until the last minute to contract with the auditor. The audit process can be very long and is usually somewhat expensive.
  • If a surety bond is required, the surety bond is coordinated with the bond already required for plan fiduciaries. Thus, if the nonqualifying assets are less than 10% of the total plan assets, then no additional bonding will be required. If, however, the nonqualifying assets exceed 10% of the total assets, then additional bonding will be required.
  • Because of the general market for casualty insurance, employers may encounter difficulty in obtaining coverage in excess of the normal $500,000 maximum limit, which is $1,000,000 if the plan includes employer securities. Don't wait until the last minute to add a surety bond.