Medical Loss Ratio Rebates: Fiduciary and Tax Considerations for Employers
Authors, Mark P. Kelly, Atlanta, +1 404 572 2755 , email@example.com and Ryan Gorman.
Now that the constitutionality of health care reform has been decided, insurers, employers and participants must all focus on complying with its onerous regulations. In December 2011, the United States Department of Health and Human Services (HHS) released final medical loss ratio (MLR) regulations which, among other requirements, require health insurers to provide rebates to policyholders for certain costs which are not spent on medical care.
Reports indicate that the rebates to employers and consumers will total as much as $1.3 billion, with the first rebates being issued by the insurers in August 2012. For employers and participants, realizing this benefit is not as simple as cashing a rebate check or receiving a discounted health insurance premium. The manner in which the rebates are distributed and handled are governed by fiduciary standards, and there are also noteworthy tax consequences with regard to the receipt and distribution of the rebates.
The substance of the MLR requirements can be found in Section 2718 of the Public Health Service Act, as amended by the Patient Protection and Affordable Care Act. The rationale behind the MLR requirements is that a majority of premiums for health insurance (85% for large-group plans and 80% for small-group or individual policies) should be spent on actual medical care, testing and research, rather than allocated to administrative, marketing and profit expenditures. Costs exceeding this ratio are to be reimbursed to policyholders in the form of cash rebates or reduced health insurance premiums. When HHS issued the final MLR regulations, the United States Department of Labor (DOL) and Internal Revenue Service (IRS) issued contemporaneous guidance on the fiduciary ramifications of rebate distributions as well as the tax consequences of the receipt and distribution of such rebates.
1. Are MLR rebates plan assets?
A threshold issue for ERISA plans is whether MLR rebates constitute "plan assets" subject to ERISA's fiduciary rules. DOL guidance provides that MLR rebates are considered "plan assets" under ERISA if a plan has “a beneficial interest in the distribution under ordinary notions of property rights." This requires a careful analysis of the plan and the insurance policy. In the absence of any plan or policy language to the contrary, where the plan (or its trust, such as VEBA) is the policyholder, any rebates attributable to such policy will be considered "plan assets.” On the other hand, where the employer is the policyholder, and the insurance policy, together with other instruments governing the plan, can fairly be read to provide that some part or the entire MLR rebate belongs to the employer, then that language will generally govern, and the employer may retain the rebate.
If the policy and governing instruments are ambiguous, the DOL will look to the source of insurance premiums to determine whether the plan or the employer has a beneficial interest in the MLR rebate, as follows:
- If the premium is paid entirely out of trust assets, or if participants pay the entire cost of plan premiums, then the entire amount of the MLR rebate is considered a plan asset;
- If the employer pays the entire cost of insurance coverage, then none of the MLR rebate is considered a plan asset, and it may be retained by the employer; and
- If the employer and participants each contribute a percentage of the premium, then the MLR rebate is a plan asset to the extent attributable to participant contributions and the balance is not a plan asset.
2. If any portion of the MLR rebate is a plan asset, how must that portion be held?
ERISA generally requires plan assets to be held in trust or applied to pay insurance premiums. DOL’s MLR guidance contains specific directions on how plan fiduciaries can avoid the trust requirement for rebates. Employers can either (i) use the MLR rebates within three months of receipt to pay premiums or provide refunds to participants, or (ii) direct insurers to hold MLR rebates, such as in a premium stabilization reserve, to offset participants’ share of future premiums or to pay for benefit enhancements.
3. What fiduciary requirements apply to distributions of MLR rebates?
Under ERISA, fiduciaries generally can use plan assets only to pay plan benefits and expenses and must act prudently with respect to a plan’s administration and operation. DOL has provided some helpful guidance on applying the ERISA fiduciary rules to MLR rebates:
- The fiduciary does not have to distribute the MLR rebate to former participants if the cost of distribution approximates the amount of the proceeds; instead, the fiduciary can allocate the rebate among current participants if the allocation method is reasonable, fair and objective.
- The fiduciary may use the rebate for other permissible plan purposes, including applying the rebate toward participants’ future premium payments or benefit enhancements if the amount of the rebate would be de minimis or have tax consequences for participants.
- The fiduciary should ensure any MLR rebates treated as plan assets benefit the participants and beneficiaries covered by the policy that generated the rebate.
Income Tax Considerations
For individuals who purchase insurance on the individual market, MLR rebates will be subject to federal income tax only if the individual took a tax deduction for the premium payments on his or her tax return for the previous year. For participants in group health plans that receive a MLR rebate benefit (whether in the form of decreased premiums or cash rebates), the taxation of such benefits will depend on whether the participant paid his/her portion of the premium on a pre-tax or after-tax basis.
1. Pre-tax payments
Participants who pay for their health coverage through a qualified pre-tax cafeteria plan will have to pay taxes on the rebate benefit. For participants who receive a cash rebate, it will be subject to federal income and employment taxes when paid to the participant. For participants who receive reduced premiums, the amount of the reduction will result in a corresponding increase in taxable compensation.
2. After-tax payments
Participants who pay for their health coverage premiums with after-tax dollars have already paid taxes on the insurance benefit, and thus will not have to pay taxes on rebates attributable to such benefit. Premium reductions are treated similarly for after-tax premium payments in the prior year, and are not subject to income tax. The only situation where a cash rebate or reduction in premium could be taxable is where the premium was paid with after-tax dollars and deducted as a medical expense on the participant’s tax return in the prior year.
As insurers begin to issue MLR rebates in August 2012, there are a few key considerations employers should keep in mind. A detailed review of plan documents and insurance arrangements is required to determine if rebates are addressed and to fully understand the employer’s obligations once they receive the rebates. If the documents do not address rebates, employers may want to consider amendments to carefully spell out how rebates will be handled. Insurers will also be notifying participants individually about the rebate. Employers should be prepared for participant questions about their rights, whether they will receive a rebate, and the tax consequences of such rebates. By proactively addressing such issues and understanding potential issues raised as discussed by the DOL and IRS guidelines, employers will be well-prepared for one of the first waves of health care reform.
MAP-21 Changes Pension Funding Requirements and PBGC Premiums
Author, Emily Meyer, New York, +1 212 556 2312 , firstname.lastname@example.org.
The Moving Ahead for Progress in the 21st Century Act (“MAP-21”), signed by President Obama on July 6, made significant changes to the funding requirements for single employer defined benefit plans. Beginning with 2012 plan years, the legislation modifies the method for calculating “segment” interest rates for purposes of minimum required contributions. These changes are expected to significantly reduce minimum required contributions in the short term. MAP-21 also sharply increases flat- and variable-rate Pension Benefit Guaranty Corporation (“PBGC”) premiums.
Pension Funding Stabilization
MAP-21 modifies the method for calculating segment interest rates used to calculate funding targets and target normal costs, a change that is expected to significantly reduce minimum required contributions in the short term. Under the new method for determining segment rates, the IRS must calculate and publish annually 25-year average segment rates, which are used to “adjust” the otherwise applicable segment rates determined (under pre-MAP-21 law) using the 24-month average yield on corporate bonds (the "non-stabilized segment rates"). If the non-stabilized segment rates do not fall within a corridor around the new 25-year average segment rates, they are replaced by “stabilized rates.” Stabilized rates are the interest rates at the lower or upper bound (whichever is closer) of the applicable corridor, as specified by MAP-21. The corridor is 90-110% for the 2012 plan year, 85-115% for 2013, 80-120% for 2014, 75-125% for 2015 and 70-130% for plan years after 2015. Given that current yields are lower than historical averages, the lower bound of the corridor will determine stabilized rates in the short term.
Beginning in 2013, stabilized rates must be used to calculate minimum required contributions, funding target attainment percentage ("FTAP") and adjusted funding target attainment percentage ("AFTAP"). For the 2012 plan year, plan sponsors that have been using segment rates may 1) elect to stay with non-stabilized rates for all purposes; 2) elect to stay with non-stabilized rates for purposes of calculating the plan’s AFTAP only (which would allow the plan sponsor to leave funding-based benefit restrictions in place); or 3) switch to stabilized rates for all purposes for which they will apply in 2013.
The first set of stabilized rates was published by the IRS in Notice 2012-55 earlier this month. The Notice states that the IRS may change the method by which it calculates the 25-year average rate (and the applicable stabilized rate) with respect to future plan years. The Notice also announced that the IRS intends to issue additional guidance related to benefit restrictions in the near future.
Stabilized rates are not substituted for non-stabilized segment rates in performing any other calculations, such as determining lump sum benefit or other accelerated payments, PBGC variable rate premiums or the amount of surplus pension assets that may be used to fund retiree health accounts or life insurance under Code Section 420. Stabilized rates also are not used in determining the tax deductibility of plan contributions or the need for reporting under ERISA Section 4010 (which is required when the plan’s FTAP is less than 80%, missed contributions exceed $1 million or a minimum funding waiver in excess of $1 million granted to a member of the plan’s sponsor’s controlled group is outstanding in whole or part).
MAP-21 does not affect monthly yield curve interest rates (which plan sponsors may elect to use as an alternative to segment rates). As a result, liabilities calculated using the yield curve will, in the short term, almost certainly be higher than liabilities calculated using segment rates. To address this imbalance, MAP-21 provides that plan sponsors that have been using the full yield curve may elect to switch to segment rates before July 6, 2013 without obtaining IRS approval.
Annual Funding Notice Changes
Certain plans must include information about MAP-21’s impact on required contributions in their annual funding notices for the 2012-2014 plan years. If, with respect to the 2012, 2013 or 2014 plan years, a plan’s funding target using stabilized segment rates is less than 95% of the funding target using non-stabilized segment rates, the funding shortfall determined using non-stabilized segment rates is more than $500,000, and there were 50 or more participants in the plan on at least one day in the prior plan year (determined by aggregating all single employer defined benefit plans maintained by the same employer), the plan’s annual funding notice for the year must include the following additional information: (i) a statement that MAP-21 modified the method for determining the interest rates used to determine the actuarial value of benefits earned under the plan, providing for a 25-year average of interest rates in addition to a two-year average; (ii) a statement that as a result of MAP-21, the sponsor may contribute less money to the plan when interest rates are at historic lows; (iii) a table showing the FTAP, the funding shortfall and the minimum required contribution for the current and two preceding plan years, determined using stabilized and non-stabilized segment rates. (For plan years beginning before January 1, 2012, the amounts shown must be determined using non-stabilized segment rates.) MAP-21 directs the DOL to issue updated model annual funding notices to reflect these new content requirements.
PBGC Premium Requirements
MAP-21 increases PBGC premiums for both single and multiemployer plans. Flat-rate PBGC premiums for single employer plans will increase from the current $35 per participant to $42 in 2013 and $49 in 2014 (indexed for wage inflation thereafter). The premium rate for multiemployer plans will increase from the current $9 per participant to $11 in 2013.
Variable-rate premiums paid by underfunded plans, currently at $9 per $1000 of unfunded vested benefits, will be indexed for inflation beginning in 2013 and will increase by $4 in 2014 and by $5 in 2015. They will be capped, however, at $400 per participant (indexed for inflation) beginning in 2013.
Given that MAP-21 will lower defined benefit plan contribution requirements and thereby increase the risk of underfunded plan terminations, it is not surprising that the legislation also included PBGC premium increases for single employer plans - the premiums are meant to create a fund from which the PBGC can draw when it must take over an underfunded defined benefit plan. Oddly, however, the Congressional Budget Office analysis of the bill classified the premium increases as general revenue and did not account for increased costs associated with underfunded plan terminations.
PBGC Governance Changes
MAP-21 made a number of changes to the governance and powers of the PBGC. Among other reforms, MAP-21:
- Provides that, with certain exceptions protecting confidentiality, minutes of PBGC board meetings must be made public;
- Provides that the PBGC’s director and board must not participate in decisions in which they have a direct financial interest;
- Establishes risk management officer and participant and plan sponsor advocate positions and requires the participant and plan sponsor advocate to report to Congress annually;
- Requires the PBGC to obtain annual peer review of its insurance modeling systems; and
- Repeals the PBGC’s $100 million line of credit.
Transfers from Well-Funded Plans
MAP-21 extended the availability of Code Section 420 transfers, which allow plan sponsors to use surplus pension assets to fund retiree health accounts, through the end of 2021. (Under previous law, such transfers would not have been permitted after 2013.) The legislation also expanded Code Section 420 to allow transfers of surplus pension assets to fund retiree life insurance.
Though it provides welcome relief to plan sponsors struggling to fund their defined benefit plans, MAP-21 also complicates the funding process for all plan sponsors. Because the new rules are effective with respect to the 2012 plan year, plan sponsors must quickly decide whether and to what extent to switch to the new stabilized segment rates. Given that the stabilized segment rates are artificially low, plan sponsors that can afford to should consider whether to make contributions higher than the minimum required. To minimize the effect of PBGC premium increases, sponsors also may wish to offer cash-outs to terminated vested or retired participants and to increase the mandatory distribution threshold to $5000.
King & Spalding would be pleased to assist you in analyzing the implications of MAP-21 for your plans.
‘Moench’ Ado About Nothing: Circuit Courts Divided on Employer Stock Presumption
Author, Laura R. Westfall, New York, +1 212 556 2263, email@example.com.
Defined contribution retirement plans (such as 401(k), profit sharing and employee stock ownership plans) that invest in qualifying employer securities have a special exemption from a requirement to diversify plan investments. Until recently, Federal courts have applied this exception generously for employers and fiduciaries, setting up a presumption in their favor, often referred to as the “Moench presumption.” However, several recent pro-participant decisions by the U.S. Court of Appeals for the Sixth Circuit (which covers Kentucky, Michigan, Ohio and Tennessee) result in a split in how the presumption is applied by the Federal Circuit Courts and sets up the possibility of U.S. Supreme Court review.
Section 404(a)(1)(C) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) generally imposes a duty to diversify pension plan investments so as to minimize the risk of large losses (unless under the circumstances it is clearly prudent not to do so). However, Section 404(a)(2) of ERISA provides an exception from the diversification requirement for “eligible individual account plans” (“EIAPs”), such as 401(k), profit sharing and employee stock ownership plans (“ESOPs”).
In 1995, the U.S. Court of Appeals for the Third Circuit addressed whether fiduciaries of an ESOP violated ERISA’s prudence requirement by continuing to invest solely in employer stock during a period when the employer deteriorated financially and its stock declined in value. Moench v. Robertson. The terms of the ESOP made clear that the ESOP was designed to invest “primarily” in such securities. The Third Circuit held that an ESOP's fiduciary is presumed to have acted consistently with ERISA where the fiduciary invests in employer stock in accordance with the ESOP's terms. This presumption is known as the Moench presumption. The court held that a plaintiff in a suit for breach of fiduciary duty may overcome this presumption by showing unforeseen circumstances that would defeat the purpose of offering employer stock in the ESOP. The Moench case dealt specifically with ESOPs; however, Federal courts have since extended the Moench presumption to cases involving other EIAPs, including 401(k) plans that offer employer stock as an investment option.
Employers who offer EIAPs that permit investment in employer stock often are subjected to lawsuits when there is a substantial decline in the employer's stock price (often referred to as “stock drop” cases). One of the key bases for dismissal of these “stock drop” cases at the pre-trial stage is the Moench presumption of prudence, which was at issue in several cases out of the U.S Court of Appeals for the Sixth Circuit. The basic Moench presumption first detailed in the Third Circuit decision has since been adopted by the Second Circuit, the Third Circuit, the Fifth Circuit, the Sixth Circuit, the Ninth Circuit, and most recently, by the Eleventh Circuit (in Lanfear v. Home Depot).
The Sixth Circuit originally embraced the Moench presumption as established by the Third Circuit in 1995, Kuper v. Iovenko, but two 2012 cases appear to pit the Sixth Circuit against other Circuits as to how the presumption is applied.
In Pfeil v. State Street Bank & Trust Co., the Sixth Circuit held that in order to rebut the Moench presumption, plaintiffs must prove that a prudent fiduciary acting under similar circumstances would have made a different investment decision, rather than demonstrate other “unique circumstances” or prove the employer’s impending collapse or similar dire straits. Also in contrast to the holding in other Circuit Courts that have adopted the Moench presumption, the Sixth Circuit held that the Moench presumption did not apply at the pleadings (motion to dismiss) stage of a lawsuit.
In Griffin v. Flagstar Bancorp, the District Court had dismissed participants' lawsuit alleging that Flagstar Bancorp, Inc. (“Flagstar”) and certain other fiduciaries had breached their fiduciary duties by offering Flagstar stock as an investment option during a period when Flagstar's financial condition deteriorated and the price of its stock declined significantly. The District Court applied the Moench presumption and dismissed the lawsuit. On appeal, the Sixth Circuit found that participants had a plausible claim that prudent fiduciaries would have stopped offering employer stock and sent the case back to the district court for further proceedings.
State of the Moench Presumption After Flagstar in Various Circuits
The U.S. Circuit Courts that have embraced the Moench presumption apply it differently. The Second, Fifth, Ninth, and Eleventh Circuits require the plaintiffs to show some proof of “dire circumstances” or the “impending collapse” of the employer to rebut the presumption. In the Sixth Circuit, however, plaintiffs simply must prove that a prudent fiduciary acting under similar circumstances would have made a different investment decision. Further, in the Sixth Circuit only, the Moench presumption does not apply at the pleadings (motion to dismiss) stage of a lawsuit.
Employers headquartered or doing business in the Sixth Circuit (Kentucky, Michigan, Ohio and Tennessee) should be aware that Federal courts in that circuit will apply the Moench presumption differently. As a result, employers and fiduciaries defending a “stock drop” case brought in the Sixth Circuit will likely be forced to litigate the matter through discovery and plaintiffs will have a lower standard to overcome the Moench presumption later in the lawsuit.
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