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Lessons from Across the Pond: Defined Contributions Plans in the US and Ireland

  • Ireland
  • General

08-12-2017

The 401(k) plan, also known as a defined contribution (“DC”) plan, is now firmly entrenched as the primary employer-based retirement vehicle in the US. DC plans are likewise becoming the primary workplace pension vehicle in Ireland. Participation, investments and distributions have become key concerns on both sides of the Atlantic. It is therefore helpful to reflect on the ways in which DC retirement plans have evolved in both the US and Ireland and to learn from examples of best practices in each jurisdiction.

Plan landscape

In the US, the most prominent type of employer-sponsored DC plan is a 401(k) plan, named after the tax code section that provides the plan’s tax-deferred nature. A 401(k) plan is based on employee contributions and employer matching and profit-sharing contributions that are generally tax-deferred upon contribution and invested in accounts over which the employee has investment control.

In Ireland, the most common employer-sponsored DC plans are occupational pension plans, although we are beginning to see a growth in the use of master trusts. Master trusts differ from occupational DC plans in that they are multi-employer schemes. Typically, each employer sets up an individual sub-plan within an overall umbrella trust housing many separate sub-plans for each employer.

DC schemes are funded through employee and employer contributions, and employees generally have an array of investment options from which they can choose. In Ireland, a plan must be Revenue approved in order to benefit from favourable tax treatment.

Participation

Because DC plans are funded at least in part by employee contributions, employers and policymakers have recognised that broad participation is crucial to their success. The US and Ireland have both approached this issue by way of using tax incentives.

1. US

One increasingly popular method of encouraging participation is auto-enrolment. New employees are enrolled in the plan and are deemed to elect deferrals at a specified percentage of pay, unless they opt out. A variation on this approach is auto-enrolling all employees, including non-participating existing employees, at a specified rate. Some employers have instituted auto-escalation, in which the contribution percentage of an employee is increased annually by a specified percentage up to a capped amount, unless the employee opts out.

Auto-enrolment and auto-escalation are not mandated by law. However, employers are incentivised to implement these features. Annual contribution testing, referred to as the “ADP test,” mandates that as a condition of tax-favoured treatment, the employer’s highly compensated employees, on average, cannot contribute significantly more than the non-highly compensated employees, on average. Employers are therefore motivated to facilitate broad and meaningful employee participation.

2. Ireland

The Revenue Commissioners regulate the tax treatment of pension schemes and there are a number of tax incentives available, such as exemptions from:

  1. Capital Gains Tax on investments made by the scheme; and
  2. tax relief on contributions paid by the employer and the employees to the scheme, subject to certain limits.

Employer and employee contributions to occupational or workplace pension schemes are treated differently for tax purposes. Generally, employer contributions are treated as a business expense and can be deducted for corporation tax purposes. Employees can get tax relief on their contributions up to the age-related percentage of their earnings for the relevant tax year. Currently earnings are capped at €115,000. 

On retirement, members will be entitled to take a tax-free lump sum of up €200,000, subject to certain conditions. Currently, the Irish Government is preparing a roadmap for pension reform which is expected to be published by the end of 2017. It will include a mechanism for auto-enrolment. However, it remains to be seen whether the current Government will commit to any firm timetable for introducing auto-enrolment.

In the meantime, it is up to individual employers to decide whether to make membership of their DC scheme a condition of employment, thereby introducing effective auto-enrolment by contract. The vast majority choose not to do so and annual auto-escalation of contributions would not feature in the Irish DC landscape.

Investments

A critical difference between a defined benefit pension plan and a DC plan is that the employee bears the investment risk in a DC plan. For this reason, and others, there has been a great deal of attention to investment options both in the US and Ireland.

1. US

401(k) plans offer investment options selected by a plan fiduciary. The fiduciary is usually a committee of company employees with financial expertise, often assisted by an outside financial adviser.

Investment options are generally selected based on financial performance, rather than social or other factors. The US Department of Labor has taken the position that non-financial factors are generally not relevant in the fiduciary decision making process, although it has acknowledged that environmental, social, and corporate governance factors can have an impact on financial performance and can therefore be relevant to the evaluation of the investment.

Plan fiduciaries also closely monitor the fees charged for investment management and record keeping. There has been a great deal of costly litigation in the US asserting that fiduciaries have failed to adequately monitor and limit such fees. As a result, many plan fiduciaries have made efforts to negotiate lower fees and improve the transparency of plan fees.

2. Ireland

Under Irish law, pension trustees are required to provide for the proper investment of the resources of the scheme in accordance with its rules. The phrase “proper investment” in this context is generally understood to mean investing prudently as if investing for someone for whom you felt “morally bound to provide”. Trustees therefore need to assess what is a prudent level of risk in making any investment decision on behalf of members.

Most DC plans allow for member-directed investment, whereby members can select from a range of designated investment options. One advantage with member-directed investment from a trustee perspective is that they can benefit from a statutory exoneration or “safe-harbour” from liability for giving effect to members’ directions, subject to certain conditions.

Invariably, most members do not take control of the investment of their retirement account and end up invested in whatever the trustees decide is their default investment strategy. Consequently, trustees of DC schemes need to ensure that the default investment strategy is appropriate for the various cohorts of members. Traditionally, this has meant that default funds automatically reduced members’ exposure to equities or other volatile assets as they approach retirement.

However, the appropriateness of those de-risking strategies is coming under some scrutiny now that many members are no longer buying annuities on retirement. Instead, they are transferring their retirement account into tax approved retirement funds (“ARFs”). ARFs are a form of drawdown vehicle available on retirement which allow for tax efficient investment from which funds can be accessed as the need arises. If members intend on taking this approach then the de-risking path for default funds should be tailored accordingly.

Distributions

The success of a DC plan is dependent in many respects on the manner in which employees draw down their account balances. Early and rapid distributions can lead to inadequate funds for retirement. The US and Ireland each have mechanisms in place that are intended to address this concern.

1. US

401(k) plans generally allow distribution in the form of a lump sum upon termination of employment. The lump sum can be taken as taxable cash  or rolled over on a tax-free basis into an individual retirement account (“IRAs”), from which distributions in a variety of forms can be taken. Some 401(k) plans also offer instalment distributions and, more rarely, the ability to purchase an annuity with the account balance.

The expense, additional administration and fiduciary risk of offering features such as instalments and annuity purchases have discouraged some employers from offering any forms of payment other than lump sums. The US Government has taken some regulatory actions to try to encourage plan sponsors to offer these distribution features. One action was designed to reduce the fiduciary exposure for selecting an annuity product to offer under the plan. Another action was intended to provide a clear path to offering a new annuity product called a “qualified longevity annuity.” This product is designed to be purchased with only a portion of the employee’s account balance and pays an annuity benefit only if the employee lives past a certain age. This hedges against the risk that the employee will exhaust his or her account balance prematurely.

While not yet widely adopted due to concerns over administration and portability, over time it may become an attractive way to offer employees both an account balance that they control, as well as protection should they outlive their assets.

2. Ireland

Traditionally members would take a tax free lump sum on retirement and apply the balance of their retirement account to purchase an annuity.

However, with the prolonged low interest rate environment of recent years, annuities have become increasingly expensive. Following legislative change in 2011, this has meant DC scheme members are transferring their pension funds into ARFs on retirement, thereby allowing them to keep their pension pot invested tax efficiently and drawdown funds as required.

This trend poses a challenge for both trustees and employers in terms of ensuring members have access to appropriate financial advice in deciding whether to take this option on retirement and choosing the right provider in a complex market.

Conclusion

The US and Ireland face similar challenges with respect to the critical role of DC plans in retirement planning. The countries have implemented some common solutions such as tax incentives, but in other cases the approaches are quite divergent, such as the mechanism of auto-enrolment and auto-escalation. Employers and policymakers in both jurisdictions would benefit by considering the experiments, successes and issues that each country has encountered in this area.

Disclaimer

This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full terms and conditions on our website.

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