Employee benefit plans (that is, both retirement plans and welfare plans), like clothes, come in all shapes and sizes. While some plan sponsors have their plans "custom tailored" by their employee benefits attorneys and pension consultants, many companies and small business owners are pressured financially to fit themselves into "ready-to-wear" plans which they can purchase "off-the-rack" at relatively little cost. However, they may not offer the best fit in terms of meeting their employee benefit goals and objectives (although the salesman always says "it looks good on you"). This article focuses on the use of "ready-to-wear" or so-called prototype plans which have become prevalent in both the retirement plan and health insurance industries.
Ready-To-Wear Retirement Plans
When it comes to retirement plans, there are three types of "fit" which can be obtained through the use of: standardized prototype plans; non standardized prototype plans and volume submitter plans; and individually designed plans. By analogy, standardized prototype plans are much like one-size-fits-all ready-to-wear apparel; non standardized prototype plans and volume submitter plans are like off-the-rack clothes available in limited sizes; and individually designed plans are the equivalent of custom tailored clothing. As one can imagine, each category comes with a different price tag and level of customer assistance.
Standardized prototypes can be picked up for seemingly nothing (except for an opening balance deposit or load on an investment vehicle) at your local bank or brokerage house. They also come with very little technical assistance in terms of helping the customer to determine which document is right for them and how to complete the necessary paperwork.
Non standardized prototype plans and volume submitter plans are often made available at a somewhat higher cost (generally, between $250 and $1,000) through insurance companies and pension consulting firms which offer some advice and assistance to the employer in selecting the right plan and the completion of the plan document. Occasionally, they are also offered by banks and brokerage houses.
Individually designed plans are usually prepared by pension attorneys and, in some cases, pension consultants on a fee basis. Such plans can cost anywhere from $1,000 to "the sky's the limit."
All so-called prototype plans (as well as related "master" plans) consist of a basic plan and trust document (the "boilerplate" portion of the plan) together with a "fill in the blanks" and "check the right boxes" adoption agreement which provides the adopting company with the ability to insert certain information, such as the name of the plan sponsor and trustees, as well as limited plan design options, such as benefit formulas, allocation formulas, vesting schedules, eligibility requirements, etc. Because the boilerplate portion of the plan is not supposed to be modified by the employer/customer, this fairly lengthy and detailed portion of the overall plan is offered on a take it or leave it basis. Unfortunately, too many employers adopt prototype plans without carefully comparing the boilerplate to their facts and circumstances to make sure that it fits their retirement planning needs.
One of the reasons for drafting plans so that they consist of a basic plan document and an adoption agreement is to facilitate the review of the plan document by the IRS. In fact, the IRS has established the categories of plan document types mentioned above which have received varying degrees of review and pre-approval by the IRS. A prototype plan which has been pre-approved by the IRS will come with an IRS opinion letter attached to it which notifies the prototype's sponsor of the extent of IRS approval.
Although we often refer to the "sponsor" of the plan as the company which adopts a particular retirement plan, in the case of a prototype plan, the "sponsor" generally refers to the bank, insurance company, credit union, brokerage house, TPA, regulated investment company, or trade association which markets and provides such plans for use by their customers and/or members. These parties keep the general provisions of the plan current.
Standardized Prototype Plans: One-Size-Fits-All
A "standardized prototype plan" is the most basic plan document option that a company or business can select. Basically, a standardized prototype plan is "pre-approved" by the IRS and the adopting employer who wishes to utilize it need only complete the adopting employer information and determine which of the available options (with regard to eligibility, contribution and/or benefit formulas, and vesting schedules) will apply.
In exchange for IRS pre-approval, such plans must be designed to automatically meet certain coverage, eligibility, nondiscrimination, and vesting requirements described by the IRS. Although these plans, if properly adopted, will automatically pass IRS muster, they often contain provisions which are more favorable to participants than are required under regular plan rules! For example, these plans are not permitted to require employment on the last day of the plan year or more than 500 hours of service during the plan year in which a participant terminates as conditions for receiving a contribution for the year. They also require the use of shorter top-heavy vesting schedules regardless of whether the plan is actually top-heavy.
The principal advantages of a standardized prototype plan are that:
- It is relatively inexpensive to obtain.
- An employer can usually rely on its IRS pre-approved status without the necessity of applying for an individual determination letter.
Non Standardized Prototype Plans & Volume Submitter Plans: Off-The-Rack In Limited Sizes
These types of plans permit somewhat greater design flexibility to the adopting employer. Since these plans contain significantly more design flexibility than standardized prototypes, and do not contain the "automatic" features required in standardized plans, they are not fully pre-approved by the IRS. Instead, the adopting employer generally needs to submit a short form application for its own determination letter to the IRS along with a user fee of $300.
Sometimes these types of plans are offered, along with standardized prototypes, by banks and brokerage houses to potential adopting employers on a "do-it-yourself" basis. More often, however, these plans are offered through TPAs and insurance companies which generally assist the adopting employer with the process of submitting the plan for its own determination letter.
Although these plans offer a somewhat better fit for many employers, they are still "modeled" to fit a certain set of retirement plan needs and to satisfy certain IRS requirements in ways that may or may not provide the best fit for a particular adopting employer. Sometimes, the retirement planning goals of an employer or the demographics of the employer's work force are such that none of these off-the-rack plans will meet the employer's needs.
In other words, to get the "right fit" out of such a plan, it still may be necessary to take the plan in for minor alterations (that is, further amendment). Unfortunately, almost any amendment (of any consequence) made to a non standardized or volume submitter plan will cause that plan to be treated as an individually designed plan (that is, custom tailored).
Of course, the simple, low cost, do-it-yourself nature of most prototypes can also lead to serious problems for the unwitting employer.
The Emperor's New Clothes?
Like the Emperor's new clothes, the virtues of prototype plans, particularly the do-it-yourself types offered by many brokerage houses, banks and mutual fund providers, are grossly oversold. Often business owners go to their favorite stockbroker on the last business day of the year to set up a new retirement plan. The financial advisor is more than happy to hand over the brokerage's latest standardized prototype plan (with instructions) for the business owner to complete, to accept the business owner as the newest adopting employer of the brokerage's prototype plan and, of course, to take the customer's initial deposit.
What is wrong with this story? Is the business owner getting exactly what he needs? Are there holes in his new clothes? Or, worse yet, is he really not "covered" at all by a new retirement plan?
Here are just a few "true life" stories illustrating how a penny-wise and pound-foolish approach to obtaining and adopting a new retirement plan can leave the business owner out in the cold, literally:
- Because the financial advisor selling the prototype plan is neither interested in nor sufficiently trained in proper retirement plan design and adoption procedures, we have seen numerous cases of improperly and inadequately completed adoption agreements. As a result, the business owner may end up providing greater benefits to his employees than he intended. There have also been numerous cases where the adoption agreement was not completed sufficiently to even constitute the valid adoption of a retirement plan. The result: the loss of the business' tax deduction for that year's contribution.
- Many business owners improperly assume that when they adopt a standardized prototype plan through their bank or brokerage house that the financial institution will take care of their plan administration needs. Wrong! In most cases, once the adoption agreement has been adopted and the custodial account established, the financial institution has no further responsibility for the proper administration of the plan. The business owner is on his own. See The Three Flavors Of TPAs. Unfortunately, we have seen more than one case where the business owner naively assumed that the financial institution was filing his Forms 5500 for him and taking care of all that administrative stuff. See Play Or Pay —Are You Sure You Are Filing All Of The Forms 5500 That Are Required?, for a description of how the late filing penalties can really add up.
- Although many employers believe that their plans are fully qualified as a result of adopting either a standardized prototype plan or obtaining a determination letter for a non standardized plan under the short form process, there may be important determinations which need to be made in connection with that employer's plan which can only be made as part of a more thorough "full-blown" submission to the IRS on Form 5300. The kind of issue which would seem to call for a "long form" submission would be whether the adopting employer is a member of an affiliated service group. See The Aggregation of Employer and Employees . . . Affiliated Service Groups.
- Switching from an existing non prototype plan to one which is "canned," can create serious problems in some cases. Keep in mind that many employers restated their plans onto various forms of prototype plans in order to comply with TRA '86 and GUST. The problem arises where no one bothers to make a thorough and detailed comparison between the old plan and the new prototype. We have seen cases in which the switch from one plan to another has resulted in the inadvertent elimination of so-called "protected benefits," such as a form of benefit payment. This unintentional amendment will violate the Code's "anti-cutback rule" and can result in the disqualification of the entire plan.
- Some employers assume that the boilerplate contained in their prototype plan document is either unimportant or something which comes only in that one version. Once again, it is important to read and understand the entire plan you are adopting. Recently, we came across a boilerplate plan provision which requires any surplus assets remaining upon termination of the plan to be allocated to the participants! Unfortunately, the employer had been counting on getting the leftover funds back as a reversion.
Ready-To-Wear Welfare Plans?
Since welfare plans are not subject to the same "qualification" rules that apply to retirement plans, you won't see them prepared as or referred to as pre-approved prototypes. Just like their retirement plan counterparts, however, welfare plan documents (that is, medical, dental, vision, cafeteria, and disability plans as well as their related summary plan descriptions) are often provided to employers by their insurance carriers or insurance brokers on the same take it or leave it basis as the basic pension plans described above.
Based on our review of hundreds of these boilerplate welfare documents, we have noticed that many are poorly drafted and are difficult for the adopting employer to understand. Incredibly, some insurance companies and brokers try to use these same incomprehensible documents to serve as both the plan document and the plan's summary plan description (SPD). Keep in mind that an SPD is required by DOL regulations to be written "in a manner calculated to be understood by the average plan participant." Accepting these "dual purpose" plan/SPD documents is like trying to share the same set of clothes with a sibling who is a very different size than you.
What To Do?
As with so many issues relating to proper plan documentation and administration, attention to detail and follow through are absolutely critical. Who wants a plan that's too tight in the seat or has a broken zipper? Although it may be possible for a company to adopt a standardized prototype plan, and thereby save the up front cost of obtaining a custom-fitted plan in the form of either a non standardized prototype or an individually designed plan, the plan sponsor needs to recognize that the "one size fits all" nature of a standardized prototype plan may not be a close enough fit in terms of its employee benefit goals and objectives and cost constraints. In some cases, a non standardized plan or volume submitter will not provide an adequate fit.
At the very least, you should obtain the advice of a good pension consultant or employee benefits attorney to confirm that the standardized or non standardized prototype you are contemplating will generally meet your needs and that the adoption agreement has been properly completed. When it comes to your company's welfare plans, make sure you can understand them and, if necessary, don't be shy about requesting that separate SPDs be prepared.