ERISA-Extra Summer 2017

Fidelity Bonding and Fiduciary Liability Insurance—An Overview

An important aspect of operating a successful 401(k) plan is making certain that the plan and its fiduciaries are adequately protected. Fidelity bonding and fiduciary liability insurance are two different forms of protection, each having its own function in protecting the plan and its fiduciaries against claims for certain plan losses. Below we outline the basic differences between the two.

Fidelity bonding requirement

Generally, fidelity bonds are a requirement for 401(k) plans—their purpose being to insure the plan against losses caused by fraud or dishonesty on the part of those who handle plan assets. Every fiduciary of an employee benefit plan and every person who “handles plan funds or property” generally must be bonded according to ERISA requirements (unless covered by an exemption).1

Plan officials who must be bonded include the plan administrator and those officers and employees of the plan or plan sponsor who handle plan funds by virtue of their duties relating to the receipt, safekeeping and disbursement of plan funds.2 Additionally, the bonding requirement may extend to service providers whose duties and functions involve access to plan funds or decision-making authority that can give rise to a risk of loss through fraud or dishonesty.3

Bonds generally must be obtained from a surety or reinsurer named on the U.S. Department of the Treasury’s Listing of Approved Sureties, in Department Circular 570.4 Generally, deductibles or other similar features that transfer risk to the plan are prohibited, although nothing in ERISA prohibits application of a deductible to coverage in excess of the maximum amount required under ERISA.5

Amount of the bond

The required amount of the bond—which must be fixed at the beginning of each plan year—is based on the highest amount of funds handled by each person handling funds or property in the preceding plan year.6 Generally, the amount of the bond must not be less than the greater of $1,000 or 10% of the amount of funds handled.7 However, it need not be more than $500,000, unless specifically required by DOL.8 If a plan holds employer securities, the DOL may require a bond of up to $1 million.9 The DOL may, following notice and a hearing, require a bond greater than the $500,000/$1 million limits described above.10

Paying for the fidelity bond

Because the purpose of the ERISA bonding requirements is to protect employee benefits plans, and because such bonds do not benefit plan officials or relieve them from their obligations to the plan, a fidelity bond may be purchased with plan assets.11

Fiduciary liability insurance

Unlike a fidelity bond, fiduciary liability insurance generally insures the plan against losses caused by breaches of fiduciary responsibilities.12 This insurance is designed to protect fiduciaries that violate the complex fiduciary rules set forth in federal rules, regulations and court rulings. Fiduciaries also may want additional protection from liability for acts of co-fiduciaries. 

Fiduciary liability insurance is neither required by nor subject to the ERISA rules on fidelity bonds.13 However, ERISA allows a plan to purchase insurance for its fiduciaries or for the plan itself covering losses occurring from acts or omissions of a fiduciary.14 Any such policy paid for by the plan must permit recourse by the insurer against the fiduciary in the case of a fiduciary breach.15 Nothing, however, prohibits the fiduciary from purchasing insurance to protect him or herself against the insurer’s recourse rights.16

This is a broad overview of the relevant rules, and many additional rules may apply. If you would like to know more, please talk with your UBS Financial Advisor.

Participant Loan Programs— Know the Rules

Although 401(k) plans are not required to offer loans to participants, they are allowed to do so, and the large majority of plans do. According to the Plan Sponsor Council of America, approximately 89% of 401(k) plans permit their participants to take out loans from their accounts.17

Plans that incorporate participant loan programs must comply with several sets of somewhat related rules to avoid disqualification of the plan, prohibited transaction treatment and adverse tax consequences for plan participants who take loans. Below is a broad overview of the relevant requirements.

Avoiding “prohibited transaction” treatment

Under ERISA’s prohibited transaction provisions, participant loans must meet several conditions in order to come within an exception to the ban on plan loans to parties in interest.18 (The Internal Revenue Code has similar restrictions, though their application is to a slightly narrower set of individuals).19

The loan program must be set forth in the plan.20 At a minimum, the plan (or a written document forming part of the plan) must contain an explicit authorization for the plan fiduciary responsible for investing plan assets to establish a participant loan program.21 In addition, the participant loan program must include (1) the identity of the person or positions authorized to administer the participant loan program, (2) the procedure for applying for loans, (3) the basis on which loans will be approved or denied, (4) any limitations on the types and amounts of loans offered, (5) the procedure for determining a reasonable rate of interest under the program, (6) the types of collateral that may secure a participant loan, and the events constituting default and the steps that will be taken to preserve plan assets in the event of such default.22

Loans must be made available to all participants and beneficiaries on a reasonably equivalent basis.23 Loans must be made available to participants and beneficiaries regardless of race, color, religion, sex, age or national origin.24Consideration must be given only to factors considered in a typical business loan situation and may include the applicant’s creditworthiness and financial need.25

Loans cannot be made available to highly compensated employees in an amount greater than the amount made available to other employees.26 The program must—based on all relevant facts and circumstances—not operate to exclude large numbers of plan participants from receiving loans under the program.27However, the program will not fail to meet this requirement merely because loans are limited to either a maximum dollar amount or a maximum percentage of the participant’s vested accrued benefit.28

Loans must bear a reasonable rate of interest.29 The rate charged must be commensurate with rates charged by persons in the business of lending money under similar circumstances.30

Loans must be adequately secured.31 The value and liquidity of the security must be such that—judged in the light of normal commercial standards—the plan administrator may reasonably anticipate that loss of principal or interest will not result from the loan.32 A participant’s vested accrued benefit under a plan may be used as security for the participant’s loan—however, no more than 50% of the present value of a participant’s vested accrued benefit may be considered by a plan as security for the outstanding balance of all plan loans made to that participant.33

Avoiding treatment as a taxable distribution

Generally, in order for a loan to a participant to not be deemed a taxable distribution under the Internal Revenue Code, section 72(p) incorporates rules very similar to  those discussed above. Further, certain additional requirements must be met, including the following:

Enforceable agreement.34 The loan must be evidenced by a legally enforceable agreement specifying the amount and date of the loan and the repayment schedule.35 The agreement must be in writing, although it may be delivered in electronic form under a system that satisfies applicable requirements.36 The agreement need not be signed if it is enforceable under applicable law without being signed.37

Term. The term may not exceed five years (except for certain home loans).38

Payments and amortization. The repayment schedule must provide for substantially level amortization of the loan over its term with payments to be made at least quarterly.39

Borrowing limits. Borrowed amounts may not exceed specified limits—generally, a plan may not permit loans to a participant that exceed the lesser of (1) $50,000, or (2) the greater of (a) 50% of the participant’s vested balance or (b) $10,000.40

Correction methods

If a plan violates these or other rules, correction methods may be available. For violations of Code rules, plans may be able to use the Voluntary Correction Program that is part of the Employee Plans Compliance Resolution System (EPCRS). For ERISA violations, relief may be available through the DOL’s voluntary fiduciary correction (VCP) program.

If you have additional questions about your plan’s existing loan program or wish to implement a loan program, please contact your UBS Financial Advisor.

Correcting Excess 401(k) Contributions41

In addition to complying with minimum coverage requirements, 401(k) plans generally must satisfy the actual deferral percentage (ADP) test (or certain ADP safe harbor provisions) every year. The ADP test places limits on the amount of elective contributions that can be made by highly compensated employees (HCEs).

What is an “excess contribution”?

For a plan year, “excess contributions” refers to the amount by which the elective deferrals made by HCEs42 exceed the maximum allowed under the ADP test.43 

Essentially, the ADP test compares the average rate at which HCEs defer with the average deferral rate for non-HCEs (NHCEs). If the difference exceeds certain limits, the plan essentially has three choices for correcting the excess contributions.

Three available correction methods

The three methods described here are the exclusive methods allowed for correcting excess deferral contributions,44 although the plan administrator is permitted to combine the three methods for purposes of correcting excess contributions.45

Distribution option. The plan can distribute the excess contributions and any plan income attributable to those contributions to the appropriate HCEs.46Generally, the distribution method requires four steps—calculating the dollar amount of excess contributions, apportioning the total excess contributions among HCEs, determining the income allocable to the excess contributions, and distributing the apportioned excess contributions and allocable income.47

Distributions must be made within 12 months after the close of the plan year in which the excess contribution arose.48 However, if the distributions are returned more than 2½ months following the close of the plan year, the employer is subject to a 10% excise tax.49 For plans that are “eligible automatic contribution arrangements,” corrective distributions can be made up to six months following the end of the plan year without incurring the excise tax.50 The distributions are taxable to the employees.51

Recharacterization option. Alternatively, the plan can recharacterize the excess contributions as after-tax contributions.52 To use the recharacterization method, your plan must have a provision allowing such contributions,53 and the recharacterization must occur no later than 2½ months after plan year-end.54Amounts recharacterized as after-tax contributions are includable in the highly compensated employees’ income for federal income tax purposes.55

Additional contributions option. Another alternative is to make qualified matching contributions (QMACs) or qualified nonelective contributions (QNECs) for the NHCEs.56 Generally, matching contributions are employer contributions made on an account of certain employee contributions, employee elective deferrals or forfeitures.57 Nonelective contributions are employer contributions (other than matching contributions) that the employee can’t elect to have paid to him in cash or other benefits, instead of being contributed to the plan.58“Qualified” matching and nonelective contributions (QMACs and QNECs) must meet additional requirements.59

Note however that recently proposed IRS regulations would make it possible for plans to use forfeitures to fund QMACs and QNECs. Specifically, the proposed regulations would require that QMACs and QNECs be nonforfeitable when allocated to participant accounts rather than when contributed to the plan.60This change would give plan sponsors that choose to correct excess contributions by making additional contributions to the plan additional flexibility with respect to how those contributions are funded. Though these changes are scheduled to apply to tax years beginning on or after the date the regulations are finalized, the IRS has stated that taxpayers may rely on the proposed regulations for periods preceding the proposed effective date.61

 If you have questions about correcting excess 401(k) contributions, please contact your UBS Financial Advisor.