Retirement Heist

by Ellen E. Schultz

  “At some point in the future, the IRS may well take the position” that supplemental executive pensions moved into a regular pension plan “violate the ‘spirit’ of the nondiscrimination rules,” he wrote. Companies have been able to blow the practice past the IRS because, when they file the amendments, they don’t explicitly note the purpose of the change and include it with a flurry of other technical amendments. In any case, the IRS staff is stretched too thin to scrutinize the dozens of pages of complex calculations companies perform to prove that they don’t discriminate. In contrast with a deduction a freelance worker might take for a home office, the IRS generally accepts an employer’s word that its pension plan doesn’t discriminate. To halt the practice, Congress would have to end the flexibility that companies now have in meeting the IRS nondiscrimination tests, which is something employers have strongly opposed.

  And though companies are supposed to disclose details of the compensation of their top officers, they maintain that, because the executives’ benefits are now part of the broad-based plans, they are no longer considered to be executive benefits, so disclosure isn’t required.

  DISCRIMINATION 101

  These techniques were spawned in the early 1990s, when the IRS issued new rules intended to rein in an employer’s inclination to set up and run retirement plans for the favored few. To get tax breaks that allow them to deduct contributions and have the money grow tax-deferred, companies had to prove that their pensions, profit sharing, and 401(k)s don’t discriminate.

  Employer groups hadn’t stood idly by awaiting these new regulations. As they had when FASB crafted new pension and retirement benefits accounting rules, employers and their consultants weighed in, demanding flexibility. They got their wish.

  As a result, employers don’t have to actually treat everyone participating in the pension or savings plan the same. They are allowed to have a certain amount of “disparity,” or inequality, as long as they can pass certain tests showing that they weren’t going too far.

  The first test is the so-called coverage test, which essentially determines that if 100 percent of the higher-paid executives are going to participate in a plan, then at least 70 percent of the lower-paid must also participate.

  Thus, in a perverse way, this anti-discrimination rule makes it legal for employers to exclude 30 percent of their low-paid workers from a particular plan right off the bat.

  Even before applying the coverage test, employers generally exclude many part-time workers, independent contractors, and “leased” employees, such as janitorial, security, and cafeteria workers. These categories make up about 25 percent of the U.S. workforce.

  The diminished pool of employees “eligible” to participate don’t necessarily get their feet in the plan right away. They must first pass certain hurdles. These might require that they be twenty-one or older, work one thousand hours, or reach December 31 of the year following the year they were employed.

  Excluding employees doesn’t just save money: It enables higher-paid employees to receive the maximum benefits. Under IRS rules, the amount higher-paid workers contribute to a 401(k) can’t be greater than a certain percentage of what the lower-paid contribute. But if the lower-paid contribute too little, the contribution gap will be too great, and the higher-paid won’t be allowed to contribute the maximum ($16,500 in 2011). The simplest way of closing the gap is to exclude as many lower-paid workers as possible. In the fast-food, retail, and hotel industries, it’s common for at least half the workforce to be locked out of the savings plans.

  Inadvertently, this kind of legal salary discrimination can have a disproportionate impact on women and minorities. For years, Hugo Boss, which makes high-end clothing, excluded the 80 or so workers at its warehouse in Midway, Georgia, from the 401(k) retirement plan that it offered to the 232 employees and managers at its Cleveland headquarters. With their low salaries, the warehouse workers, mostly black women, would have contributed little to their accounts, causing the plan to fail another discrimination test, one that compares the contributions of the low paid and the highly paid. If the gap is too wide, the highly paid can’t contribute the maximum to their accounts ($16,500 in 2011). Ironically, the easiest way to prevent this outcome is to exclude low-paid workers altogether.[14]

  Countless studies and surveys lamenting the low participation rates of employees barely making a living wage have portrayed low-income workers as apathetic about saving money. Similar studies also trot out statistics about the low savings rates of blacks and Hispanics, and of women compared with men.

  Lorenzo Walker, one of the warehouse workers at Hugo Boss, didn’t fit this stereotype. Walker, in his fifties, was earning only $6.50 an hour but still wanted to save some money for his retirement. He preferred an account like a 401(k), where his contributions would be withheld automatically from his paycheck, perhaps receive a matching contribution from his employer, and grow untaxed. His wife, a nail technician, had no retirement plan. Social Security was going to be the couple’s primary source of income, plus whatever Walker could squirrel away. He’d had a 401(k) at a prior job at a poultry-processing factory and had saved up about $11,000.

  So one of the first things he asked when he started his job at Hugo Boss was whether the company had a retirement plan. The company said no. In fact, the company actually did have a 401(k) and the warehouse workers were shut out because their low incomes and savings rates would drag down the tax breaks of higher-income employees.

  In 2006, the company agreed to let the employees’ union, Unite Here, set up a separate 401(k) for the warehouse and help run it. In exchange, the company would provide small matching contributions to their plans. The arrangement enabled the warehouse workers to have a 401(k) and receive company contributions, without affecting the Cleveland employees at all.

  Many companies have these separate-but-unequal arrangements, with different 401(k)s for lower-paid and higher-income employees, who often get bigger company contributions. IRS rule 401(a)(5) says “a classification shall not be considered discriminatory merely because it is limited to salaries or clerical employees.” In plain English, a company can have a lousy plan covering clericals and a terrific plan for the professionals. “Cadillac plans versus ghetto plans” is what one lawyer called them.[15]

  There’s another benefit to excluding low-paid workers from the retirement plans, or segregating them to less generous plans: It makes it easier for plans that executives participate in to pass another required discrimination test, called the “benefits” test. To prove it is nondiscriminatory, the plan must pay the low-paid participants, as a group, at least 70 percent of what the higher-paid get.

  GERRYMANDERING

  This is where the real creativity comes in. The tests don’t require employers to compare the benefits of individuals; they can compare ratios of the benefits received by groups of highly paid with those of groups of lower-paid employees. Benefits consultants developed software that enabled them to gerrymander employees into hypothetical groups. One might have only highly compensated employees, or HCEs, to use the technical lingo. Another might have only lower-paid employees. Still another group might include only executives and low-paid seasonal workers hired during the holiday.

  The goal is to reduce the gap—albeit artificially—between the high-paid and low-paid in each group. To make the benefits of the low-paid, as a group, appear bigger, companies like CenturyTel count Social Security as part of employees’ pensions. Employers might also contribute a small amount to the savings plans of low-paid workers—which makes their percentage of benefits look higher. This helps the plan pass the test, and doesn’t cost the company anything, because the temp workers won’t stick around long enough to vest and forfeit the employer’s contribution.

  This works with pensions as well. In 1999, for example, Royal & Sun Alliance Co., with the assistance of PricewaterhouseCoopers, amended its pension to award a small increase to one hundred employees. One employee got a pension increase of an additional
$1.92 a month in retirement. This enabled the company to pass the discrimination tests and award eight officers and directors significantly more. The largest payment went to John Winterbauer, the sixty-year-old vice president of human resources, who got an additional $5,300 a month for life, paid out in a lump sum of $792,963.

  PricewaterhouseCoopers, which pioneered many of these techniques, has used them on its own workforce. The accounting and benefits consulting giant provides its partners’ contributions to the 401(k) with a 200 percent matching contribution—putting in $2 for every $1 the partners contribute—but only 25 percent for lower-paid workers.

  The plan passes the discrimination test in part because new employees joining the plan receive a 200 percent matching contribution in the first month of participation, which is always in December, which is also when the company tests the plan for discrimination. This practice has the effect of making the contributions to the lower-paid, as a group, appear higher, which helps the plan pass the test.

  YOUNG AND VESTLESS

  Another clever way to pass the discrimination tests is by providing matching contributions. A common scenario is that an employer will chip in fifty cents for every dollar an employee contributes to his 401(k), up to 6 percent of pay. An employee making $50,000 who contributes 6 percent of pay ($3,000) to his 401(k) will get a matching contribution from his employer of $1,500.

  Employers say they provide matching contributions to encourage lower-paid and younger employees to participate. That’s true, but a bit disingenuous. If that were the whole story, the contributions would be the employees’ to keep. In reality, lower-paid workers commonly forfeit the employer contribution, because of lengthy vesting requirements, which used to be as long as ten years but now are three years for savings plans and three to five years for pensions.

  A company with high turnover can afford to provide a more generous match, since ultimately it won’t pay it all out. Employers use the forfeited matching contributions to make future contributions, which reduces their costs. A 2 percent match will cost only 1 to 1.5 percent, because of forfeitures.

  When employees forfeit the employer contributions, they also forfeit the earnings on those amounts. This means that the employer not only gets its contribution back; it also receives tax-free earnings on the money.

  The vesting period can be stretched out in other ways. Some plans have required employees to be employed on the fifth anniversary of the day they were hired in order to vest, or on the last day of the fifth year. Wal-Mart employees must work for 1,000 hours in a consecutive twelve-month period to be eligible to participate in the profit-sharing plan. In 2009, 79,339 employees forfeited some of their benefit when they left.

  The company then redistributed the money to the remaining employees “based on eligible wages,” meaning that some company contributions originally destined to aid lower-paid employees ended up benefiting longer-service, higher-paid employees.

  Employers are perennially seeking to loosen the discrimination rules even further. They scored a big coup with Automatic Enrollment, a provision in the Pension Protection Act that became effective in 2007. This was touted as a way to improve participation. The theory is that poor participation rates are the result of worker apathy and that if they are automatically enrolled, it would solve that problem. It’s hard to see how it will help improve savings rates: Employees can drop out at any time, and they aren’t forced to contribute. At Wal-Mart, 8 percent of the employees who are considered participants in the retirement plan have nothing in their accounts.

  What the new rules do, however, is give employers a free pass from the discrimination rules: As long as a plan merely offers automatic enrollment, employers don’t have to worry about passing discrimination tests.

  Chapter 9

  PROJECT SUNSHINE

  A Human Resources Plot to Dissolve Retiree Benefits

  AT AGE NINETY-TWO, John Wesley Galloway had beaten the actuarial odds for someone who’d spent a lifetime in hard labor in an iron foundry. For thirty years, he’d churned out parts for Kelsey-Hayes, the Rockford, Illinois, unit of a Midwestern farm equipment maker. Galloway had also beaten even more impressive odds: He’d survived more than two decades with his retiree health coverage largely intact, despite the relentless efforts of his former employer—and the current owner of the retiree portfolio he’s part of—to take it away. The company and its successors had used almost every trick in the book: legal maneuvers, illegal maneuvers, restructuring games, and deceit. Despite myriad attempts to whittle down the coverage for Galloway and his wife, Pansy, it was still intact.

  But in 2006, and again in 2008, the plan administrator came up with a new trip wire. It sent Galloway a letter telling him that his health coverage would be canceled unless he could prove he wasn’t dead. If the company didn’t receive a notarized affidavit attesting to his continued presence on earth, the company, TRW, would cancel this coverage. Galloway had heard about IRS audits, but not death audits. This is just one of the many cost-saving maneuvers consultants have dreamed up in recent years to help their clients reduce the cost of their retiree health plans. Over the past twenty years, Galloway had just about seen it all. And there was more to come.

  Galloway had never worked for TRW but, like millions of other retirees, including the Western Electric and AT&T employees who ended up with Lucent and the McDonnell Douglas retirees who ended up at Boeing, he was part of a portfolio of retirees that had passed through several owners’ hands. Not surprisingly, none of the owners felt like paying the retirees’ benefits, but they couldn’t cut the pension plans, which are protected by law. Yet the law protecting retiree health benefits wasn’t as ironclad as they thought. So this was where employers directed their legal firepower.

  The quest to end Galloway’s retiree health coverage actually began at another company, Massey Ferguson, which bought the company he worked for, Kelsey-Hayes. Massey Ferguson isn’t a household name outside the Farm Belt, but for most of a century it was an almost iconic fixture in the Midwest. Founded in 1847 by a storied Canadian family whose descendants include the actor Raymond Massey, the company thrived until the agricultural recession in the 1970s dried up demand for its combines and tractors. The struggling company subsequently passed through many hands, all eager to extract a profit, at whatever cost. Conrad Black, the controversial Canadian businessman, gained control of the company in the late 1970s and added it to the portfolio of mining, media, and other businesses owned by holding company Argus Corp. The company didn’t thrive, and Black resigned as chairman of Massey Ferguson in 1979 and moved on to become a media baron and a prison inmate after being convicted of mail fraud and obstruction of justice.[16]

  Black may have been gone, but he was replaced by a new chief executive cut from the same cloth: Victor A. Rice, a pugnacious Brit who claimed to be the son of a chimney sweep. In 1986, Rice changed the name of the company from Massey Ferguson to Varity (after his initials), bought a couple of companies, including Kelsey-Hayes, the one Galloway worked for, and began looking for ways to boost profits. The retirees were an obvious resource.

  Soon after ascending the throne, Rice demanded a status report on retiree costs. The managers at the company’s Buffalo, New York, headquarters gave their boss what they assumed was good news. The pension was overfunded, and retiree health costs were “low.” But Rice wanted to cut retiree benefits anyway, even for the most elderly. A memo summarizing his “Philosophy & Objectives” made this clear. “The Company is not committed to maintenance of a retiree’s standard of living.”

  Varity’s managers sprang into action, but nothing they suggested was dramatic enough to satisfy Rice. He told them to be a little more creative, and he didn’t let up. Under increased pressure to deliver a plan that would generate big savings, human resources manager Jill Wellman produced this snappish memo: “You have asked that I be inventive in coming up with a solution,” she wrote to her superiors a week before Christmas in 1986. “As far as I can determine there is
only one solution” to save the company the most money, she concluded. “That would be the death of all existing retirees.” This happy outcome was, alas, many years in the future.

  So Wellman’s memo went on to detail “more practical” but “not necessarily legal” solutions to help her employer meet its cost-cutting goals. One option: Establish “an offshore company responsible for the retirees but not accountable under United States law and have it go bankrupt and thus terminate the plans.” Another: Simply terminate the benefits, wait for the retirees to sue, and then drag out the litigation until the retirees gave up or died.

  But Paul Pittman, a benefits and compensation manager, was worried that Wellman’s suggestion about provoking a lawsuit was risky. The company had promised the benefits to both salaried and union retirees. Varity’s lawyers prepared a “litigation risk” report, which noted that the company had promised the benefits. “Worse yet,” the report had said, “there is language in many of the contracts, booklets, and general descriptive material that implies a lifetime commitment. We would never succeed in court.”

  Indeed, Wellman herself had drafted a form letter she called a “death letter,” which for years she sent out to widows of retirees, promising health coverage for life. A letter to one Flossie Pietila reassured her: “Mrs. Pietila, our health and dental benefits will continue for the rest of your life at no cost to you.”

  Pittman suggested lying to the retirees. In his memo, he called this the “pleading” strategy. The company should tell retirees “that the burden of medical expenses amongst US retirees is unbearably high and would ultimately cause Varity Corporation to cease trading in the US,” Pittman suggested, “and that this would necessitate not only a loss of medical benefits, but also possibly the loss of some pension rights as well.” Although this wasn’t true, if the retirees believed it, they might agree to benefit reductions.