Pension Trends and the Self-Employed [Reprint 2022 ed.] 9781978815575

Table of contents :
Preface
Contents
I Introduction
II Pension plans and social security
III Legislative proposals
IV Financing methods
V Impact of statutes and regulations
VI Methods and mechanics of trust administration
VII Investing for the qualified fund
VIII Pensions in our economy
IX Summary and conclusion
Notes
Appendices
Bibliography

Citation preview

Pension

Trends and the

Self-Employed

The Rutgers Banking Series consists of books in the field of American banking which have grown out of research at the Stonier Graduate School of Banking

Pension Trends and the Self-Employed by Richmond M. Corbett

Rutgers University Press • New Brunswick, New Jersey

Copyright © 1961 by Rutgers, The State University Library of Congress Catalogue Card Number: 61-10258 Manufactured in the United States of America by H. Wolff, New York

Preface

A proposed act of Congress, an amendment to the Internal Revenue Code known as H.R. 10, which will affect ten million professional and other self-employed taxpayers in the United States: this is the Keogh bill. It has been variously referred to as the Jenkins-Keogh bill, the Keogh-Simpson bill, the SmathersMorton-Simpson-Keogh bill, or the Self-Employed Individuals' Tax Retirement Act. Representative Eugene J. Keogh of New York was the original sponsor of the bill, and has continued to be in the forefront of the legislation. This is not a textbook on the Keogh bill, but it will provide the reader with a basic understanding of the bill and the background information to evaluate its significance, and to see how it fits into the old age security pattern. The book is designed for the use of self-employed persons and for their advisers and consultants—the insurance men, trust officers, attorneys, and others who will be called upon to serve this important segment of our population. It does not attempt to anticipate and solve all the legal and statutory complications or the administrative problems arising out of the legislative proposal, but the impact and possible effects of the bill are studied along with the extent to which banks and trust companies, insurance companies, and investment companies may participate in this important saving program for some millions of our self-employed citizens. Without pretending to be comprehensive, it is the purpose of the book to stimulate discussion and to promote further study of pension trends for employees and the self-employed, to assist

vi

Preface

in anticipating possible changes and improvements which may develop in the legislation, and to present administrative suggestions for the creation and operation of pension plans for the selfemployed and their employees. It is our hope that this book will help the reader to understand the role of the Keogh bill and its various amendments in the development of private pension plans. RICHMOND

Chicago, Illinois June, 1961

M.

CORBETT

Contents I

Introduction

3

II Pension Plans and Social Security

The Urge for Security

6

8

Just a Hope 8 Just Good Business 9 Social Security and Related Influences 10 Basic Protection 10 Floor of Protection on Escalator 11 Most Self-Employed Now Included 12 The Surge for Security 12 Taxes and Pensions 13 Disability and Early Retirement Provisions 14 Other National Retirement Plans 15 Social Security—A Costly Bargain 15 A Big Load for Our Future Citizens 16 The Present Trend in Pension Coverage 16 Welfare Plans Cover More Employees Than Pension Plans 17 Private Plans Supplement Social Security 18 III

Legislative Proposals

20

Early Proposals for the Self-Employed The Keogh-Reed Bill 21 Later Bills 22 The Ray Bill 23

21

Contents

The Smathers-Morton-Keogh-Simpson Bill 24 Hearings and Proposed Amendments 24 Other Revisions 26 Treasury Proposals and Senate Amendments Tax Relief in Other Countries 29 British Counterpart 29 Canadian Income Tax Act 30 New Zealand and Australia 31 IV

Financing

Methods

33

Insurance Funding 35 Qualified Annuity Policy 35 Insured Pensions for Employees 36 New Features and Conflicts 37 Disability 38 Refund of Excess Contributions 38 Another Variation for the Insurance Industry Trust Funding 40 Qualified Trust 40 "Pooled" or "Commingled" Funds 41 Trust Flexibility 42 Trust Funding Continues in the Lead 42 Differences in Insurance and Trust Funding 44 Insurance Problems 44 Adaptability of Trust Funding 45 Competition Continues 45 Both Funding Methods Needed 47 V

Impact

of Statutes

and Regulations

Contractual Requirements Statutory Limitations 49 Perpetuities 50 Accumulations 52 Alienation 52

49

48

Contents

Statute of Wills 54 Insurance Limitations 54 Trust Provisions and Problems 55 Refunds or Excess Contributions 55 Investments 56 Owner-Employees 56 Releases 56 Resignation 57 Amendment 57 Transfers 58 SEC Considerations and Collective Investment Pooling of Mortality 59

58

Tax Deductibility of Contributions 60 Contributory Plans and Nondeductible Contributions Taxability of Distributions 63 Premature Distributions 63 Regulations 64 Alternative Tax Relief 64 Professional Associations with Corporate Characteristics 64 VI

Methods and Mechanics of Trust Administration

Administrative Complexities 66 Individual Accounts 67 Mechanization 67 Annual Statements and Reports 68 Advertising and Promotion 69 Costs and Fees 69 Other Cost Elements 70 Fees 7 1 Types of Trusts 72 VII

Investing for the Qualified Fund

74

Collective Investments Contemplated

74

66

Contents Balanced or Dual Funds

75

Permissible Investments

75

Federal Reserve Standards Prior Limitations Removed Voting Stock Limitation Issuance Stamp Tax Prohibited

77 78 78

79

Transactions

79

Freedom to Choose Investment VIII

Pensions in our Economy

Medium

80

82

Pensions and the Flow of Saving and Investment Economic Variables and Inflation Effect of Academic

Concepts

The Impact of Pensions

83

84

85

Equity Investments and Variable Annuities Pensions and the Cost of Living IX

Summary and Conclusion

go

Does H.R. 10 Solve the Problem? Opposition

88

95

95

Claims of Proponents

95

What's Ahead for the Self-Employed? Future of the Pension Structure Notes

101

100

97

86

Appendices A

OUTLINE OF MAIN PROVISIONS OF THE KEOGH BILL, H.R. LO, AS PASSED B Y THE HOUSE OF REPRESENTATIVES

B

OUTLINE OF MAIN PROVISIONS OF H.R. 1 0 AS REPORTED TO THE SENATE

(86th Cong., 2nd Sess.—ig6o) 111

B Y ITS COMMITTEE ON FINANCE C

(86th Cong., ISt SeSS.—lQ^Q)

OUTLINE OF MAIN PROVISIONS OF H.R. IO AS INTRODUCED IN THE HOUSE OF REPRESENTATIVES, WITH NOTATIONS OF THE PRINCIPAL VARIATIONS UNDER S. 5 9

AS INTRODUCED IN THE

(8jth

SENATE

Cong., ist Sess.—ig6i) 116 D

ILLUSTRATIVE PROVISIONS OF A DECLARATION OF TRUST B Y A BANK OR TRUST COMPANY CREATING A COLLECTIVE QUALIFIED OR RESTRICTED RETIREMENT FUND FOR SELF-EMPLOYED INDIVIDUALS

E

ILLUSTRATIVE AGREEMENT

PROVISIONS BETWEEN

OF

THE

BANK OR TRUST COMPANY

AN INDIVIDUAL INTERVIVOS SELF-EMPLOYED

INDIVIDUAL

122 TRUST

AND A

133

F

ASSOCIATIONS AND ORGANIZATIONS FAVORING THE KEOGH BILL

G

CHART: TAX-DEFERRED DOLLARS

H

TABLE: TAX SAVINGS UNDER THE KEOGH BILL

I39

143 I45

1

COMPARISON OF DEFERRED COMPENSATION PLANS

146

J

ILLUSTRATION OF THE USE OF L I F E INSURANCE UNDER H.R. 1 0

I48

105

Appendices K

COMPARISON OF T A X ON L U M P S U M DISTRIBUTIONS

L

COST OF E M P L O Y E E SECURITY BENEFITS

Bibliography

154

152

Pension

Trends and the

Self-Employed

I

Introduction

Today, retirement has begun to symbolize a dream—not a dread. Pension and welfare funds with their tremendous development in recent years have emerged as an established force in our economy. Private pension plans now cover over twenty million employees. This coverage is increasing at the rate of nearly one million each year. Over $4 billion are contributed annually to such programs, reserves of private pension funds now exceed $40 billion, and public retirement funds have aggregate assets of over $50 billion. New concepts and influences have built up a pension pyramid, spreading throughout our economy—to every part of the country. But—self-employed persons have always been denied the benefits of a pension plan. These self-employed persons—numbering about ten million, an important segment of our workersare the victims of a kind of legislative discrimination. A corporation can set aside retirement funds for its employees and, for tax purposes, charge it to the cost of doing business. But the self-employed (lawyers, accountants, doctors, dentists, farmers, and many others) get no such tax relief on funds they may set aside for retirement. Whatever they save is subject to the full tax, as are the subsequent earnings on these savings.

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

4

Considerable agitation to bring about a reform has been developing in recent years and a number of bills have been presented to each Congress since 1951. The Keogh bill has always had the most general support. It was designed to encourage selfemployed persons to establish voluntary pension plans in order to make some provision for their retirement. The later amendment to the Keogh bill, reported to the United States Senate by its Committee on Finance, required the self-employed persons to cover in these retirement plans on a nondiscriminatory basis any employees they may have or may later acquire. It permitted a self-employed person to deduct a limited amount of earned income, up to 10 per cent or $2,500, whichever is smaller. The Keogh bill was passed by the House of Representatives in two separate sessions, and the Senate considered it in its amended form. Senator Smathers introduced a new version as S. 59 in 1961. Representative Keogh made substantial changes in the new H.R. 10 as presented to and passed by the House in the same year. The highlights of the bill as first passed by the House, as reported to the Senate, and as revised and passed in 1961, are included in the Appendices. This book reviews the growth and development of private pension plans and the extent to which the legislative proposals for the self-employed are a natural development in the continuing quest of our citizens for security in old age. It notes the influence of social security on pension trends and savings for retirement. It outlines the history of the legislative proposals and laws leading up to the recent versions of the Keogh bill, including comparable tax relief measures now enacted in Great Britain and Canada. The various amendments of the bill proposed to the House of Representatives and the Senate are described. Variations between insured and trust-funding methods of financing pensions, and the influence of these factors on the legislation are examined. The relationship of savings to investment and inflation is discussed, as well as the questions of whether tax deductions and savings for retirement are antiinflationary, and whether or not the purchase of equity securi-

Introduction

5

ties may adjust for inflationary trends or variations in the cost of living. The extent of the injustice involved in denying pension benefits to the self-employed is analyzed. Our tax laws are complicated and highly technical. When these laws are amended, it will take time—perhaps years—before the regulations, rulings, and court decisions clarify Congressional intent and establish Treasury interpretations. A knowledge of the background of the law and the trends leading up to these statutory changes helps us to understand them and to be better prepared for the future unfoldment of the tax laws in the particular area involved.

II Pension

plans

and social security The "diffusion of literacy and average comfort and well-being among the masses is one of the major achievements in human history and is . . . an enormous contribution to civilization. . . . The task of democracy is to relieve mass misery and yet preserve the freedom of the individual." 1 Pension and welfare funds have made a partial contribution toward the accomplishment of this objective. Pensions are not a product of any one concept or influence. They are, rather, the result of an accumulation of forces developing over the years from the basic human urge for security. The nationwide emphasis on this development is due to the increasing percentage of aged persons in our population and the inability of the aged to share equally in the fruits of economic progress.2 There were five million people over 65 in 1920. There are over 15M million today, with a predicted 19M million by 1970. Growing at a greater rate than the younger segment of the population, the aged are likely to increase from 8.6 per cent to 9.4 per cent of the population residing in the United States. In terms of relative proportions, these older persons constituted 4.7 per cent

Pension pians and social security

7

of our total population in 1920, and are expected to be over 11 per cent by 1980.3 Many factors have contributed to the growth of pensions. Medical science has made rapid strides since 1915 when there were 13.2 deaths per 1,000 of population. In 1950, that figure had fallen to 9.6 per 1,000. The expectation of life at birth in 1900 was 47.3 years.4 In 1950, it was 68.2 years, and the 1960 census shows about 70 years. But that is a lifetime figure. Once a person reaches his retirement range of years, he's going to live quite a while longer. At 65 his expectation of life is about 14 years. That means he has about a fifty-fifty chance to live to age 79 or beyond. There has been a transition from a nonmechanized, agricultural society to an urban system with the emphasis passing from the self-sufficiency of the family unit, with several generations under the same roof, to our current concentration on mobility and youth with its ability to adapt to rapid change. New pressures extended the spread of private pension programs. The depression of the thirties put a vast new premium on the goal of security. If the individual cannot provide for himself, the government should. This set the stage for social security. World War II brought high levels of economic activity and profits, high corporation and personal income tax rates, and the freeze on wages and salaries. But pension costs were deductible by the corporation and exempted from wage stabilization controls. The inflationary period after the war kept taxes high, and low interest rates restricted the accumulation of savings and the purchasing power of such savings. Labor leaders pushed management during those prosperous postwar years to provide for workers' retirement. In 1948, the decision in the Inland Steel case held pensions subject to collective bargaining.® Banks, insurance companies, lawyers, and consultants joined the bandwagon. In 1945, 6.4 million workers were covered by pensions. By 1950, 9.8 million were participating in pension plans. Four years later, the total had jumped to 14.1 million—nearly a 50 per cent increase.6 The explosive expansion of pension coverage con-

PENSION TRENDS AND THE SELF-EMPLOYED

8

tinues, and today more than 20 million employees participate in private pension plans.

THE

URGE

FOR

SECURITY Just a Hope

Pensions have matured from their early status when they were more or less in the nature of gratuities. In 1901, Andrew Carnegie set up a pension plan for his employees through the Carnegie Relief Fund with a $4 million endowment. Then in 1911, U.S. Steel's first pension program was established. Pensions were paid on an informal basis to retiring employees of long continuous service. Some of the early pension plans were more in the nature of pension arrangements. The employees had no rights in the plans, which were considered gratuities, not wages, and the employer could turn payments off and on like a faucet. An employee had no assurance that he would ever receive any pension payment or that it would continue for life if it started at all. There are still some "pay-as-you-go" arrangements of this type in existence today, but they are rapidly disappearing. Funded qualified plans have taken their place, giving the employee real assurance of security in old age. Up to 1925 the retirement plans of any importance were limited to those established by some of the giant corporations. The earliest plan was that of the American Express Company in 1875. Other pioneers were the Baltimore and Ohio, the Pennsylvania, and the New York Central Railroads, the Consolidated Gas (now Consolidated Edison) Company of New York, and the Standard Oil Company of New Jersey. The American Telephone and Telegraph Company plan was initiated in 1913 and has the largest fund today.7 These early plans were looked upon by some as a device used by wealthy concerns to keep their underpaid employees from seeking more gainful occupation elsewhere. It was almost a

Pension plans and social

security

9

corporation serfdom. An employee hesitated to go to another employer, and self-employment was not attractive if he wanted to retain his retirement benefits. Samuel Gompers, for nearly forty years president of the American Federation of Labor, opposed compulsory social insurance, but he urged unions to set up their own independent benefit programs. Perhaps his position retarded the development of social insurance in this country, but at least it left the way open for employers and unions to set up their own programs. The entry of life insurance companies into the employee pension field became more than just occasional after 1925. The insured pension plan came into some prominence. The group annuity contract let the employer transfer to the insurer most of his pension problems. No more did he have to concern himself with adequacy of the fund or its administration. All he had to do was to pay the premiums. But this was not always easy to do, year after year. Sometimes it tested the financial adequacy of the employer. Employee contributions came into greater use as a means of helping to reduce the employer's cost. If the plan was insured, the premiums were partly paid by the employee contributions; if it was a trust fund plan, part of the required deposits came from these contributions. Just Good Business During the 1930's as our modern industrial society developed, there was further formalization of retirement practice. Many companies were recognizing the cost of superannuation among their work force, and that providing in advance for it was a cost of doing business. It was becoming more and more apparent that human assets were not unlike the business assets of a company. Both depreciate, and it is sound business practice to write off the cost of the assets during the years when they are in productive service.8

PENSION TRENDS AND THE S E L F - E M P L O Y E D

10

SOCIAL SECURITY AND RELATED INFLUENCES The base of the pension pyramid already was spreading when, in 1935, the Social Security Act was passed. Until then the problem of retirement had been regarded as primarily a matter of individual initiative. The depression made it clear that personal budgeting cannot be depended on to provide adequate retirement income for the population at large. Here was the start of a new era. It embodied the notion of social responsibility for furnishing minimum income to our older citizens. The conflict between enterprise and security was taking shape. The new legislation changed pensions from the category of the unusual to that of the commonplace. It approached benefits as a matter of right and not as a gift. It was another step in establishing "basic protection" against economic adversity as a generally accepted objective.9 How was this objective to be attained? Should government alone be responsible for the implementation of man's economic rights? If this was to be avoided, then management must assume the leadership in implementing these rights. With the conflicting and changing opinions on this pension controversy, it became certain that whatever is done today will be changed in the years to come. It is doubtful that any of the legislators who passed the original law back in 1935 could have envisioned the extent to which social security affects the average family today. It is difficult for legislators to resist the steady drive toward higher and more varied benefits, although Congress has attempted to maintain the system on a self-supporting basis by keeping benefit costs very closely in balance with contribution income. Basic Protection The social security system has achieved wide public acceptance. It is one of the dominant influences on the working habits of the

11

Pension plans and social security

nation, the hiring practices of employers, and the provisions and costs of private pension programs. There is not enough money in the $23 billion trust fund to pay future benefits to the present beneficiaries. Some observers will say that it should be larger, but no one knows how large the social security's reserve should be. There are too many indeterminable factors. The extent of the future industrialization of our economy, the further growth of the population, the trends and changes in mortality, covered employment, family composition, and interest rates—all are elements of uncertainty. The system was conceived to provide a floor of protection. "The social security program illustrates the relation of government in the United States to the well-being of individuals. By providing only basic benefits the program stimulates individual thrift and initiative; it does not replace them." 10 Floor of Protection

on

Escalator

The idea of a floor of protection is reasonable. But many recent legislative proposals attempt to put a floor voider people's incomes and under the economy as well. Experience proves that, once a recession has started, there is nothing more effective to combat it than old-age assistance, pensions, unemployment compensation, and relief.11 So onward and upward goes social security. But how far is up? Should payments be sufficient to maintain a modest standard of living? If the system is to be a solid base of income, why not make it provide for emergencies of labor shortage as well as unemployment? Early retirement could be encouraged by adding to the social security benefits when it is in the interests of the economy, including the interests of the younger workers who need the oldsters' jobs. Then when the demands of the economy are reversed, certain credits might be given these older people for a return to work when their labor is needed. 12 Next, social security might provide protection against all forms of wage loss not covered under other government programs.

PENSION TRENDS AND THE SELF-EMPLOYED

12

These projections carry us far afield from the old theory that old age shall be the central concern of the system. With these changing concepts of the nation's security needs, social security policy is apt to be determined by practical compromise, with political considerations given equal or greater weight than the basic objectives of the program. The social security act is indeed "on a treadmill of time." 13 Most Self-Employed Now Included Every election year since 1950, Congress has passed a bill increasing benefits for the nation's old folks. The amendments of 1956 extended the basic coverage to most professional groups including self-employed lawyers, dentists, osteopaths, and just about all the other, except the doctors of medicine. Members of the armed forces are covered and self-employed farmers and farm workers, even if they are employed only on a part-time basis. Now more than 90 per cent of the jobs in the nation are covered by social security. In addition to his retirement benefit, the covered worker is now insured against the possibility of his dying and leaving a wife with dependent children under 18. Other important changes in 1956 were the disability provisions after age 50, and the early retirement available for women. In 1958, benefits were increased 7 per cent or $5 per month on the average for the 12 million beneficiaries. In 1960, medical care and earlier disability payments were proposed and passed. These changes naturally lead to similar liberalizations in private pension plans. The Surge for Security The urge for security has become a surge for security. Benefits under the system are now received by more than 12 million persons every month. The trust fund built up by the payment of social security taxes has grown to $23 billion. Today there are over 50,000 pension and profit-sharing plans, and the number is increasing at the rate of several thousand a year. More than 23 million employees are estimated to be covered by retirement

Pension plans and social

security

13

plans other than social security, and about one million persons are being added to this number each year.14 Total assets and reserves of private pension plans are in excess of $40 billion of which over $25 billion represents the assets of noninsured, selfadministered programs.

TAXES

AND

PENSIONS

The modern pension plan is "funded." This means simply that the moneys to pay a pension are accumulated with a trustee or an insurance company in the employee's working years when the cost is incurred so that the requisite sum is at hand when he retires. This spreads the cost over the years where it belongs, and avoids distortion of the profit-and-loss picture. Not only is the funded plan more businesslike, but it is much cheaper to operate because of the income tax advantages of a plan that meets Treasury requirements, that is, a "qualified" or "approved" plan. Qualified pension plans derive their advantages from the tax law subsidies in three ways: (1) by exempting from tax the income of the trust created to fund the plan; (2) by permitting a current deduction to the employer for his contributions to the fund; and (3) by allowing the employee to defer paying tax on his benefits until his actual receipt of them. Of these subsidies, the employer's deduction has been the most important.15 Thus, a $10,000 contribution made by a corporation subject to a top-bracket tax rate of 52 per cent actually costs only $4,800, because that's all that would be left if the $10,000 were subject to tax. This is the mathematics that has led to the wholesale adoption of pension plans. There must be added to this the fantastic growth of contributions over the years in a tax-sheltered fund— $1 a year put away for 30 years at 4 per cent will be worth nearly twice $30, for 40 years at 4 per cent more than twice $40. Even at 2% per cent, $1 a year will accumulate to more than $45 in 30 years.16

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

14

Finally, an employee under an approved plan pays no tax on the pension being accumulated for him until benefits are payable to him. When he starts to receive benefits, generally at retirement, he is usually in a lower tax bracket and the tax is not so much of a burden. One of the major problems facing business today is adequate incentives for top management. Our sharply graduated personal income tax structure makes it even more difficult for a company to pay salaries which would adequately reflect a man's importance to the organization. It is, likewise, very difficult for people in higher income brackets to amass any substantial estate. Thus attractive nonwage benefits are practically mandatory to attract, hold, and stimulate top-grade specialized personnel. Tax deferment provides incentive by postponing salaries and delaying taxes until they can be paid at lower rates. Tax considerations are, therefore, of prime importance in the pension field.17 The tax law naturally imposes some conditions as to structure and operation if a pension plan is to have the tax benefits of an approved plan. There are various requirements for such approval, but any reasonable plan (1) intended to be permanent, (2) with determinable benefits and (3) its funds segregated for the exclusive benefit of (4) a broad class of eligible employees, and (5) without discriminating in favor of the highlypaid or stockholder-executives, will have little difficulty qualifying for tax-exempt status. Disability and Early Retirement Provisions The entry of social security into the area of disability payments and the lowering of the retirement age for women to age 62 may have a considerable effect on private pension programs. Disability benefits are included or are being added to most private pension plans. Reducing from 65 to 62 the age at which working women can qualify for reduced benefits puts pressure on existing programs to include early retirement provisions where there are none. Changes may be required in social security adjustment options, under which persons who retire prior to age 65 may

Pension plans and social security

15

receive a total retirement income, including the pension and social security, which is a level amount throughout the individual's lifetime. Other National Retirement Plans Congress amended the Civil Service retirement plan some years ago, providing additional benefits for federal employees and members of Congress and increasing their contributions up to 6M per cent and 7% per cent, respectively.18 The Civil Service retirement system (and, to a certain extent, many similar plans for state and local government employees) tends to be much closer to a private pension plan than to social insurance. Another of our national programs, the railroad retirement system, adheres to the principle of individual equity, and thus includes features often found in private pension plans. For instance, retirement and disability benefits are directly proportional to length of covered service, and total benefits paid are guaranteed up to an amount equal to the employee contributions.19 Social Security—A Costly Bargain In comparison, the social security program is indeed a bargain, although it will be somewhat less so in future years as contributions increase and as retired persons have more and more years under covered employment and, therefore, will have paid for the benefits over more and more years. For them the bargain is not so evident. But the cost in the early years was remarkably low. Persons retired then were getting back many times what they individually put in. Beneficiaries on the social security rolls at the end of 1953 had prepaid along with their employers only 1/24 of the costs of the benefits they were then receiving— scarcely enough to cover the administrative costs.20 The level premium, even at the 3K per cent or 4 per cent rate of contribution from employer and employee, with no difference in cost because of marital status, age, salary, or gender, is inconsistent with usual actuarial procedures used in private pension

PENSION TRENDS AND THE SELF-EMPLOYED

16

plans. The inclusion of disability and early retirement benefits will further increase the ratio of cost to benefit for persons receiving these new social security payments. A Big Load for Our Future

Citizens

Where are these benefits coming from? Somebody has to pay for them. Yes, they will come out of taxes. But who's going to pay them? Obviously, future generations. The postponement of these costs, presenting them to our future citizens with our compliments, may be more of a burden than we expect—in taxes, in higher living costs, or in both. However, the people seem very largely agreeable to this decision on the theory that it was proper for the government to help individuals to protect themselves against the potential poverty, humiliation, and worry of old age, even if the necessary taxes come out of their children's pockets. 21 If the employees and the self-employed of the nation wish to devote a larger portion of their present and future wages to a higher standard of living in their old age, they should be free to do so, and the government may be inclined to take the necessary steps to encourage them in that effort, especially when it comes out of their own pockets—not those of future taxpayers. THE PRESENT TREND PENSION COVERAGE

IN

An analysis of one hundred of the most significant collectivelybargained plans indicates that in more than half the plans a worker earning $3,600 a year would retire after twenty-five years of service with total retirement income (including the primary social security benefit) equal to at least half his pay prior to retirement. At the $5,000 level, however, this was true of only one-fourth of the plans. 22 These figures tend to show a certain contemporary attitude toward the level of retirement income that pension plans should provide—at least as a minimum. By this standard, there remains a large area for supplementing social security, particularly in those industries or occupations

Pension plans and social

security

17

where a large percentage of the employees earn $4,800 a year or more. It is likewise clear that for lower-paid employees it is not generally considered adequate to fulfill a certain percentage objective—such as 50 per cent of average compensation after twenty-five or thirty years of service. A certain standard of minimum subsistence is considered necessary, so that higher-thanproportionate benefits are provided for those with lowest earnings. A sound relationship tofinalpay is desirable in achieving the objective of adequate benefits. Consequently, it has become common practice to supplement social security with private pension plan benefits, even where the earnings of a large number of the covered employees fall below $4,800 a year. What is the likely growth of private pension plans for the future? For some years they have been adding about one million workers a year to their coverage. Is it likely to continue at this pace? For the next five to ten years, a good part of this growth is more or less inevitable, assuming only that employment continues at fairly high levels. Some of the growth in the immediate future will simply represent the gradual extension of plans to industries and employers who, from present evidence, are bound to have them sooner or later. For example, there are branches of the construction trades which have pension plans only in a few localities. It is simple to predict that the pattern will gradually spread to the entire craft, at least wherever it is unionized. However, since the largest and best-organized industrial segments have already been covered, this sort of growth will not be as rapid as we have seen in the past. Welfare Plans Cover More Employees Than Pension Plans There are reasonable grounds to anticipate considerable differences in the extent of welfare plan coverage and pension coverage. Despite the rapid growth of welfare plans—that is, life insurance, hospital and medical benefits, etc.—so that they cover the great majority of employees today, they can hardly be ex-

PENSION TRENDS AND THE SELF-EMPLOYED

18

pected to reach 100 per cent of all employees within the next ten years. The upper limit for private pension plans is considerably lower. Welfare plans represent current benefits to current employees. By contrast, pension plans accrue rights to retirement income based on long years of service. There are many industries and types of employment in which welfare benefits can be established readily, but for which a private pension plan is at best awkward or unrewarding. There is the small employer with just a few employees where continuous employment into the retirement age range is not likely. Does the employer have a small or large percentage of young women? Does he have a sufficiently secure long-term future to make a pension plan meaningful? Is there enough of a profit margin for a long-term commitment? Will his competitors assume the same added cost for benefits? All of these considerations apply to pension plans, but none of these, except the last cost question, apply to welfare plans. It has therefore been estimated that, unless we have unusual economic changes, approximately 45 per cent to 55 per cent of the wage and salary labor force—outside government and agriculture—will be covered by private pension plans in another ten years.23 It is true that some speculations have imagined wellnigh 100 per cent coverage by private plans. This certainly does not seem imminent. However, with the increasing magnitudes of all existing pension arrangements—larger asset accumulation, greater number of persons covered, and higher benefit levels— the pension structure will tend to become even larger and more complex. Private Plans Supplement Social Security The further growth of private plans depends to some extent on the future development and continual extensions of social security. The most reasonable assumption to make is that while pressure for increases in social security benefits is not likely to let up, public policy will not shift in the near future to the point of converting social security from a system that provides a mini-

Pension plans and social security

19

mum bedrock of retirement security into one that will do the full job for most employees. That being the case, a very large percentage of the American population will still need private pension plans as supplements to their social security.24 In a recent survey of the development and present status of pension plans, presented to the December, 1959, hearings of the House Ways and Means Committee, Professor Daniel M. Holland of the Massachusetts Institute of Technology concluded that not more than one-fourth of the labor force is currently participating in pension plans, and only a little over 45 per cent of those who conceivably could be covered under pension plans are so covered. While coverage may continue to grow, it will probably be at a slower pace than in the past. He also noted that average pension plan benefits tend to lag behind the cost of living.25 No one considering factors involved in economic behavior may safely ignore the influence of pensions.

Ill Legislative

proposals

Since 1942, various legislative proposals have been advanced to accord favorable tax treatment to savings, particularly those for retirement purposes. A system of averaging for individual income tax purposes has often been proposed as a means of improving the equity of the income tax for self-employed professional men, or for individuals with fluctuating incomes resulting from illness or cyclical unemployment. Professional workers have a lifetime earning cycle which starts on a low level, gradually increases over a fairly long period, and then rises to a peak for perhaps just a few short years, with a very large part of these high earnings taxed at such high rates that there is little chance to save for retirement. In comparison, a person with the same lifetime income distributed equally throughout the years pays a lower lifetime effective rate of tax. Averaging might help, but it does not accomplish the tax postponement provided in the Keogh bill, or in the amended Senate and House versions, entitled the Self-Employed Individuals' Tax Retirement Act.

Legislative

proposals

EARLY THE

21

PROPOSALS FOR SELF-EMPLOYED

As social security was extended and tax rates continued at higher levels, the advantages of employment by a corporation became more apparent. The Internal Revenue Code has for many years extended preferential income tax treatment to employees whose employers have set up pension or profit-sharing plans for them. Actually, such persons are thrice blessed: first, their employers contribute funds for their ultimate retirement; second, they are not being taxed currently on either the employer s contributions or the earnings thereon; and third, they have this deferred income taxed as distributed in later retirement years when normally it will fall into lower income tax brackets (if it does not escape tax altogether) or, if received in a lump sum on termination of service, will be subject to the maximum capital gain rate of 25 per cent. The self-employed and the pensionless employed were not eligible for such tax relief on funds they set aside for retirement purposes. The opportunity to provide for future security should not depend on being employed by another. However, the correction of this inequity would cut into tax revenues and thus might have to wait until the nation's tax needs are somewhat reduced. The Keogh-Reed Bill A movement began to develop in the late forties among the members of the American Bar Association. One of them, Leslie M. Rapp of New York, drafted a bill which was introduced by Representatives Eugene J. Keogh and Daniel A. Reed, both of New York, in the Eighty-second Congress in 1951. It was entitled "A bill to permit the postponement of income tax with respect to a portion of earned net income paid to a restricted retirement fund." It was more of a true retirement plan than an

PENSION TRENDS AND THE SELF-EMPLOYED

22

income-averaging device. It would have allowed all taxpayers to deduct a portion of their income paid into a restricted retirement fund, the deduction being limited to the lesser of 10 per cent of earned net income or $7,500. Self-employed professional groups and pensionless employed were included.1 The KeoghReed bill required that the trustee be a bank. There was no reference to the use of insurance or annuities. It was predicted that this would bring about that rare occurrence when trust service would be actively sought by large numbers of people who would qualify under the act. The main vehicle was to be a plan set up by an association (such as a bar association, medical society, accountants' institute, and the like) in which its members might elect to participate on an individual basis. Income tax would be deferred until such amounts would be received at retirement or prior death. The proposals were expected to encourage millions of selfemployed to save and to provide, by individual initiative in their productive years, for the needs of old age. Some people were hopeful that the increase in savings could have an anti-inflationary effect. Many millions of self-employed were not eligible for social security benefits at the time and this proposed legislation would fill a need. It attracted widespread support from many well-known professional groups in addition to the American Bar Association, including the American Medical Association, the American Institute of Accountants, the American Dental Association, and a host of other organizations.2 Later Bills When a bill affects millions of taxpayers it stimulates general legislative interest. This was evident in the next seven sessions of Congress when many different or similar bills were introduced with the same objective. One permitted tax deductibility for insurance or annuity premiums. Another—the Silverson plan —gave the taxpayers the right to create their own pension plans by buying a special type of nonassignable government bond with a moderate interest coupon. Limited amounts so invested

Legislative

proposals

23

would be excluded from gross income. The face amount of the bond with accumulated interest would be fully taxable in the year of redemption, or over a period of years when payable to a beneficiary of a deceased purchaser. A later proposal by Senator Curtis (Nebraska) permitted the tax free purchase of nonnegotiable government bonds at discounts based on age at purchase. The Treasury would prefer such a plan. This was evident in the Senate amendments to the Keogh bill, as fostered by the Treasury, permitting the purchase of a special issue of United States bonds maturing when the self-employed purchaser reaches age 65. This would tend to lengthen the average term of the federal debt and also to reduce the amount of bonds being cashed before maturity. In the early years of the Keogh proposals to Congress, the Treasury objected because of potential revenue loss and asked what the ultimate fate of the income tax would be if deductions were to be allowed for various forms of savings. The Treasury later admitted the tax discrimination against self-employed and pensionless employed individuals, but stated that such tax relief could only be made available when general tax relief is possible in the future. The Ray Bill The bill introduced by Representative John H. Ray (New York) was expanded to include "thrift," and "to stimulate expansion of employment through investment." It had almost universal application. It removed all existing discrimination by including not only the self-employed and the pensionless employed, but also employees already covered by qualified pension plans. The latter group would be entitled to lesser exclusions. It was comparable to the Canadian legislation, as noted later. Custodian accounts in addition to trust funds were permitted and deposits could be transferred from one to the other. Freedom to select insurance or trust funding and higher deductions over age 50 were permitted. Withdrawals could be made, but penalties

PENSION TRENDS AND THE SELF-EMPLOYED

24

would attach if the funds were paid out to persons under retirement age. Capital gain treatment of lump sum distributions was eliminated in favor of a simulated five-year spread. In other words, a lump sum payment after five years' contributions would not be taxed more than five times the regular income tax rate on 20 per cent of the amount. Here was introduced the first modification of the capital gain treatment which had become the accepted income tax treatment of lump sum distributions under qualified pension plans. THE SIMPSON

SMATHERS-MORTON-KEOGHBILL

Legislators are faced with a dual problem in considering legislation of this type in these times. They want to grant equitable tax treatment to all taxpayers; nevertheless, they must still maintain the national revenue. A number of changes were made in the Keogh bill in the succeeding years as the interested groups affected by the bill expressed themselves and convinced the legislators that modifications should be made. The Keogh-Reed bill became the Jenkins-Keogh bill when Representative Reed moved up to the chairmanship of the House Ways and Means Committee, and Representative Jenkins (Ohio) replaced him until Representative Simpson (Pennsylvania) moved in to take over as Republican sponsor of the new Keogh-Simpson bill when it passed the House for the second time and was referred to the Senate Finance Committee. Senator Thruston Morton (Kentucky) then introduced S.841, and Senator George A. Smathers (Florida) introduced S.1979. These were identical to the Keogh-Simpson bill, which had then achieved bipartisan sponsorship in the Senate, too. Hearings and Proposed

Amendments

The Senate held four days of hearings during the summer of 1959. There was evidence of increasing support for the measure

Legislative

proposals

25

from more self-employed groups. Sixty-six national associations and a countless number of local associations had endorsed the bill. Thirty-seven witnesses representing different associations of self-employed persons testified in favor of the bill. Represented at the hearings were: architects, dentists, industrial designers, young lawyers, senior lawyers, women lawyers, patent lawyers, lawyers from Philadelphia and Chicago,3 authors, mobile-home dealers, plumbing contractors, furniture salesmen, livestock men, life underwriters, wholesale salesmen, commissioned traveling salesmen, realtors, doctors, appliance dealers, medical clinic employees, accountants, farmers, actuaries, professional engineers, optometrists, veterinarians, and others.4 Elimination of the tax discrimination against the self-employed was the keynote of this testimony. The opposition witnesses were few—primarily from the Treasury Department, with some adverse comments from the A F L C I O and the National Education Association. These were not the first objections. Others had been expressed at the earlier hearings before the House Ways and Means Committee. The National Association of Manufacturers had referred to the bill as "another tax gadget" which only avoided meeting the real issue of excessive rates of surtax in the upper and middle brackets. Such general tax reduction certainly is a commendable objective, but "while welcome to all taxpayers, would not remove the discrimination against the self-employed and the pensionless employed in the matter of retirement benefits." 5 Even the United States Chamber of Commerce raised a question as to the form of the bill on the ground that it excluded persons under qualified employee pension plans, "some of whom might receive only small monthly benefits thereunder." The continued objections of the Treasury finally resulted in reducing the annual exclusions from $7,500 to $2,500 and the aggregate lifetime exclusions from $150,000 to $50,000. Once, when the Keogh bill was tacked onto another bill in hopes of expediting its passage, the maximum deductible amount was re-

PENSION TRENDS AND THE SELF-EMPLOYED

26

duced to $1,000 per year, but everybody without a pension was included whether employed or self-employed. The House Ways and Means Committee also had under consideration bills to increase the benefits and contributions under the Railroad Retirement Act. One of these bills provided that each employee's yearly contribution to the Railroad Retirement Fund would be excluded from his gross income. The committee voted to approve the bill—much to the consternation of the Treasury Department, whose officials pointed out that no such tax-free treatment was given to social security taxes, nor to employee contributions under any retirement system, public or private. Other Revisions There were a number of amendments and refinements submitted to the Senate from various sources. The changes presented by the Employees Trusts Committee of the American Bankers Association are discussed elsewhere in more detail. Permissible investments were extended to conform to Federal Reserve Board regulations, including common trust funds or other collective funds, and to the trust laws of the particular state where the trustee is acting. There was a further limitation up to 10 per cent of the value of the trust in any one security, excepting government obligations or stock in a regulated investment company. Another amendment permitted free selection of either the insurance or trust fund method of financing retirement benefits. Other changes in the bill were submitted to Congress by other interested individuals and organizations: 1. Investments which banks, as trustees of restricted retirement funds, may make should be extended to include savings accounts insured by the Federal Savings and Loan Insurance Corporation or by the Federal Deposit Insurance Corporation. Insured thrift institutions, mutual savings banks, and savings and loan institutions should qualify as authorized depositaries of restricted retirement funds.

Legislative proposals

27

2. If a trust agreement by its terms restricts the investments to obligations of the United States government and shares of publicly held investment companies registered with the Securities and Exchange Commission, the bill should not require that the trustee be a bank, but should require only that a bank be custodian of the securities in the trust under appropriate regulations of the Secretary of the Treasury. This proposal came from the National Association of Investment Companies. 3. In a similar vein, the Investment Counsel Association of America, Inc., recommended that the Keogh bill be amended to provide that banks, as trustees of restricted retirement funds, may share or delegate the power to control the investment and reinvestment of funds held in such trusts. 4. A number of the senators expressed concern about the extension of coverage under the Keogh bill to employees of the selfemployed. Comparable retirement benefits should be provided for the employees of each self-employed person before he becomes a qualified member or participant in a Keogh type trust or buys a restricted retirement policy. This provision is now part of pending legislation. 5. There was presented a proposal to change the allowable deduction rules from the 10 per cent or $2,500 per year. The Conference of Actuaries in Public Practice and the American Farm Bureau Federation endorsed the new formula presented by Dr. Frank G. Dickinson. The new plan would allow the self-employed person a deduction in each year of an amount which would be sufficient to provide benefits equal to 1 per cent of his earnings in that year, deferred to commence at age 65. The maximum amount permitted would be the amount necessary to provide a pension at age 65 of $1 per day. This plan came to be known as the "1 per cent or $1 a day" formula.® Another revision to appease the Treasury objections would allow a tax deduction for payments into a qualified individual retirement fund to the extent of 50 per cent of such payments, rather than allowing 100 per cent deductibility as contemplated by all of the prior legislation until the 1961 Senate bill, S.59, was introduced. This divides up the contributions to a fund in a man-

PENSION TRENDS AND THE SELF-EMPLOYED

28

ner similar to private plans, many public funds, and social security. Each dollar of tax-deductible money paid into a restricted retirement fund would be matched by a dollar of after-tax money. Another deduction schedule suggested to the House Ways and Means Committee in December, 1959, was geared to the different ages of the self-employed participants. A tax-free deduction would be made available to everyone within certain age limitations, and with an upward graduation in the percentage according to the age of the person, from 3 per cent if under age 30, to 10 per cent for those age 60 and over.7 Treasury Proposals and Semite Amendments The Treasury Department submitted suggestions and recommendations to the Senate Finance Committee referring to the defects of H.R. 10 and objecting to its "unique benefits" which would have an adverse effect on "our existing laws pertaining to retirement income." The Treasury plan would (1) reduce somewhat the present benefits available to stockholder-employees under existing qualified plans, (2) permit self-employed individuals (including partners and proprietors) to obtain retirement benefits only by establishing a qualified pension plan for their own employees, and (3) provide safeguards to prevent unwarranted advantages or discrimination in favor of owner-manager self-employed persons. A version of the bill modified for the Senate Finance Committee along the lines of the Treasury proposal would permit a self-employed individual to be included in his own qualified pension plan if the plan covered a reasonable grouping of employees and did not discriminate as to coverage, contributions or benefits. Partners or proprietors would qualify as "employees" under such a plan if contributions and benefits were proportional to wages or salaries paid to each covered employee. A portion of earned income could be contributed to a trust or used for the purchase of insured annuity contracts, and a group of

29

Legislative proposals

self-employed could use an association to pool their funds for investment purposes. The basic deduction allowed under this modified version of the Treasury proposal was patterned after the Keogh formula— 10 per cent of earnings up to $2,500 per year—but it differs in the following respects: (1) "earned income" is the base, which generally would be less than "self-employment income"; (2) there is no total lifetime limitation of $50,000; and (3) there are no increased contributions and deductions for persons between 50 and 70, as were provided in the earlier Keogh bill. The Treasury proposal required the establishment of a nondiscriminatory "money purchase" pension plan. Such a plan could be established for the self-employed alone if he had no other permanent employees. If he had other employees, it could be integrated with social security benefits provided he would not thereby exclude all nonowner employees. While vested rights generally would not be required until retirement, some form of vesting would be necessary if the self-employed wanted (1) to exceed the 10 per cent-$2,500 limitation, or (2) to fund the plan from profits only. "Contributory plans" (permitting employees to contribute) are allowed if there are nonowner employees under the plan but nondeductible contributions may not exceed the 10 per cent-$2,500 formula in any year. A copy of the different bills may be obtained from the usual sources of government documents. An outline of the Keogh bill asfirstpassed by the House of Representatives, the amended Senate bill, and the 1961 version of H.R. 10 are included in the Appendices.

TAX

RELIEF

IN OTHER

COUNTRIES British Counterpart

Other nations with similar tax structures had similar problems and were taking steps to avoid tax discrimination. Our system of income taxation and that of the British are basically alike. Taxa-

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

30

tion advantages come automatically to employees who can participate in employer-sponsored or trade-union-negotiated plans. That privilege had been denied to the self-employed or the pensionless employed. The Royal Commission on the Taxation of Profits and Income approved the recommendations of a special committee to remove "the obstacles that impede the thrift of the middle class self-employed, with their long tradition of saving against rainy days and old age." This plan is similar to one of the early versions of the JenkinsKeogh bill. The self-employed and employees with no "permissible" income are permitted to lay aside tax free u p to one-tenth of their annual income to purchase special annuities from insurance firms, or to deposit amounts in approved retirement trust funds. The age of retirement under the British bill is 60, with an annual limit on income thus made tax exempt of approximately $2,100. The benefit commencing at 60 or later must be a life pension, not a lump sum, although a lump sum would be available in the event of death before retirement. There can be no other return of premiums unless there is a surviving widow or a dependent to receive any survivorship annuity benefits. A pension may not begin after age 70 or before age 60 unless earlier retirement is common to the particular occupation of the selfemployed individual, or unless he has become disabled. Canadian Income Tax Act The Canadian Income Tax Act was amended in 1957 to allow individuals to deduct from their taxable income amounts up to 10 per cent of earned income and not over $2,500 which they set aside to provide retirement income. If a person is covered by a retirement plan which is "registered" (similar to a "qualified" plan here), the maximum deductible from taxable income is reduced to the lesser of 10 per cent of compensation, or $1,500 per year including contributions to both employer-established and individual plans. Thus, the Canadian pensions are available to the self-employed as well as the present participants in em-

Legislative proposals

31

ployer-sponsored plans on a reduced basis. Both employee and employer contributions to "registered" pension funds or plans have been deductible from taxable income as long as pension provisions have been included in the Income Tax Act. A "registered retirement savings plan" must provide for regular annuity payments to commence no later than age 71. No payments may be returned to the annuitant before maturity of the contract except (1) as a refund of premiums (subject to a flat tax of 15 per cent) in event of death, or (2), if there is a rebate, a minimum tax rate of 25 per cent is applicable. No further income tax deductions may be taken after annuity payments commence. Canadians may invest their money in life annuity policies purchased from licensed insurers, including government annuities, in savings or investment contracts providing for payment of a fixed or determinable amount at maturity, or in corporate trusts. Canadian trust companies are using pooled funds—either a diversified fund or one forfixed-incomesecurities and one entirely of equities—permitting free selection of either fund by participants. Registered plans have been established by the Canadian Medical Society and other professional groups for their members. The Canadian plan clearly is more than a measure to remove a discrimination against the self-employed and the pensionless employed in the matter of retirement pensions. It opens up income spreading as a positive policy and makes it available to everybody. New Zealand and Australia New Zealand and Australia have their so-called "superannuation or pension schemes" for industrial companies. These "arrangements" are similar to the approved employer-sponsored pension plans in England and Canada, under which contributions of the employer and employee are deductible from income tax. Such plans may involve either life insurance policies or corporate trust funds. Benefits are payable only in the form of annuities.

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

32

Both of these countries now have granted similar tax relief to self-employed persons with regard to their savings for old age retirement. In New Zealand, 15 per cent of assessable income or about $500, whichever is the lesser, is the tax deduction allowed to self-employed persons under the changes in the income tax law adopted in 1957. In Australia, too, within certain limits, contributions made by self-employed persons to superannuation or pension schemes are now deductible against income in the assessment of income tax.

IV Financing

methods

The two basic methods for financing a pension plan may be used separately, or there may be a combination of both methods. The first is to insure the benefits of the plan with an insurance company. The second is to transfer the funds to the custody of a trust under the terms of a trust indenture. 1 These alternatives for investing contributions are available to a self-employed retirement fund under the Keogh bill and its later versions. These deductible retirement deposits will always be arbitrary amounts, within limits, appropriated by a self-employed individual without regard for ultimate benefits or the specific payments to provide those benefits, but with the primary purpose of setting aside not just another savings account but what he thinks he will not need for all the years to his sixtieth birthday. Such varying arbitrary amounts will be deducted from his taxable income. These deductible amounts will be low when his earnings are low, higher when his earnings are up. Deposits made each year into trust funds for retirement, and likewise premiums to insurance companies for insured plans, are at a very high level. The current bill provides for the use of either one of these generally accepted financing methods. The trust

PENSION TRENDS AND THE SELF-EMPLOYED

34

company and the insurance company, however, may be extending their horizons a little when they start to function under the Self-Employed Individuals' Tax Retirement Act. Certain definite restrictions and limitations will be in effect at the time of the deposits and still others will be maintained during the working life of the self-employed person who establishes a qualified retirement plan. The funds deposited are in a sense frozen until the self-employed participant reaches age 60, or dies, or becomes disabled. The trustee may have some responsibility here for investigation or at least some verification. The trust officer can do that without too much trouble. He is used to it, since he has to follow specific provisions and limitations, sometimes with discretionary powers, in every trust he administers. An insurance company must have specific directions set forth in its contract or policy. Its duties and the rights of the insured, or of the annuitant, must be spelled out in detail. The insurance company will not assume or exercise discretion. In the initial concept of the individual retirement act, a corporate trustee was the only financing vehicle considered.2 It was apparent to the legislators that the bill would have to contain reasonable safeguards against abuses of the tax revenues in the maximum amounts which may be set aside, in the manner of administration, and in the distribution of the tax free accumulations upon death, disability, or the attainment of retirement age. 3 A corporate trustee has the responsibility, permanence, and the capacity to perform these difficult assignments with completeness and efficiency. A retirement plan may be set up by a particular group of selfemployed, such as members of a local medical society or bar association, farmers of one county, or other similar organization. In this case, the bank or trust company may serve as the trustee with a committee of members assuming the necessary powers of direction as to administration and investment of the fund.

Financing

35

methods

INSURANCE

FUNDING

Life insurance provides protection against a risk—primarily the risk of premature death. An annuity is just the opposite. It is a contract of indemnity affording protection against the economic hazard of living too long. Life annuities are an important part of the insurance business, and other policies—particularly endowment and ordinary lifeare frequently used to accumulate funds for protection against both this risk and the economic hazard. It is natural that life insurance will be considered as one of the financing media. The life insurance companies expect to be a part of any nationwide program involving savings for retirement. At first, only annuities were permitted in the 1953 and 1955 bills. Then any insurance policies, except term, were included with the trust fund as a financing vehicle. Later, the amended bill went back to the annuity contract requirement. Qualified Annuity Policy A restricted retirement policy was the insurance funding method under the Keogh bill before the Senate amendments and under the new Senate bill, S. 59. It was an annuity, endowment, or other life insurance contract, or combination thereof, excluding term insurance. The self-employed taxpayer could obtain tax deferment only on the portion of the annual premium attributable to the savings or annuity features of the policy excluding the cost of the life insurance protection. Under the terms of the policy, the self-employed insured had complete ownership and the policy would be endorsed to show notice to the insurance company of his intention to deduct premiums as retirement deposits. Under the later amended act, an annuity policy could not be assigned or pledged without being taxed as a distribution. Any loan on the policy would be treated likewise as a distribution.

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

Insured Pensions for

36 Employees

Insurance funding of pension plans has had its greatest success in the blanket coverage of groups of employees, first under group annuities and later with deposit administration and group permanent contracts. Insurance companies generally use one of the following basic methods to fund pensions for employers, although there are literally hundreds of variations and combinations of these several methods: 1. Group Annuity is one of the oldest and most popular types of coverage, first offered by the life insurance companies in the early twenties to provide pensions. Usually a minimum annual premium is required to provide this type of coverage. Contributions are discounted for mortality experience but not for turnover. Rates are guaranteed for five years, after which they may be increased (and in some cases they have been increased substantially). Although the rate of return on investments may exceed materially the assumed interest rate, the insurance company determines the adequacy of the reserves necessary to protect it against losses from possible adverse mortality experience. As a result of the accumulation of these contingency reserves, dividends have been almost nonexistent.4 2. Deposit Administration involves the accumulation of premiums in a deposit fund without allocating any part of the premiums to purchase benefits for any individual employee until his date of retirement. This type of plan is like the trust fund plan to the extent that it gives the employer more control over the contributions and more flexibility in some of the plan provisions.5 3. Group Permanent insurance is a combination life and retirement income coverage similar to retirement income plans with individual policies but under a group contract. It is particularly appropriate where substantial death benefits are desired with the annuity payments. Usually a minimum volume of insurance is required, so it is available only to the larger companies. 4. Other financing vehicles involve the use of individual insurance or annuity contracts, or retirement income policies providing both death benefits and life income installments commencing at the

Financing

methods

37

date of retirement. This type of plan is much more costly because it involves funding on an individual rather than a group basis.6 It requires the purchase of a definite amount of life insurance for each $10 of monthly income provided under the plan. These individual policy plans frequently make use of a trust to provide ownership or custody of the policies, receive and make payments, or accumulate additional funds necessary to purchase annuities or pay supplemental benefits, as required under the plan.7 The life insurance companies, being in the business of insuring against the risks of premature death and living too long, naturally are participating in the new program for self-employed persons. New Features and Conflicts There are confusing features in the proposed self-employed retirement program. Life insurance companies, in the past, have been concerned only with the acceptance of premiums to pay for a specified risk or a particular ascertainable benefit. Now under the proposed qualified annuity or restricted retirement policy, they may have to accept varying annual premiums from each insured—$100 this year, perhaps $500 the next. The allocation of the part of the life premium attributable to insurance, annuity, reserve, contingencies, expenses, etc., has always been a matter of internal accounting for each insurance company. Tax deductibility has never been available on life insurance premiums paid by the insured policyholder. Under the new bill, the premium paid for a retirement annuity would be excludable. If any part of a premium would pay for any life insurance protection, such part should not be tax free for that would create a new discrimination against the millions of policyholders who pay life insurance premiums with after-tax dollars. The value of the current life insurance protection would be determined as it is under present qualified plans for employees by subtracting the cash value from the minimum death benefit and multiplying by the values shown in a table prescribed by

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

38

the Internal Revenue Service. A similar practice may be prescribed under the amended act. 8 There is a conflict between savings for unrestricted future use, such as a savings account or ordinary life or endowment insurance, and tax-exempt savings for retirement which cannot be used for any other purpose nor be available any earlier than retirement age. The earlier bill included the reserve portion of life insurance policy premiums. In a sense, that extended its purpose into the field of savings and made it no longer strictly a retirement bill, but a little like the Silverson plan in H.R. 1173, referred to in the last chapter, with its limited deduction for the purchases of a special type of government bond.9 But the Treasury Department prevailed upon the Senate to go back to the straight annuity without any insurance benefits or values. Disability The insurance company has its own established practice on disability. We know that the introduction of disability into the Social Security Act may cause some more liberal interpretations, perhaps laxity, in the determination of disability. Disability provisions are included in the amended bill. This may cause some conflict because disability standards for an insurance claim might be more strict than under lenient social security interpretations. Under the current wording, withdrawal of funds before age 60 is penalized with the unpaid income tax and penalty unless the self-employed is disabled or dies. Refund of Excess Contributions The amendments of the new bill require a participant to recover amounts which he contributes in excess of the amount he is permitted to deduct from his income. These excess contributions and any income earned on them must be returned within six months after notification is received, or the plan becomes disqualified with regard to the person on whose behalf the excess contribution was made, and he is taxed on any income earned on his interest in the plan. If premiums are paid in error, or in

Financing

methods

39

excess of excludable amounts, it is presumed the same provisions for recovery would be applicable. This is another item which will eventually have to be clarified by regulations. Another Variation for the Insurance Industry People are accustomed to having certain rights under their insurance or annuity policies. One of these rights permits a policyholder to borrow on any one of his policies, or he may, if he chooses, drop a policy and take the cash value. The insurance company, under the Senate substitute for the Keogh bill, may have to file information returns whenever (1) there is a surrender of a qualified annuity policy for its cash value, or any assignment of the policy; (2) any nonforfeiture option is exercised and becomes operative; or (3) any part of the cash or loan value is borrowed by the self-employed policyholder. When a self-employed person buys an annuity as a part of his qualified pension plan, the restrictions under the act will be severe. He will be inclined to forget about them when financial stringency arises and he may ask the insurance company for a loan or for the cash value before he reaches age 60. He may blame the insurance company for the income tax and the penalty he will have to pay before he gets this cash value. The insurance industry has been concerned about changes from standard underwriting practices. But it would be more concerned if there were any further shifting of premium income to qualified pension funds with banks and trust companies. There have been other recent departures from insurance precedents, such as variable annuities, three-level premium rates based on the size of the insurance policy, and interest-free loans. One more variation from accepted patterns in the life underwriting field will be these new annuity policies.

PENSION

TRUST

TRENDS

AND

THE

SELF-EMPLOYED

40

FUNDING Qualified Trust

The Senate presented a complex and controversial substitute for the Keogh bill. It set aside the simple approach of the Keogh bill which limited the legislation to the problem of the selfemployed. It substituted a new type of individual retirement plan under tax regulations covering qualified pension, annuity, and profit-sharing plans. There were sweeping changes affecting all existing plans, and additional requirements when a plan covered owner-employees who own more than 10 per cent of the business. The self-employed would have to set up a retirement plan for his employees with more than three years' service in order to get benefits for himself. The retirement funds established under the substitute bill must be deposited with a bank or trust company as trustee, used to buy annuities from an insurance company, or invested in a new type of United States government bond. The plan would provide for the investment and reinvestment of the fund in assets which are permitted for the investment of trust funds and for the distributions to the self-employed and employed participants commencing not before age 60, except in the case of disability, and not later than age 70, subject to the following conditions: 1. The plan must meet the requirements which the law provides for all retirement plans, including the usual rules relating to nondiscrimination of coverage, allowing the self-employed to be treated as their own employers and employees. 2. The trustee must be a bank or trust company. 3. An annuity may be purchased for a participant but payments must start not later than age 70/2 and cannot extend beyond the life or life expectancy of the participant and his spouse. 4. The trustee is required to return within six months any amount paid to the fund in excess of the amount deductible by the participant.

Financing

41

methods

5. If the plan covers owner-employees, (a) in the case of profitsharing and stock bonus plans, an employee's rights must be nonforfeitable and the plan must provide a definite formula for contributions, (b) the entire interest of any deceased owneremployee must, within five years of his death, be distributed to his beneficiaries or used to buy immediate annuities for them, (c) two or more businesses controlled by an owner-employee must be considered as a single business in satisfying the nondiscriminatory requirements, and (d) earned income only is to be considered in determining the amount of contributions to a qualified retirement plan. Earnings on the fund would be taxable neither to the fund nor to the members until distributed. It is expected that payment will be deferred to age 60, but any distribution will be taxable. Lump sum payments after 60 and death benefits will be taxed under a formula which makes the rate not more than it would be if spread over five years instead of being taxed all in one year under the higher surtax brackets. Many of these changes were incorporated in the latest version of H.R. 10 (see Appendix C). "Pooled?' or "Commingled"

Funds

A trust company has the facilities and the "know-how" to perform any and all of the functions set forth in the section of the law covering the new self-employed pension plans. Most of the provisions in this section are found in plans now administered by the trust company. The corporate trustee can group all of its self-employed participants into a kind of pooled plan. It may have had experience in the administration of a bank fiduciary fund, or one of the pooled pension plans for groups of employers in the same industry, or corporations located in the same geographical area. Perhaps it has a collective investment fund for qualified pension and profit-sharing funds of such employers and is hopeful that it could include Keogh funds within this framework. These pooled funds of the different types have attracted large numbers of depositors and become successful and profitable

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

42

operations through the enterprising salesmanship and efficient management of the banks and trust companies. Trust Flexibility A large trust fund is cheaper per unit than is a small one, and the trustee's costs for services may be on a lower per-dollar-benefit basis. The larger fund offers greater diversification, liquidity, and cheaper administration. These practical considerations have stimulated the rapid trend toward group plans.10 Pooled funds for pension and profit-sharing trusts are sometimes set up in two parts, one for fixed income securities, and one for equities. The bank or trust company with its experience in pooled plans will be ready to set up a trust for participating self-employed pension plans under the new bill. A trust arrangement has sufficient flexibility and variation to permit each participating selfemployed person to satisfy his own needs within the boundaries of the new law. Whether the funding medium will be a collective type, a common trust which individuals may join, or whether it will be best to arrange special trusts for particular self-employed groups, are technical matters which deserve careful and expert study.11 Final decisions might be deferred until Treasury regulations are issued, but public demand and enterprising trust salesmanship may necessitate faster action. Trust Funding Continues in the Lead Banks and trust companies now manage a very large segment of the accumulated pension and profit-sharing funds, and a substantial portion of the new funds are flowing into that channel. There were 40,982 qualified plans in the United States at the end of 1957, according to the Internal Revenue Service.12 That was almost double the 20,675 plans in 1953. There were only 110 in 1930. At the end of 1958 there were 47,578 such plans, an increase during the year of more than 6,500 plans. Of these new plans added during the year only 2,130 were insured pension plans, according to the Institute of Life Insurance, and the aver-

Financing

methods

43

age size of new groups covered by insurance has generally been declining.13 Of the 19.4 million workers, both active and retired, covered under private pension and profit-sharing plans at the end of 1957, 14.7 million were in noninsured (or trust-funded) plans and 4.7 million covered under insured plans. Total reserves or assets of all plans amounted to $34.8 billion at the end of 1957, of which trusteed funds held $20.8 billion and the remainder, $14.0 billion, were held by insurance companies under insured plans. Approximately 15.5 million persons in the United States were covered by noninsured private pension plans at the end of 1958—up 800,000 in one year—bringing the total number of persons with pension protection under both types of private plan to about 20.4 million, including those already retired, an increase of one million during the year. The pension reserves with life companies stood at $15.5 billion and the assets of the noninsured trusteed plans were some $23.8 billion at year-end.14 That's a billion and a half dollars for insurance and $3 billion for trust funds added during the year. Pension, profit-sharing, and other employee benefit trusts are becoming a substantial part of the fiduciary business of national banks, according to the Comptroller of the Currency. While statistics are not maintained as to either number or the market value of such accounts, a survey of several major trust departments indicated that probably 15 per cent of all fiduciary business of national banks consists of employee benefit accounts.15 "There has been a spectacular growth of pension plans since 1950, most of them taking the form of self-insured funds." 16 Trust companies and banks are continuing to maintain their leadership in the dollar volume of pension trust business as well as in the number of persons covered under private pension plans in the United States.

PENSION

TRENDS

DIFFERENCES AND TRUST

AND

THE

SELF-EMPLOYED

44

IN INSURANCE FUNDING Insurance Problems

There will be a great many problems in operating procedure for both the insurance company and the corporate trustee when they go into the self-employed retirement business. The Keogh type of annuity policy is different, but it can be adapted to insurance underwriting techniques. Its success will depend on various factors including the ability of the insurance companies' agents to sell a sufficient volume of these qualified retirement annuity policies. Some sections of the act are extremely complicated and will be difficult for the insurance agents and their customers to understand. Elaborate directions and instruction procedures may be required using illustrations and printed material with simpler language in order to clarify the provisions of the law. There are limitations on the exercise of the usual insurance options. The treatment of death benefits, cash values, loan rights, and assignments of a policy will require revision or interpretation. The taxing of all payments under a policy (even dividends) —whether the recipient is the insured, the annuitant, or the beneficiary, whether a portion or all of the premium was originally deductible or taxable—is only one of the items which will require explanations to the customers and agents and reports to the Internal Revenue Service. Premiums are described as "contributions which may be deductible," or allocable to life or other insurance, and "not deductible." Payments before age 60 and after 60, and payments below and above the maximum limitations of $2,500 or 10 per cent of "earned" income require different treatment.17 Premiums on retirement policies or annuities may be made right up to April 15 for the preceding taxable year. The taxpayer will need a certificate or other evidence from the insurance company to file with his own tax return by the same date. The time

Financing

45

methods

element may make it impractical or difficult to carry out the strict terms of the law. Technical changes or amendments of the bill, or clarifying regulations, may eliminate or moderate many of these problems. Adaptability of Trust Funding Some insurance companies are resisting the idea of variable annuities, which deviates from the traditional procedures of the insurance field. The trust companies are using the variable annuity principle to a considerable extent right now. In 1954, 21 per cent of all retirement funds administered by New York banks was invested in equities. This figure has gone over 30 per cent, based on book value; it is about 40 per cent on the basis of market value. The trend is upward, as equities are a well recognized part of any pension or profit-sharing portfolio. The flexibility and adaptability of trust funding is indicated in the common trust fund, the pooled investment plan, and the bank fiduciary fund. All of them were conceived by the trust companies to provide another important type of trust service. They will continue in their readiness to serve this substantial portion of our people, the millions of self-employed who come under the Self-Employed Individuals' Tax Retirement Act, and furnish them with expert administrative and investment facilities to provide a more effective program of savings for retirement. Competition

Continues

The competition between insurance companies and trust companies for pension business has gone on for years. It has not yet been resolved. The insurance companies claim that they operate nationally and have extensive experience in the field of annuities, and that they guarantee the full final benefits if the premiums are paid u p to the retirement date of each employee. Dividends will adjust for overpayments if experience is more favorable than the estimate, and initial cost is the only place where the trusteed plan is cheaper. The insurance man points out that the insurance company carries the ultimate risk with no

PENSION

TRENDS

AND

THE

SEL F - E M P LOY E D

46

worry for the employee or the employer (except to pay the premiums), and that the insurance company provides a complete actuarial-investment service from one source without legal or other consulting services. The trust companies maintain that the insurance companies charge too much with their ultraconservative cost estimates, low mortality, high loading charges, low or nonexistent dividends on pension or annuity policies, and high reserves, and that trust companies have the advantage of flexibility in both the plan and the funding. The prefunding technique of the insurance company covers past and future expenses. This contrasts with the current expensing technique of the self-administered or trust funding method. 18 To the insurance company claim of "guarantee," the trustee replies that if he is investing in the senior securities of Du Pont, General Electric, American Telephone and Telegraph, or General Motors, is not the guarantee of any one of them or all of them collectively equal to that of an insurance company? But the insurance company guarantees 3M per cent, more or less, for five years on monies deposited in the first year! The trust company or bank may counter with its investment in the safest type of security today at 4M per cent or better—obtaining a guarantee of that yield for the entire period during which the bond remains uncalled.19 The recent change in the income tax law granting a life insurance company credits for its pension plan reserves puts the insurance company a step closer to the normal investment return on a trust fund. They may now issue more favorable rates or declare a dividend on their annuities. The segregated asset law permitting equity investment adopted in Connecticut and the variable law passed in New Jersey may result in further improvements, although without a nod of approval from New York State, any such major changes in insurance procedures cannot be generally available in other states. There is evidence of the preference for the trust funding method in the continuing conversions from insured to fully trus-

Financing

methods

47

teed plans and in the larger inflow of pension funds into trust companies than into insurance companies. Both Funding Methods Needed There is a place for both funding methods. Cooperation between the trust and insurance companies could be mutually advantageous in meeting the needs of a considerable number of selfemployed persons. It is notable that one of the provisions of the bill authorizes the trustee to purchase annuities. The transfer of the cash values in retirement annuities to qualified retirement funds seems reasonable. It is possible that a combination trusteed-insured plan may be developed to provide the annuity features at age 60 or 65 through insurance after the accumulation of the fund has been accomplished through a trust, under the investment management of a trust company or bank. Some of the benefits in many trusteed employee pension plans are now funded by insurance company contracts. This method was found in about 8 per cent of the New York bank trusteed funds in 1955. 20 If savings-for-retirement is the primary purpose, then a cooperative program using both insurance and a trustee may offer one good solution. A combination Keogh-type program might be formulated (if final rules and regulations permit) under which a portion of each contribution would be allocated to the qualified retirement fund, and a portion would be set aside by the trust department for premiums on qualified annuity policies to be held by the trustee for delivery to the self-employed participant on his retirement at age 60 or later. The insurance company could issue a policy adapted to the needs of the self-employed individual and could rely on the trust company to supervise the administrative functions required by the act to assure the continuance of the tax-exempt features.

V Impact of statutes and

regulations

The Self-Employed Individuals' Tax Retirement Act, being an amendment of the Internal Revenue Code, sets forth the basic principles for a deduction from gross income of a limited portion of earned self-employment income paid into a qualified retirement fund or to an insurance company as premiums for a qualified annuity policy, and the postponement of income tax on such payments. The Treasury will issue regulations to clarify the application and administration of the Internal Revenue Code as amended. These regulations will be the ground rules under which the Internal Revenue Service will review and enforce the statutory changes, including the qualification of self-employed individuals, deduction limitations, and the tax treatment of distributions. There will be other legal problems not related to these tax considerations. Some may be resolved only after court decisions. Statutory limitations or restrictions under the various state laws may require administrative enactments or amendments to existing laws and regulations although these problems are not likely to be too troublesome. We have seen how pension plans and retirement funding agreements have become well established and generally accepted in business and industry. It should not

Impact

of statutes and

49

regulations

be too difficult, therefore, to make the new retirement trust agreements and policy contracts conform to the laws and statutory requirements of the different states. The supplemental unemployment compensation plans which had their beginning in the automobile industry and then spread to various other fields were faced with some statutory conflicts. It did not take long for most of the states concerned to amend their statutes or for the administrative bodies to issue rulings which would permit the unemployed workers to receive the benefits from the negotiated plans without being deprived of their rights to receive unemployment benefits from the several states.

CONTRACTUAL

REQUIREMENTS

The self-employed individual using the retirement fund device will undertake a contract obligation with a bank or trust company. He will be the settlor of a small limited term trust, or a participant under a composite trust set up by a bank-trust company for self-employed persons pursuant to the limitations of the act. If his funding method is insurance, then he will purchase an annuity policy from an insurance company. He will buy this policy contract in the form prepared by the counsel or legal department of the particular insurance company selected. The trust vehicle will be governed by trust law and state statutes. The insurance policy must conform to the insurance laws of the jurisdiction of the self-employed insured as well as to those of the state in which the insurance company involved is incorporated.

STATUTORY

LIMITATIONS

The establishment of any pension plan or trust agreement necessarily involves questions of validity under state laws. These

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

50

include (1) the rule against perpetuities, (2) the rule against accumulations, (3) the nonassignability of a participant's interest, and (4) various statutory restrictions involving insurance. These problems have been eliminated by the enactment of appropriate legislation in many of the states. In plans for employees such as pension, stock-bonus, disability, death-benefit, or profit-sharing plans, to which the employees may or may not contribute, "the question sometimes arises whether there is any violation of the rule against perpetuities, or a rule against restraints on alienation, or some other rule. The question is particularly pertinent in states like New York where the question is not one of remoteness of vesting, but of suspension of the absolute ownership or of the power of alienation and where the permissible period is limited to two lives. It seems clear that even if such employees' plans violate the letter of these rules, there is nothing in them which is contrary to the policy which underlies the rules." 1 The review of state laws will start with these two points: (1) whether trusts for the self-employed will be free of the rule against perpetuities; and (2) whether they will be subject to statutes against accumulations. In the earlier Keogh bill there may have been a question whether the requirement that a member's interest in a Keogh-type trust be nonassignable was in conflict with the state's law regarding spendthrift trusts. Under the later Senate version there is a penalty for assignment but it is not forbidden. If problems like this arise, they will vary in character with each state and can best be resolved locally. Perpetuities The rule against perpetuities might raise some difficulty since the plan is one in which persons may join who were not in being at the date of establishment of the plan, although there seems to be support for the theory that the rule is inapplicable generally to pension trusts.2 These trusts might be considered similar to charitable trusts 3 and as noted do not seem to violate the policy behind the rule.

Impact of statutes and regulations

51

If a trust is created for several beneficiaries and the interest of one or more of them will not necessarily vest within the period of the rule against perpetuities (a period of lives in being and 21 years),4 the trust fails as to those interests. The author has not found any recent cases where the trust device used in connection with a pension or a profit-sharing plan has been determined to be invalid in whole or in part for violation of the rule against perpetuities. It is quite likely that the question will never be raised in litigation. The participant will not raise it because he wants whatever share of the fund is allocated or distributable to him. The employer will not attack because if he is successful in maintaining its violation, he will doubtless lose the tax exemption previously granted to him. The Treasury Department probably will not raise the issue because of the political implications and the possible detrimental effect on the many employee benefit plans and funds on which it has already granted approval. A challenge under the rule is not probable under the several proposed self-employed retirement bills unless some creditor should try to use this device to reach the retirement contributions of a participant. A trust for an association or a group of individuals set up with a corporate trustee under the Keogh bill or the later Senate version is similar to many existing profit-sharing or pension trust funds. The dominant purpose is to create a trust divided into separate shares, terminable by separate lives, with the interest of each, variable in amount and separable even if commingled in one fund. Thus, the trust will be valid even though the trust property is to be held as one fund by the trustee through the lives of the various beneficiaries. The rule against perpetuities deals with the remoteness of the vesting and not with the duration of the vested interest.5 The interests of the participants in a separate trust for many qualified self-employed persons will vest immediately upon deposit even though the enjoyment normally will be postponed until retirement, death, or prior withdrawal. Since the interests of the self-employed individuals under the trust would be vested

PENSION TRENDS AND THE SELF-EMPLOYED

52

at once there should be no question of vesting within the period of the rule. The fact that the trust may continue beyond the period for other participants should not invalidate it. Some 35 states have disposed of this problem by excluding pension and profit-sharing trusts from application of the rule. These include New York (in 1928), Alabama, California, Colorado, Connecticut, Delaware, Florida, Georgia, Illinois, Indiana, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Nebraska, Nevada, New Jersey, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Dakota, Tennessee, Texas, Virginia, Washington, West Virginia, and Wisconsin.6 Accumulations A provision in the trust that the income of the trust estate shall be accumulated by the trustee, and that the income so accumulated shall be held in trust, is invalid if the period of accumulation is longer than the period of the rule against perpetuities. 7 For those states in which the common-law rule against accumulation prevails, if the perpetuities question is resolved, the accumulations question is likewise resolved. Accumulations are generally permitted for the period of the common-law rule against perpetuities, except for such states which permit accumulations only during minorities. A pension trust does not violate the common-law rule against accumulation if it does not retain more income than is required for reasonable management, and if under all the circumstances the period of accumulation is not unreasonably long.8 Alienation The Keogh bill and its predecessor bills have provided that the interests of participants in these plans must be nonassignable. It is generally accepted that when an individual attempts to create a trust for himself and makes it nonassignable, it is an invalid restraint on alienation, and his creditors can reach his interest. 9

Impact of statutes and

regulations

53

The Jenkins-Keogh bill of 1955 provided that the participating individual could not receive any distribution from the trust he has created until he reaches age 65, but the new version is modified so that he may get his money earlier, but he must pay the income tax and the penalty. Any conflict with this equitable doctrine of restraint on alienation may be avoided by legislative action in the several states. A number of states, including California, Minnesota, Mississippi, New Mexico, New York, Oklahoma, and Texas, have adopted measures to safeguard individual retirement funds from attachment by creditors. Minnesota's statute specifically provides that self-employed individuals' retirement trusts may continue beyond the period and may embody limitations on the power of such individuals or their beneficiaries to sell or otherwise encumber their interests, and to anticipate payments or terminate the trusts.10 In California, the suspension of the rule against perpetuities and of the power of alienation is made applicable to any "trust forming part of a retirement system" in order "to accomplish the purposes of the trust." 11 This wording appears to be broad enough to free trusts for self-employed persons from the restrictions without specific reference to them. New York accomplished the same result by removing the application of the rule against perpetuities and the suspension of the power of alienation on any retirement trust which is exempt from federal income taxes. Here the qualified tax-exempt status of the trust under a retirement plan eliminates the statutory restrictions.12 Presumably, a tax-exempt plan for self-employed members would likewise avoid the rule. It may be necessary for other legislatures to take action to protect these funds from creditors' claims. If there are states where creditors can reach these qualified retirement funds, then the regulations will have to cover such contingencies. If there is a recovery by a creditor the Treasury may attribute to him or the trustee transferee liability for the taxes due if not paid by the debtor who took the deduction. Someone will have to pay the income tax—the self-employed contributor or his creditor.

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

54

This question of nonassignability will demand attention in those jurisdictions which look with general disfavor upon restraints on alienation, and with even less favor on restraints imposed by a settlor in the creation of a trust for his own benefit. Statute of Wills The beneficiary of a trust cannot make a testamentary disposition of his interest unless the requirements of the Statute of Wills are complied with. Each self-employed person will, of course, designate some person to receive the proceeds of his interest in any qualified retirement fund or policy. Such a disposition is probably not testamentary. However, a number of states, including New York and Illinois, have provided by statute that such designation under a retirement plan or trust "shall not be subject to or defeated or impaired by any statute or law relating to the signing and attesting of wills even though such designation is revocable or the rights of such beneficiary, payee or owner are otherwise subject to defeasance." 13 Insurance

Limitations

The operations of the life insurance companies have for many years been subject to the insurance laws of the several states. Every state required each insurance company to be licensed under the applicable statute before doing business in that state. Most state laws have requirements as to cash values, policy loans, and other policy provisions which may be in conflict with the new act. The Keogh bill, as passed by the House, limited payment of any policy values prior to age 65, except by the payment of the tax and penalty. It provided for tax deferment only on the annuity or savings part of the insurance premium, excluding that portion which is properly allocable to life insurance protection. Under the new wording of the Senate amendments to the act, the cash value continues to be available (and taxable) to the self-employed insured and reportable by the insurance company to the Internal Revenue Service. The regula-

Impact of statutes and

55

regulations

tions controlling this determination are to be promulgated by the Treasury Department. Other similar insurance problems requiring interpretation or clarification involve foreign insurance companies, group coverage, and the conversion of existing policies to qualified tax-deductible status.

TRUST

PROVISIONS

AND

PROBLEMS

A qualified trust will be established with a bank or trust company under a retirement plan for the exclusive benefit of the self-employed participants and their employees, if any, but subject to the necessary restrictions as to contribution, distribution, discrimination, and investment. Refunds or Excess

Contributions

The trustee will be required to refund any amount in excess of the amount deductible or of the amount permitted as nondeductible together with all income attributable to such excess. In 1955, the bill required submission of "proper proof of such excess," raising the question as to what constitutes sufficient proof of these excess contributions. The revised bill requires that any excess contributions must be refunded within six months after notification has been received to avoid temporary disqualification of the plan with regard to the person for whom the excess contribution was made, and he is taxed on the annual income earned by the plan which is attributable to his interest. If an excess contribution is willfully made, his entire interest in all plans in which he participates as an owner-employee must be distributed to him and he is further disqualified from participating in any pension plans as an owner-employee for five years. The determination of these excess contributions and the responsibilities for notification will require clarification from the regulations. The trustee may have additional responsibility and risk to assume in this respect.

PENSION TRENDS AND THE SELF-EMPLOYED

56

Investments The trust instrument will contain the necessary powers of investment as provided in Section 401 or other applicable sections of the Internal Revenue Code, subject to the "prohibited transaction" rules in Section 503 and other restrictions imposed by the bill as amended from time to time. The trust laws of the state where the trustee is located may require other specific provisions.14 Owner-Employees The plan or trust instrument must incorporate other provisions. Under H.R. 10 and S. 59, distributions may be made only when the distributees are within certain ages. Employees of a selfemployed person must have access to retirement benefits on a comparable, nondiscriminatory basis. Additional restrictions on forfeitures and vesting and the requirement of a definite formula for contributions must be included in order to deal with possible abuses and to be sure that the plans, in reality, will be for the general benefit of employees as contrasted to the owners of the business.15 Releases A bank or trust company will, of course, want its accounts settled so that its responsibility is fixed and its liability is limited and periodically released. A release and indemnity document will be obtained from each self-employed participant when final distribution is made. This may be sufficient. If some additional protection is required by the trustee in a continuing pooled fund, then permission for a court accounting at the discretion of the trustee could be included in the trust agreement. It might be possible to empower a committee under the instrument to examine the accounts of the trustee, determine the correctness thereof and issue the approval and release. Such a committee

Impact of statutes and regulations

57

might be hard to find, and its duties might impose an undue burden unless the committee were members of the organization sponsoring the qualified retirement fund. The plan may set u p a so-called unit system for determining the value of the individual member's interest in the collective investment fund—like a common trust fund which has become a familiar investment medium in the trust field. Others will use the periodic allocations on the dollar value basis to the individual self-employed accounts as is customary in the case of profitsharing plans. If a qualified plan is established for an association or group of self-employed individuals and their employees by means of a collective investment fund, the trustee may have its accounts audited by an independent public accountant and have the report certify the accuracy of the trustee's records and values of the fund. A copy of the audit would be available for inspection. A statement of the value of the share of each participant would be prepared and mailed each year. Resignation The trustee should have the right to resign, and that raises the question as to how a successor trustee should be appointed. Perhaps the duty to designate the successor could be granted to the acting trustee where a collective investment trust is used, with notice to the participating individuals. If an association creates the plan, it may retain the power to appoint a successor trustee. Amendment A power of amendment must be included to make the plan conform to any changes in the law affecting the tax exempt status of the plan and trust. Such authority may have to be vested in the trustee, with due notice to the participants or members. Their consent might be required in the event that their substantive rights would be affected by the change.

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

58 Transfers

There are provisions in the bill permitting the purchase of annuities by qualified retirement trusts. It may be assumed that annuities could be cashed in and transferred to qualified trust funds, although such changes would be subject to review and consent by the Internal Revenue Service. Although some freedom in the transfer between funds of different trustees would be reasonable, there should be limitations or penalties affixed to such changes if they are too frequent or carried too far. A selfemployed participant should not be encouraged to shift too freely from a plan with one trustee to another whenever he thinks he can improve on the results. One trust company might be making 4 per cent on its investments for a restricted retirement trust whereas another trustee might be getting only 3M per cent. There should not be too much freedom to change the trustee every time a member hears a rumor or "the grass looks greener." Such funds cannot be used for speculation although high grade equity securities will be included in most portfolios. SEC Considerations and Collective

Investment

Other statutory considerations include the Securities Act of 1933 requiring registration procedures before securities may be sold to the public by any means; the Securities Exchange Act of 1934, requiring that securities must be listed on an exchange and prescribing certain reports and investment information; and the Investment Company Act of 1940 requiring registration of companies selling securities in interstate commerce. The questions which may arise under these several securities acts are: 1. Do the interests of participants in such a fund come within the definition of a "security"? 2. If so, is the bank or trust company which is acting as trustee of a collective trust for many participants the "issuer" of the security?

The term "security" includes any "investment contract," which has been defined rather broadly by the United States Supreme

Impact

of statutes

and

regulations

59

Court. However, under each of these federal security statutes an exemption is available in the case of securities issued by a bank or trust company. If the issuer is deemed by the SEC to be other than a bank, then registration with the SEC by that issuer and compliance with the other requirements of these statutes will be necessary. Individual intervivos trusts have always been exempt from regulation under these statutes. A Keogh-type trust created by an individual would come within this same classification. But when qualified funds of many individuals are invested collectively in a Section 17 common trust fund or pursuant to Section 10(c) of Regulation F, the SEC may take jurisdiction. With the self-employed qualified trusts coming under the same section of the Internal Revenue Code as qualified employee plans, the SEC jurisdiction may be minimized. If all participants in a qualified collective investment fund reside within the same state, then intrastate exemption will be helpful in avoiding registration. It has been noted that most of the states also regulate the issuance and sale of securities as well as the activities of investment companies. Trust companies and departments and their counsel will give careful consideration to these federal and state security laws in the use of common trust funds and pooled funds for self-employed and their employees. It is likely that discussions between the American Bankers Association, the Securities and Exchange Commission, and the Treasury officials may be undertaken if necessary to clarify this matter. If exemption becomes doubtful, perhaps some modified form of qualification or registration may be possible. The insurance companies do not appear to be affected in view of their existing exemptions under these various acts. Pooling of Mortality One of the important cost elements in pension plans is mortality or longevity. In insured plans, adjustments for the variation in mortality experience is reflected in the premium rates and dividends. In many trusteed plans, favorable experience in mortality

PENSION TRENDS AND THE SELF-EMPLOYED

60

and severance is reflected in lower costs to the employer or higher benefits to the employees, according to the actuarial calculations. There was no provision for a pooling of mortality under the various versions of the Keogh bill. However, a joint venture on mortality would be a tontine risk and is not likely to appeal to small groups of self-employed persons if they understand the nature of the risk. It is doubtful if such a plan could qualify unless the bill were amended to permit this kind of mutual relationship. The greatest benefit from a pooled mortality fund would be derived by those few survivors who live a long time after retirement, not by the many who took the tax deductions. The Treasury may object to this. It wants any distributions or transfers of interest taxed promptly with no deferment beyond normal retirement age. The state insurance laws may also be involved, requiring some registration or qualifying procedure. TAX DEDUCTIBILITY CONTRIBUTIONS

OF

Although there are other statutory and legal considerations, the two most important features of the Keogh bill and its successors are the amendments of the income tax law providing tax deductibility to the self-employed and his employees and the continuing tax exemption of the trust accumulating and investing the retirement contributions. A set of standards for self-employed pensions will develop as it has for private pensions. If these standards are met, the special tax treatment will be made available in two ways: 1. The contributions made by qualified self-employed persons are deductible from their gross income in the year for which they are paid. When an annuity or life policy is used, the premiums not attributable to the cost of life insurance protection would be deductible. 2. When a trust is involved, earnings and any increase in value of the trust fund are not taxable. Any accumulations under the policy and the increments in value thereof would likewise not be taxable.

Impact

of statutes and

regulations

61

They would be subject to income tax at regular or adjusted rates when the participant receives distribution, usually after age 65; with a 10 per cent penalty if received before age 60 or prior death. The focus here is on the objective of tax deferment on a limited portion of the earned income set aside by self-employed persons for their own retirement. In the early versions of the bill there was to be an exclusion from gross income of a portion of earned income set aside for retirement purposes. Later the Keogh bill added to the list of itemized deductions for individuals a new deduction relating to amounts paid as retirement deposits. Then it became a deduction from gross income in computing adjusted gross income. Thus, the self-employed could take this deduction and still qualify for the standard deduction under the bill as currently proposed. The trustee will have to file information returns with the Internal Revenue Service or confirm the amounts of these contributions to and distributions from the fund, and such other information as may be required under Treasury regulations. A self-employed person without employees is allowed to make annual deductible contributions equal to 10 per cent of his earned income, or $2,500, whichever is smaller. If he has employees and if he controls the business through a more than 50 per cent ownership interest, he must give all these covered employees immediate fixed (nonforfeitable) rights in any contributions made for them in order to take deductions for himself. His deductible contributions will be limited to one-half the aggregate of such deductible contributions vested in the other employees. The Keogh bill provided for the deductibility of larger amounts for self-employed persons 50 years of age or over. This provision was eliminated in the recent Senate versions of the bill. The previous bill permitted unused deductions to be used in subsequent years. The lifetime deduction of $50,000 or 20 times the maximum annual contribution was a part of the earlier Keogh bills. These restrictions were eliminated in the 1960 Senate amendments and reinserted under S.59 in 1961.

PENSION TRENDS AND THE SELF-EMPLOYED

62

The self-employed person may contribute more than the 10 per cent or $2,500—up to one-half of the amount contributed and deducted on behalf of all covered employees (other than owner-employees) if these nonowner employees have immediate vested rights to these contributions. There are additional restrictions on all retirement plans when they cover owneremployees—those who own more than 10 per cent of the stock of the company or more than 10 per cent interest in an unincorporated business. These limitations may require a special provision in the plan or trust agreement permitting the trustee to refund sums received from the contributors upon the receipt of some appropriate certification. There should be some means of verification of the refundability of such payments. The trustee will be entitled to some protection if excess contributions are "wilfully made" by an individual without its knowledge. Perhaps the notice of the refund to the Director of Internal Revenue or some certification of such notice would suffice. This is another item for clarification in the Treasury regulations. Contributory Plans and Nondeductible Contributions Contributory retirement plans, as well as those to which the employer alone makes contributions, may be established under the bill. If the employees who are not owner-employees are permitted to make nondeductible contributions to the plan, the owner-employee may make corresponding contributions on his own behalf up to $2,500 or 10 per cent of his earned income. Such contributions will not be deductible either by the employee or the owner-employee, but must be made out of income that has already been taxed. An owner-employee with no true employees would not be permitted to make nondeductible contributions.

63

Impact of statutes and regulations

TAXABILITY

OF

DISTRIBUTIONS

The bill contemplates generally that retirement funds will not be payable until age 65 (age 60 under the amended version), but benefits must begin not later than age 71. They will be subject to income tax in the hands of the participants at the time distributed. Lump sum distributions after age 65 (or 60) are to be taxed under a special formula to avoid having the retirement funds largely dissipated by being taxed in one year under the higher surtax brackets. In lieu of the rates otherwise applicable, the lump sum distribution will be assessed at five times the tax rate applicable to one-fifth of the amount. The same treatment will apply for payment to a beneficiary in the event of the death of the participant. Premature Distributions Withdrawal of the retirement fund prior to age 65 (or 60) will be permitted, subject to the payment of a penalty, under the Senate version of the Keogh bill. If the earlier distribution were $2,500 or more, the tax would not be less than 110 per cent of the increase in tax that would have resulted if the income had been received ratably over the five years ending with the year of distribution. If the premature distribution amounted to less than $2,500, the tax due would be 110 per cent of the increase in tax resulting from inclusion of the entire amount of the premature distribution in gross income for the current year. For purposes of this penalty, taxable income for any of those years is deemed to be not less than the appropriate portion of the distributed amount reduced only by the deduction for personal exemptions, and the tax so computed can be reduced only by the credit for withheld taxes. As a further penalty in case of a premature distribution, the owner-employee is disqualified from participating in a retirement plan on his own behalf for five years following the year in which the total distribution is made. These penalties are imposed in order to prevent retirement plans from, in effect,

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

64

becoming income-averaging plans under which deductible contributions would be made to the plan in high-income tax years and the assets would be drawn down in low-income or loss years when little or no tax would be due. It is the purpose of this bill to provide means for financing retirement; these penalties are designed to insure that retirement plans will not be used for other purposes.

REGULATIONS The statutory and administrative rules governing the contributions to qualified trusts and as premiums for qualified annuities or insurance policies will be extensive. There will be problems in the distributions from these qualified trusts or annuity plans. Some of the problems and legal relationships have been suggested. Other complications will arise, but solutions will be found through regulations or rulings or, perhaps, through further amendments to the bill.

ALTERNATIVE

TAX

RELIEF Professional Associations with Corporate Characteristics

The delay in the enactment of H.R. 10 has stimulated the interest of self-employed professional people in another possible form of tax relief under the regulations of Section 7701 of the Internal Revenue Code. If a group of professionals form an association with the necessary corporate characteristics, they can have a qualified retirement plan with the usual tax-deferment under Section 401 (a), provided an employer-employee relationship exists between these professional participants. The qualification procedure is elaborate and will be difficult unless the state laws permit the corporate practice of professions or unless the partnership laws are amended. Such new laws have

Impact

of statutes

and

regulations

65

been passed in South Dakota (covering physicians), Arkansas (physicians and dentists), and Minnesota (physicians). Georgia and Tennessee have amended their partnership laws so that professional groups can have the corporate characteristics required by the new regulations. Alabama, California, Connecticut, Florida, Iowa, Oklahoma, Oregon, Pennsylvania, Rhode Island, and Wisconsin have bills pending to accomplish similar relief.

VI Methods and mechanics of trust administration An important phase of the Self-Employed Individuals' Tax Retirement Act involves the administration of the restricted or qualified retirement fund, the methods and mechanics initiated and maintained by the trust company or bank. Efficient methods with maximum mechanization will permit a sound retirement savings program at a reasonable cost. If large numbers of selfemployed persons can be attracted away from insurance and perhaps mutual fund competition, a successful operation may be achieved.

ADMINISTRATIVE

COMPLEXITIES

In the previous chapters various elements and problems involved in preparing for this type of trust business have been suggested. Each involves some phase of administrative or operational procedure. Tax deductibility must be established and maintained, with the depositor or contributor and the trust company each assuming a share of the responsibility. The operating procedures of the trustee must be based at first

Methods and mechanics of trust administration

67

on assumptions—perhaps rather rash assumptions. Continuing careful study of methods used and the analysis of actual experience will lead to possible improvements. Mechanization and ingenuity will help to reduce the impact of the high cost. Volume may be the only solution to the profit problem. Trust men must find a way to provide this service to the self-employed through a common trust or collective fund, or if no such medium has been set up by the trust department, then a cooperative program among the banks and trust companies in one area may be the best way to provide this trust service for the qualified persons in the community and yet avoid an operating loss. Individual Accounts In the collectively invested qualified retirement fund, like a profit-sharing trust fund, the income will be added to the principal and invested. A separate account must be kept for each participant with his contributions, and likewise his share of the earnings and gains or losses, credited at least once each year. Any withdrawals made by the participant will, of course, be deducted from his account. If there is one balanced fund containing both stocks and bonds, a general and one subaccount or two general accounts may be used to record (1) deposits and cash for distributions in a lump sum or in periodic payments, and (2) cash and investments in stocks and bonds. This latter account may be divided into two accounts, making three in all, if there are to be two funds, one for common stocks and one for bonds. Accounts may be kept in "units" or the dollar value method may be used. Mechanization Mechanization will be an important part of a Keogh-type collective trust operation because a large volume of accounts will be expected with a large number of transactions to be entered. Each participant's account can be maintained on a punch card using any customary form of identification. Each card could have two accounts, a cash account and an account showing the

PENSION TRENDS AND THE SELF-EMPLOYED

68

number of units held in the mixed fund, or in the separate funds. Deposits will probably have to be accepted at any time, but the purchase of units or the actual inclusion of the contributions in the collective fund might be on quarterly dates adjusted to the needs of the self-employed participants and also to any possible operational cost savings in the tabulating and accounting departments of the trustee. There will be mail—lots of mail—and there is no easy fast way to handle mail. Return envelopes will help to identify and route these retirement deposits and letters. The usual entry and credit procedures will be required on deposits, dividends, receipts, notices, etc. Letters will be handled separately, and routed to a trust officer or trust administrative man if necessary. This reference to a trust man will have to be minimized. Extensive correspondence or interviews with them will increase the costs of administration. Annual Statements and Reports Annual statements for each participant and annual information returns for the Internal Revenue Service will be required. Perhaps they can be processed at the same time. Each will require much the same data: (1) contributions, (2) distributions or refunds, (3) charges or expenses, and (4) value of each share of the fund at the beginning and end of the year. A statement or certificate of eligibility from the self-employed participant may be required. An annual report of the entire operations of the fund, showing investments, earnings, and the value of the fund, would also be sent to each participant. Periodic monthly or quarterly pay-outs may be offered to a participant when he reaches age 65. Although it will take some years before large numbers of these new customers become 60 or 65, some day this will be a problem which will add to the cost of administration. Therefore, it should be anticipated in the planning.

Methods and mechanics of trust administration

69

Advertising and Promotion Each bank or trust company will decide how far to go in the promotion and development of this business among its selfemployed prospects. For some banks this expense can be included in the existing advertising budget. It may well result in increasing savings deposits or new commercial accounts. This would justify a shifting of a part of the advertising budget to include a concentrated effort directed toward these self-employed persons. A successful advertising program will require the counsel of the public relations department and the advertising agency of the bank or trust company. It is quite possible that the direct mail campaign may offer the best results in carrying the trust department's message effectively to the qualified self-employed prospect. A bank trustee may decide to concentrate on the professional organizations and trade associations within its sphere of influence in seeking this type of business. Another corporate trustee may take a more aggressive approach, setting up by declaration of trust its own collective investment fund for any and all selfemployed contributors and their employees among its own depositors and other qualified people in its own area. It will make a survey of potential participants and contact them by direct mail as well as through advertising in local publications and trade journals. Its officers will talk to the doctor, the lawyer, the small store owner; keep in touch with trade associations and other professional groups; invite them to luncheons and panel discussions; and offer to attend their meetings and help them to develop a retirement program for their members.

COSTS

AND

FEES

Each institution will recognize that immediate profits cannot be anticipated. It may take a number of years—perhaps five or more

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

70

—before a sufficient number of self-employed depositors can be induced to set up accounts or join in a collective trust plan. However, after a break-even point is achieved, the increase in amounts of deposits and number of depositors should make this trust operation a profitable one if the fee schedule is realistic.

Other Cost Elements Other administrative cost elements to be considered are: 1. In the event a participant should terminate his interest by withdrawal or otherwise, a special closing fee would be reasonable to cover the additional services. 2. There will be added costs involved upon the death of a participant, examining inheritance tax waivers, evidence of death, and filing the necessary information papers with the Internal Revenue Service. 3. Making a refund of an excess payment will involve special service and a report to the tax authorities. 4. The expense of an annual audit can be charged to the fund as it is done in a common trust fund. 5. The expense of amending the agreement will have to be absorbed by the trust company in its account charge or in its overall investment fees. 6. Other items include developing and printing forms, a suitable reproduction (elaborate or simple) of the trust agreement, forms for participants to sign, forms for reporting to the government and, of course, the promotion and development costs. The average cost on these items becomes infinitesimal as the number of participating self-employed accounts moves on toward infinity (to use the word loosely and hopefully). A successful retirement fund with many contributors will attract more accounts and encourage larger deposits. It is the "average" that tells the story. A higher average contribution each year with an increase in the number of participants spells a potentially profitable operation.

Methods and mechanics of trust administration

71 Fees

After the bank or trust company has decided on the type of fund or funds and has set up the operations and procedures for handling the accounts, it will be ready to determine a schedule of fees. Its executives will have come to certain conclusions or assumptions as to the potential volume of business it will be able to develop. The trust fees may well be divided into two parts, investment management and account maintenance. Compensation for the investment service is well established in the trust field. There should also be a fee for the cost of operating and maintaining the individual accounts, receiving deposits, buying units, keeping records, advising customers, notifying the Internal Revenue Service, etc. In determining fees the trustee may have concluded to set up rules for deposits and distributions in order to keep costs at a minimum. For example, deposits might be received only on certain quarterly or other fixed dates. Other devices will be found to reduce costs so that fees need not be set too high. The trust company or bank is entitled to be fairly compensated when the expected volume of business has been achieved. It would be reasonable to charge fees for investment management on the basis of one-half of 1 per cent to 1 per cent of the market value of the principal supervised. A straight percentage will make the operation more profitable as the fund grows larger over the years. The fees for account maintenance could be a flat amount for each deposit and withdrawal, such as $1 per deposit with perhaps a maximum of four quarterly deposits permitted each year. Some trust departments may feel that a more realistic approach to this portion of the fees would be a percentage of the amounts involved. A fee of 1 per cent of each deposit could be charged, with a minimum annual fee of $5. On withdrawals under $1,000 or other amount, a 1 per cent charge could be made with a minimum of $3 to $5 for each distribution. If a withdrawal exceeded

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

72

the $1,000 limitation, then the fee could drop to one-half of 1 per cent on this excess. The main objective of the trust executive will be to develop a simplified plan, efficient procedures, and an effective advertising and development program. Then he will pray for a sufficient volume at the end of five years or so to show a little profit. By that time his cost accountant may see a ray of hope for this phase of his trust operations.

TYPES

OF

TRUSTS

As trust men and their attorneys have given thought to how these self-employed retirement funds can best be operated, three basic patterns of trusts have begun to emerge. These are: 1. A self-employed person may establish an individual intervivos trust conforming to the requirements of the act, under which the trustee may invest directly in permitted assets or in a common trust fund operated by the trustee pursuant to regulations of the Federal Reserve Board. (See Appendix E.) In the future it may become possible for a trust company to combine this service with an investment advisory or living trust account by segregating the deductible contributions in a special retirement account subject to the limitations of the bill. 2. A professional or other association, or group of individuals acting together, may establish a trust conforming to the requirements of the act under which separate accounts for each member will be maintained, but assets will be invested collectively; and 3. A bank may declare a trust, stating its intention to qualify such trust as a qualified retirement fund and to accept contributions therein from qualified self-employed individuals for collective investment, with separate accounts to be maintained for each participant. (See Appendix D.) It seems most likely that the bank-declared, collective form of trust (number 3 above) will be the most commonly used. Trusts

Methods and mechanics of trust administration

73

of this form may reasonably be expected to attract many thousands of members, because of the investment advantages and administrative economies to be derived from the pooling by the participants of their retirement resources.1 George M. Humphrey, when he was Secretary of the Treasury, expressed the hope of the trust officer when he stated his views to the Committee on Ways and Means at one of its hearings on the Keogh bill. He stated, "A pension trust is such a well recognized thing now that you can go to almost any trust company and set up a pension trust at a relatively small expense and have it administered by that bank in a very careful, satisfactory manner. I think the trust departments are pretty skilled in this sort of thing. They do it very easily and for a reasonable fee."

VII Investing

for the

qualified

COLLECTIVE CONTEMPLATED

fund

INVESTMENTS

In the several bills which have been introduced in Congress, it has been apparent that the draftsmen and sponsors have in every case recognized the fact that retirement funds of self-employed persons are to be held by a bank or trust company as trustee and that it will be necessary that the funds of a number of selfemployed persons be invested collectively. While the problem has been accentuated by the reduction from $7,500 to $2,500 as the maximum annual deposit by each individual, it has always been apparent that even the maximum deposit of each selfemployed person would in no event be substantial enough to permit its separate investment, unless the special issue of United States bonds were purchased under a qualified bond purchase plan. One of the early bills went so far as to provide that the trustee-bank could invest retirement funds of the self-employed only in a common trust fund. Another previous bill included only a plan set up by an association or trade group with its selfemployed members having undivided interests in a trust fund

Investing for the qualified

75

fund

held by a bank or trust company. Although these restrictive requirements have since been liberalized, it is still abundantly clear that plurality is contemplated and that it is intended that retirement funds be invested collectively. For example, the Keogh bill provided that, . . . the term "restricted retirement fund" means a trust established under a retirement plan for one or more self-employed individuals. . . . the term "retirement plan" means a trust instrument for the exclusive benefit of the participating individual or individuals who are members of the plan. . . . If the trust has more than one member, the interest of each member shall be proportionate to the money he has paid in . . . and to the income and other adjustments properly attributable thereto. With self-employed being classified for tax purposes as employees under the amended bill, qualified retirement plans will be established for the self-employed and their employees, and there will be pooling of these funds for investment purposes just as there has been with qualified employee trusts set up b y the smaller corporations. Balanced or Dual

Funds

A trust in which many self-employed persons may participate might provide for a balanced fund or two funds, one for investment in bonds and fixed income securities, another restricted to equities. There will be questions and explanations in the event of violent market swings, particularly when they are downward, but most trustees recognize this situation and will include provisions in each agreement to protect them in this contingency.

PERMISSIBLE

INVESTMENTS

The Keogh bill in one of its recent versions, when the tax treatment came under a separate section of the code for selfemployed persons only, contained more restrictive investment

PENSXON TRENDS AND THE

SELF-EMPLOYED

76

provisions. It provided that under the trust instrument the trustee may not invest or reinvest the corpus or income of the trust other than in stock or securities listed on a securities exchange, in bonds or other evidences of indebtedness issued by the United States or any state or territory or the District of Columbia or any political subdivision or instrumentality thereof, and in stock in a regulated investment company. The purchase of an annuity on the life of the individual member was also permitted. In the face of the clear intention of the Keogh and its precursor bills on the subject of collective investment, trust men have centered their planning around the most familiar medium of collective investment, the common trust fund. The above investment limitations raised the question, however, whether investment in a common trust fund would be in technical compliance with the requirements of the statute. A common trust fund might consist solely of securities falling into the categories of investments enumerated in the bill. Would the retirement trust hold an undivided interest in each of the securities making up the common fund, on a conduit theory, or would the common trust fund be regarded as a separate legal entity in which the retirement trust held units of participation? These former investment provisions included the limitation to securities listed on a securities exchange. The fact that stock or securities are so listed may be indicative, but is not controlling as to their investment merit. Many assets of trust investment quality would be barred from use. Mortgages would be eliminated. Also, many bonds of high quality are not listed on a securities exchange and cannot be purchased through such an exchange. These investment conditions were included at least partly because the custodian account had also been included in the bill at that time as an acceptable depository for the so-called restricted retirement funds. It was desirable for this reason to list specifically the investments which would be permissible. Then the bill was changed back to its original requirement that only trusts may be used—trusts which must have a bank or trust com-

Investing

for the qualified

fund

77

pany as trustee—so that a less restrictive and more reasonable approach to permissible investments was possible.

Federal Reserve Standards In substitution for the "legal list" approach to permissible investments contained in the earlier bill, the revision suggested by the Committee on Employee Trusts, Trust Division, American Bankers Association, set the same standard as permitted for the investment of trust funds by national banks under Federal Reserve Board regulations issued pursuant to the Federal Reserve Act. What this meant specifically is seen in these condensed quotations from the Federal Reserve Board's Regulation F : Funds received or held by a national bank asfiduciaryshall, . . . subject to the rules of law applicable to fiduciaries, be invested promptly and in strict accordance with the . . . instrument creating the trust. . . . When such instrument does not specify the character or class of investments to be made and does not expressly vest in the bank . . . a discretion in the matter, funds received or held in trust shall be invested . . . in any investments in which corporate or individualfiduciariesin the State in which the bank is acting may lawfully invest. . . -1 Funds . . . shall not be invested collectively except that such collective investments may be made in accordance with Section 17 of this regulation. . . .2 Funds . . . shall not be invested in stock or obligations of, or property acquired from, the bank or its directors, officers, or employees, or their interests, or in stock or obligations of, or property acquired from, affiliates of the bank.3 These same high standards will probably continue to guide trustees in the investment of qualified retirement funds and permit the use of a common trust fund or a collective form of trust for qualified self-employed individuals. Regulation F of the Federal Reserve Board also involves certain limitations in the use of a common trust fund or other collective investment device. (1) Any funds so invested must be used for a bona fide fiduciary purpose. Any Keogh-type trust

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

78

would seem to have all the elements usually associated with bona fide fiduciary purposes. (2) Any bank having such a fund must not advertise or publicize its earnings or value. This will require consideration but should not adversely affect the administration of Keogh-type funds. (3) Regulation F limits participation in a common trust fund by any one trust to $100,000, although this might be increased in future years. The common trust fund will normally be used only if a self-employed person creates a separate trust for the investment of his retirement deposits for himself and his employees. Since the annual deposits are limited in amount, they will in most cases come within the Federal Reserve dollar limitation even with the reinvestment of any capital appreciation and dividends and interest over a long period of years. (4) A separate collectively invested retirement fund for qualified self-employed individuals and their employees will probably be the medium used by the larger trust departments. Such a collective fund also may be used where a professional or trade association creates a fund for its qualified self-employed members by direct agreement with a bank or trust company.

PRIOR

LIMITATIONS

REMOVED

Before submission of the Senate amendments to the Keogh bill, there were other proposed legislative refinements in the bill which were related to investment considerations. These included voting stock limitations and permissible investments, transfer stamp taxes, prohibited transactions, and the transfer of the cash value of a retirement policy to a retirement trust just as funds from the latter may be used to purchase a retirement annuity policy. Voting Stock Limitation There was a provision under the 1959 Keogh bill that investments in any one company by the trust and its members cannot

Investing

for the qualified

fund

79

exceed 10 per cent of its voting stock. The Committee on Employees Trusts of the American Bankers Association suggested the change to "not more than $10,000 or 10 per cent of the fair market value of the trust" as a workable substitute for the limitation on voting stock. This would accomplish the purpose of preventing the settlor of an individual trust from financing his own business through the trust's investments on a tax-exempt basis. The use of government bonds, mutual funds, and common trust funds or collective investment funds would not be restricted since they provide adequate diversification. Issuance Stamp Tax Federal documentary stamp taxes are no problem as long as selfemployed retirement plans come under Section 401 of the Internal Revenue Code. Exemption from such taxes is extended to a common trust fund or a collective investment fund for qualified trusts under the latest version of H.R. 10 which extends coverage to self-employed under Section 401. 4 Prohibited Transactions The Keogh bill defined a prohibited transaction as any transaction in which: (a) lends, "(i) the trust maker, (b) pays compensation (ii) a member, for personal (iii) a member of the services, family of a mem(c) makes its services ber, or (1) The trustee to available preferen(iv) a corporation contially, or trolled directly (d) acquires from, or or indirectly by a sells member (2) The fund ceases to meet in any respect the requirements for a retirement plan as set forth in the act; or (3) The trustee or other interested persons fail to comply with any provision of the trust instrument required by the act.

PENSION TBENDS AND THE SELF-EMPLOYED

80

The limitations set forth in item (1) would have prohibited any transaction whatsoever with a member or participant regardless of its reasonableness or the adequacy of consideration. Such provisions seem unnecessary with a bank or trust company serving as trustee. The latter should be entitled to receive reasonable compensation for its services whether it is the declarer of the trust or the trust was established by others. Attorneys and brokers who serve such a trust fund should be paid their reasonable fees and regular commissions even though they are participants or members of the group establishing the fund. The Senate version of the bill tightened these previous rules but made them applicable only for trusts where a self-employed or corporate owner-employee controls the business with more than a 50 per cent ownership interest. Such an owner-employee should not borrow from a trust he has established, nor buy from nor sell to that trust, and should not charge fees for services rendered to the trust. Prohibitions are necessary to avoid abuses, but it can be expected that adjustments or interpretations to eliminate injustices or innocent mistakes will be accomplished by Treasury regulations, consistent with the existing provisions of Section 503 (c) of the Internal Revenue Code.

Freedom to Choose Investment Medium In the 1959 version of the bill, a member's share in a restricted retirement trust could be used to purchase for him a restricted retirement annuity policy. Under the Senate changes either method of funding could be used because qualification comes under Section 401 of the Internal Revenue Code. Changing conditions—either personal to the member or general to the economy—could make such transfers desirable, either way, from a fund to a policy or from a policy to a fund. A member should be in a flexible position to adjust his retirement program to meet his changing conditions. A third alternative was added by the Senate amendments permitting investment in a special series of United States government bonds. They could be purchased directly by the self-

Investing

for the qualified

fund

81

employed under a qualified bond purchase plan or by a trustee under an existing pension plan. A trust company or bank may set up retirement funds so that self-employed participants, for themselves and for their employees, may select the types of investments they prefer for their own retirement funds. To one person, a portion in bonds and a portion in stocks will form a desirable arrangement; to another, a portion in insurance and a portion in stocks will seem appropriate; and others may conceivably prefer all insurance, or all bonds, or all stocks, or other combinations. Surveys made by banks among persons to be covered by the act have shown that the trusts to be established should permit this flexibility.5

Vili Pensions in our

economy

What are the signposts in today's dynamic fast-growing pension structure? Its present stature may be attributed to many economic and sociological influences. It has become a powerful force in the economy. Pension maturity, however, is a long way off. Pensions will continue to affect, and be affected by, economic magnitudes and variables—the extent of the growth and progress of the economy; saving, investment, and inflation; fiscal and monetary policies of the government; equity investments or variable annuities; and changing benefit levels.

PENSIONS SAVING

AND AND

THE FLOW INVESTMENT

OF

Economic progress requires both saving and investment. Saving without investment will not add to the productive capacity of an economy. Indeed, it will generate depressions as not all of the goods produced are taken off the market. Investment without saving creates inflation and, in all likelihood, investment secured in this manner cannot be sustained.

Pensions in our economy

83

Economic progress is necessary to provide for population growth. Great amounts of money must be invested each year to prevent the growth of population from reducing the ratio of capital equipment to manpower and thus the national income per person. Our plant and equipment—factories, power plants, railroads, airlines, telephone systems—are embodiments of past saving. They are there because people in years past were willing to save, to forego current consumption. They represent stored-up labor. They must be renewed if we are to sustain our living standards. They must be expanded if we are to provide for population growth. They must be renewed, expanded, and improved if we are to have progress. That means less emphasis on consumption and more on capital formation. We will have to replenish the pools of venture capital, the money that goes into brand-new enterprises which are the seeds of progress. We have benefited so long from the saving-investment process that we tend to take it for granted. This is a serious mistake if we really want to accelerate economic growth and most particularly if we want an easier life as we go along, with shortened working hours, more paid time off the job, earlier retirements, and more adequate pensions. Economic Variables and Inflation Economic theories will attempt to explain and influence progress. It is rather well recognized that inflation is a danger but growth is good. Economic trends—the likelihood of booms or depressions—are affected by these theories and by the political climate. Governmental tax policies may encourage, expand, or create social measures according to the political party in control. However, monetary authorities have been, and it is hoped will continue to be, independent of political pressures. In periods of broad and sustained economic expansion, unemployment, low wages, and curtailment of production are of less concern than an increase in the quantity of money. Savings in such periods tend to be outstripped by demands for capital.

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

84

There is an inflationary danger in the increase of the money supply at a time when monetary expansion is already threatening to outstrip, if not actually outstripping, the nation's productive capacity. The gradual working off of the superabundant liquidity inherited from the depression and the war years has made the economy more dependent on credit. The expansion of credit had the same effect as the increase of money supply. These and other influences have brought about the steady growth and greater stability of the economy since the last war with just a few short recessions of moderate proportions. Consumption and personal incomes have continued to increase every year, with a heavy flow of savings and also heavy credit demands. High taxation has had its effect on the volume of savings and the type of investments selected. The redistribution of income (both before and after taxes) has affected the apportionment of the nation's income as between consumption and saving. Continuing inflationary tendencies (or rising price levels) have an effect on willingness to save, investor preferences between bonds and stocks, and also on demands for credit. If such action continues, it may bring about a basic revulsion from the savings propensity in favor of spending or risky speculation. But there seems to be a growing awareness that rising prices can contribute to the loss of export markets and a general instability in the economy. Whether conventional fiscal and monetary measures can cope with "cost-push" inflation due to the advance of wage rates at a faster rate than productivity gains, is, however, a question which only time can answer. Effect of Academic

Concepts

Men in business and finance sometimes underestimate the potential steam behind academic concepts when they are first put forth. Thus, it was comparatively easy in 1936 to take lightly the soft money delusions of the late John Maynard Keynes when his General Theory first appeared. But it was very difficult, psychologically, emotionally, and politically, to attack these concepts eight years later when at Breton Woods, N.H., a program of

Pensions in our

economy

85

action was adopted to conform to the Keynesian philosophy. With a prosperous and expanding economy today the big government spenders are streamlining this philosophy. They still urge more government spending—not now to prime the pump and make jobs, but rather to strengthen our competitive position with Russia, or to step up the rate of national economic growth to 5 per cent per year or better. But American achievement is heightened by a system of rewards and incentives, not by oppressive taxation. Even though it is politically popular, we cannot spend ourselves rich. Reasonable expenditures for desirable governmental services, including national defense, are essential to perpetuate the circumstances of our productive society. The ratios and priorities for public and private expenditures must be subject to some control and direction. Extravagant government expenditure inevitably leads to crushing taxation or inflation. Uncontrolled inflation is the result of fiscal mismanagement and leads to the loss of precious human rights. And the right to own property and to protect and preserve its value against the inroads of inflation is a basic human right. So let the search continue for a monetary and fiscal policy which will hold to the center between the hazards of inflation and unemployment, and on the path of noninflationary full employment and maximum economic growth. A useful productive central banking authority will move contrary to mob hysteria. We need fiscal policies to calm overenthusiasm during excesses and encourage revival of hope and venturesomeness during extreme pessimism, leveling off the peaks and valleys in the economy, checking recessions and stimulating creative effort and growth without opening the floodgates to inflation. The Impact of Pensions Savings, and their distribution among different types of investment, play a large role in determining how rapidly we will be able to turn out goods and services in the future. Progress means doing more for people. And that means more pensions. The effect of pensions on savings and on the various forms in which

P E N S I O N TRENDS AND THE

SELF-EMPLOYED

86

savings are invested is widely recognized and the impact becomes more significant each year. Pensions will need to reflect the growth of the country. They'll need to be adequate. EQUITY VARIABLE

INVESTMENTS ANNUITIES

AND

Equity investments have taken a more prominent place in all pension and profit-sharing funds. This has been due to the feeling or the hope that the increasing values of well-selected common stocks would help to reflect the growth of the economy and the continuing rise in price levels. Over long periods in the past, changes in the market value of high-grade equity investments have roughly corresponded to changes in the cost of living. However, in none of the three business recessions in recent years has the American cost of living receded appreciably. It is possible, nevertheless, to make a pretty good case for variable annuities, or at least substantial equity investments, in any retirement program. The professional man or the self-employed merchant will, of course, have good years as well as bad years in his business. There may be a partial adjustment available for these variations if allowable deductions could be carried over subsequent years. Although this privilege appears to have been eliminated from the Keogh bill, it would be only a partial answer to the building of a reasonably adequate retirement fund for many of these selfemployed persons. If the cost of living rises in future years as it has in the past, a self-employed individual will aim to accumulate enough to allow for these higher price levels when he is ready to retire. A partial adjustment for this trend in past years could have been accomplished by investing a part of his retirement contributions in equity securities, if he held the right stocks for the right length of time. The heart of the problem is that pensioners no longer have much earning power of their own. They are almost completely

Pensions in our

economy

87

dependent on the purchasing power of the pensions. In a variable annuity this pension payment fluctuates with investment results. Its appeal lies in the possibility of preventing the deterioration in purchasing power of fixed dollar retirement annuities after long periods of rising prices. There is a risk in equity investment. The short swings in the market can be violent and may bear little relationship to living costs or price levels. But the long-term trend—assuming selective investment in basic industries—has given validity to the theory of the broad parallelism of equity prices and the cost of living. The pension based on the equity portion of a variable annuity depends upon the market value of the stocks and the earnings on these investments. If security values go up, pension benefits increase. If the values go down, pension benefits decrease. Equity annuities appear to be appropriate for individual purchasers who fully understand what they are buying. The volatility of the share values, the panic psychology in a declining market, and the risk of fluctuation are the inherent dangers. The Teachers Insurance and Annuity Association (TIAA) was the first insurance company to establish such a program of variable annuities. Under its plan, up to half of the contributions or premiums may be invested in equities through a different company, the College Retirement Equities Fund (CREF). Each premium paid into the equities fund in behalf of a participant purchases a certain number of units representing his share in the fund. He also receives additional units from the fund's dividend income. Thus this part of the participant's pension depends upon the units to his credit. A number of industrial firms have adopted a similar variable annuity program for retirement. Among the prominent companies which have adopted such plans are Boeing Airplane, Northrop Corporation, General Mills, Chemstrand, Long Island Lighting, Bristol-Myers, and Warner-Lambert. They use the trust fund medium for financing. Two life insurance companies in Washington, D.C., are writing variable annuity policies. A number of others are entering

PENSION TRENDS AND THE SELF-EMPLOYED

88

the field in several states as the various legislative impediments are being removed. Kentucky and New Jersey were the first states to grant legislative authority. Since the United States Supreme Court decision in March, 1959, holding the Variable Annuity Life Insurance Company of Washington, D.C., subject to SEC jurisdiction, the state insurance departments and the state securities administrators have indicated an interest in their possible jurisdiction over insurance companies offering these variable annuities for sale to the general public. Pensions and the Cost of Living Adjusting payments to conform to equity values for the remainder of his life after retirement will not be easy for the selfemployed person unless some life insurance company is writing a single premium variable annuity at that time. However, the variable annuity principal for the self-employed can be carried out during the years of accumulation up to retirement age. Then the accumulated fund must be distributed or used to purchase annuities. It may be possible that such a fund could be retained by the bank or trust company with a substantial continuing equity position. If the original agreement doesn't cover this contingency, a separate agreement might be entered into between the retiring participant and the trust company requiring annual payments to be made over a period up through his 70th year (the age limit for distributions under the act), at which time any balance remaining in the fund would be distributed to him at once or over a period of years equal to his expectancy. There has been considerable interest in this new approach to the problem of linking the pension benefit to the general prosperity of the country through investment in equities and sharing in their earnings and their growth. There are dangers but the parallelism theory seems to have won general recognition. In times past, it would not have been so easy to support the variable annuity. The criticisms would have been more serious 20 or 30 years ago, but the whole economic environment has

Pensions in our

economy

89

changed in this country since World War II, and it would seem that the new form of annuity is in response to a new demand. The man on the street is becoming more sophisticated about common stock risks, thanks to the educational work of mutual funds, investment counselors, the New York Stock Exchange, banks and trust companies, and other retirement fund administrators and agencies. Many annuitants and prospective annuitants would like a share in the nation's economic expansion and protection against rising prices. The variable annuity promises them a measure of both. 1

IX Summary and conclusion

There are many problems revolving around the aged and their growing importance in our population. The development of pensions is the result of (1) the growth in population of people over 65 years of age, and (2) the increase in the scope and functions of government. The depression of the thirties and two world wars put government into the pension business with social security, railroad retirement, old age assistance, and veterans' payments. The economic depression brought into focus the need for formal pension plans. Superannuated personnel could be eliminated to make room for younger, more aggressive employees as a measure of efficiency. Employers soon realized that pensions are expensive and it is just good business to accumulate funds to pay these pensioners during their active working careers. While the history of private pension plans can be traced back to 1875, a speeding up of their growth began with World War II and has continued since. During the war some unions turned their attention to the establishment of pension funds or increasing existing private pensions (and other fringe benefits). Direct wage increases were limited under the stabilization policy then

Summary

and

conclusion

91

in force. Many employers looked on pensions as a device for attracting scarce workers and holding their labor supply. Additional contributing factors were the high rates of corporate tax, and the provision introduced in the Internal Revenue Code of 1942 that the employer's contributions to pension plans would be considered a deductible business expense if the plans did not discriminate in favor of officers or certain highly paid personnel. Later events—the inclusion of a pension program as part of the coal strike settlement in 1946, the Inland Steel Case decision by the National Labor Relations Board in 1948 (confirmed by the Supreme Court in 1949) to the effect that pensions are a bargainable issue, and the Steel Industry Fact Finding Board's recommendation in 1949 that pension programs should be supported solely by employer contributions—all tended to accelerate this trend. High tax rates made any tax deferment a prime objective. A portion of salaries could be postponed, thus delaying taxes until they could be paid at lower rates. Private pensions have become the most important fringe benefit for employees. It became evident that our tax laws could mean the difference between financial hardship and economic security in old age. A substantial portion of our population was unable to participate in this rapid rise of private pension plans. Professional and other self-employed persons were not entitled to such tax relief. Social security had been extended to most of these people. However, they were subjected to a kind of legislative discrimination on any tax savings for retirement. It was natural that efforts would be made to permit these advantages to be extended to this large class of self-employed—farmers, professional men, lawyers, doctors, dentists, architects, accountants, engineers, salesmen, artists, artisans of all kinds, and businessmen who work for themselves. Social security benefits continue to move upward. Every election year Congress has passed a bill increasing benefits for the nation's old folks. The original basic objectives of this government program are expanding, and future citizens will have to pay the ever mounting costs.

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

92

The Keogh concept began to fit into the pension picture. It would provide for the self-employed at least a partial answer to that ever elusive objective of security. Legislation was first introduced in 1951. At first the tax relief was to be granted only to members of professional and trade associations. Then all selfemployed were to be included. Later it became available to the self-employed only if they made similar provisions for their own employees. At first the investment medium was a restricted trust fund with a corporate trustee. Then the door was opened to insurance companies. The big objection to earlier legislative action was the loss of revenue. This potential loss of revenue was the impetus behind the Senate amendments of 1960. The Senators were attempting to reduce the tax loss (1) by the requirements that self-employed must cover their employees in order to deduct their own contributions (fewer self-employed were expected to take advantage of allowable deductions), (2) by basing deductions on earned income, (3) by eliminating the over age 50 increase in deductions, and (4) by introducing the new element of a reduction in the allowable tax deductions by corporations for their executive stockholders or owner-employees who are participating in existing pension and profit-sharing plans. Pensions involve the accumulation of large reserves. The rapid rate of growth of social security, railroad retirement, federal, state, and local employee retirement, and private plans have engendered increasing interest in the effects of pensions on such important economic variables as savings, investment, productivity, mobility, the level of income and employment, and the redistribution of purchasing power. Self-employed retirement plans will participate in the continuing growth of private pension programs, with their probable tendency toward increased coverage and liberalization of benefits. It is apparent from the changes in the Keogh bill initiated or fostered by the United States Treasury Department and included in the amended bill as reported to the Senate, that there may be a new influence evident in future pension trends. The

Summary and conclusion

93

Treasury Department is continually asked to express its views on legislation having tax implications. They have been actively opposed to this legislation because of the revenue loss involved, but also because the bill did not provide uniform tax treatment between two types of individuals, those under corporate retirement plans and those under the proposed self-employed retirement plans. And they may have had a secondary purpose in introducing entirely new and seemingly unrelated amendments which would change the tax treatment of owner-employees under existing plans. New opposition to the amended bill would become so violent that Congress would defeat the measure. Did they use one device to accomplish another objective? The obligation to maintain the national revenue may require plugging a "loophole" here or eliminating an "abuse" there and, if need be, usurping a little of the legislative function. The growing awareness of the future impact of the larger magnitudes of the entire pension structure will introduce new factors limiting tax reductions and influencing legislation. Pension funds as one of the many forms of savings alter the direction of the flow of income. Cash wages, corporate profits, and professional fees and the resultant income tax payments are redirected toward deferred compensation. The enlarged scale of public and private provisions for the aged, coupled with a growing awareness of the value of such benefits, may change people's spending and saving habits. The substantial annual additions to pension fund reserves affects both the level and composition of savings. There are two primary redistributive effects of pensions: (1) redistribution among income classes, and (2) redistribution of purchasing power from the working population to the retired aged. The first has an economic effect on both savings and incentive to work arising from the income class distribution of "burden" and "benefits." The other involves the extent of the "drain" on future resources. How great will be the "burden" imposed by pensions on future generations? Is the build-up of benefit rights

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

94

accompanied by an equivalent amount of saving and capital formation? There has been a notable rise in common stock holdings of pension funds. Common stocks constitute an increasing share of the portfolios of pension funds, and a large proportion of new common stock issues are purchased each year for these funds. In 1959, 50 per cent of net receipts of all pension funds were invested in common stock.1 Thirty-eight per cent of net new equity issues in 1959 were acquired by pension funds. Is this investment policy caused by expectations of inflation over the long pull and the desire to maximize the benefit per dollar of pension expense? Will there be a limit to higher yielding issues or those with greater growth or capital gain possibilities? Will this rising interest in common stocks affect people's saving behavior? Equities might become the predominant type of assets they seek as media for their savings. If a larger proportion of more and more funds from investors generally flow into equities, a rising market may reduce the rate of return and the growth potential. Then a new relationship between the level of market values and the cost of living may develop and we may have to take another look at common stock as a hedge against increasing costs. Pension plans will continue to play a part in the savinginvestment process. Savings propensities may be changed by pension programs or by equities in pension funds. People may disregard pension accumulations and save about the same as before, or they may save more or less. But pension coverage is still new and its full impact will be delayed. The trends in savings will be affected by other factors in the economy. The ratio of personal saving to personal income, over long periods of time, appears to have been roughly constant in spite of significant institutional changes in the economy. The increasing role of the state in the provision of security may affect the ratio of consumption (and hence, saving) to income. The expansion of money and credit has kept pace with the nation's productive capacity. The apportionment of income to consump-

95

Summary and conclusion

tion and saving depends on the extent of this economic growth and the level of taxation. A growing awareness of the dangers of rising prices and economic instability gives hope that the value of the pension dollar will be protected.

DOES

H.R.

10 SOLVE

THE

PROBLEM? Opposition

In the arguments for and against H.R. 10, opponents of the bill say its passage would cause new inequities, new legislative discrimination. The bill would give the self-employed special privileges not generally available under present pension plans. A taxpayer is going to get a tax deduction on his own contributions to his pension plan. Nobody gets that privilege now. If one group gets that kind of privilege everybody ought to have the same right—and that would cost $3 billion per year in lost revenues. The income tax becomes a consumption tax. Savings would be exempt from taxation for the first time. The higher the income the greater would be the benefit in tax dollars retained or dollars not paid for taxes. The lower income groups, having the chance to save very little or none at all, already supply the major portion of our tax receipts and will carry this additional tax load. It is just a straight tax deduction of 10 per cent of income or $2,500 to a select group who have no special claim to a tax deduction. There are too many loopholes in pension laws, say the opponents, particularly capital gains and unreasonable vesting requirements in favor of owner-employees. The revenue loss would add to the national debt. A major principle of taxation is at stakel Claims of Proponents The proponents say that we must encourage any and all forms of saving. We must stimulate individual enterprise and initiative. The proponents' case is based on the difference in treatment between the person who is employed and the one who

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

96

works for himself in his own business or profession. The selfemployed individual has wide fluctuations of income. He is beset with inherent risks in this kind of enterprise. This is evident in the high rate of small business failures. He finds it increasingly difficult in the face of high costs and high taxes to build up an adequate amount of savings during his productive years. We have granted tax relief to millions of employees. They are accumulating substantial funds without any taxes until retirement. Why do we penalize the self-employed? He is asking to set aside a little of his own money—not an employer's money—and pay taxes on it when he receives it. Why is it necessary to work for someone else in order to set aside some reasonable amount of savings for retirement? It is a matter of simple justice to extend this tax deferment to the small independent businessman whose initiative and enterprise help to build up the basic strength of our economy. Whether it is called inflation, a rise in prices, or depreciation of money, something has happened to the cost of living. The depreciation of money can be converted to an annual rate of return which a saver would have to receive and reinvest at compound interest to have the same amount of purchasing power. The annual depreciation rate in the United States for a number of years was 3.4 per cent. Thus, a capital sum invested for ten years at 3.4 per cent compound interest would grow enough to keep up with the average rate of depreciation of the dollar, but only if the interest were free of income tax. A person in the 20 per cent income tax bracket would require a taxable interest rate of 4.3 per cent; in a 40 per cent bracket, 5.7 per cent; in an 80 per cent bracket, 17 per cent—and all this simply to hold even with the depreciation of the dollar and avoid actual loss.2 The selfemployed saver will continue to fall behind in this cost-of-living race unless he can set aside such funds for retirement without being subject to income tax. The proponents maintain that the tax loss is overstated by the Treasury Department. The setting up of qualified pension plans for the self-employed would be a gradual process. The revenue

Summary and conclusion

97

loss during the first few years would be small, and a part of it would only be deferred until distributions are received and taxed. If the restrictions on owner-employees continue and with the necessary inclusion of nonowner employees together with the other limitations of the act, the number of new plans will be minimized. The technical limitations of the act will limit the number of new self-employed plans to qualify. WHAT'S AHEAD SELF-EMPLOYED?

FOR

THE

These differences between the opponents and proponents of tax relief for the self-employed will probably continue. There are arguments about many other phases of our tax laws. It is recognized that our whole tax structure involves many inconsistencies and inequities. The Congressional aim is to minimize these inconsistencies and to equalize inequities while maintaining our revenue requirements. A reorganization and complete rebuilding of the Internal Revenue Code may be the perfect solution but such an undertaking is colossal in scope and is not likely to be achieved in the very near future. The curbs on corporation plans which were introduced in the Senate amendments were quite unrelated to the principal question of tax relief for the self-employed. Any proposed tax revision of corporate plans should be decided on its own merits after full Congressional hearings limited to this one important subject. What will be the eventual form of this legislation? Representative Keogh and the other Congressional leaders who favor this legislation seem to agree on certain changes. W e have had the opportunity to discuss this matter with various attorneys and others 3 who have devoted much time to the study of this subject. It is generally agreed that the bill will permit a selfemployed person to qualify a plan for himself and his employees under Section 401 of the Internal Revenue Code under conditions similar to those required of a corporation. This prediction is reflected in the new H.R. 10 as introduced in 1961 by Repre-

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

98

sentative Keogh and passed again by the House of Representatives. There should also be an alternative qualification procedure in order to minimize administration and investment expense for the small self-employed professional or business man. Perhaps a simplified application form could be used setting forth simple basic questions and answers which would permit automatic qualification to the average self-employed applicant. Section 401 (IRC) appears to be basically sound. Approved pension plans have grown to gigantic stature. Millions of our citizens are relying on these plans for security in their retirement years. After many years they have become established and accepted by the public generally. There may be some abuses, but they do not appear to be substantial. Equivalent tax treatment for the self-employed and their corporate neighbors is a reasonable objective. The new legislation embodied in H.R. 10 and S. 59 seems to indicate a trend toward the acceptance of the following as reasonable objectives for creating a favorable tax atmosphere for the self-employed: 1. Deferment of taxable income for retirement purposes will be dependent on the same nondiscriminatory provisions contained in IRC Section 401 with the additional inclusion of self-employed persons. Each plan, therefore, could not discriminate in favor of employees who are officers, shareholders, supervisory or highly compensated employees, or in favor of owner-employees. Where a self-employed person has no employees the maximum contribution limitations would be retained. 2. A plan would qualify automatically under IRC Section 401 if: (a) It includes one or more self-employed persons or owneremployees, and, if such owner-employee has employees, the plan also includes them. (b) The benefits under the plan for each participant in the plan would be either: (1) A specified uniform percentage of compensation applied to total compensation; or

Summary and conclusion

99

(2) A specified benefit payable at normal retirement equal to a uniform percentage applied to average monthly or yearly total compensation for any period of employment of five or more consecutive years, or total period of employment, such as 1 per cent of salary for each year of service. (c) Amounts that can be contributed under the plan for any year would not exceed the lesser of: (1) A specified percentage (15 per cent, 20 per cent, etc.) of each participant's compensation or earned income for that year, or (2) A specified amount ($2,500, $5,000, etc.) if such dollar limitation seems necessary, or (3) That amount which would be required at each participant's then attained age to provide for him a "normal benefit" commencing at age 65 (computed in accordance with a table to be set forth in the act) equal to not more than 1 per cent of his total compensation for that year. (Since contributions and benefits must be reasonable in amount under Section 401, an over-all limitation of 20 per cent of compensation or earned income would seem to accomplish this objective as it would be comparable to the deductible limitation in IRC Section 403(b)). (d) The amounts contributed for each participant in the plan would be fully vested. (e) The amounts contributed would constitute a "retirement deposit" as defined in Section 217 of the 1959 version of H.R. 10 and of S. 59 in 1961. 3. A self-employed person would be defined the same as was done in Section 217(c)(1) of H.R. 10, and would be treated as an employee for all purposes of IRC Sections 401, 402, 403, and 404. He would be an employer for purposes of IRC Section 404, and he would also be a "creator" of a trust for purposes of IRC Section 503(c). A selfemployed person's "period of employment," if applicable, would be the period during which he has received "earned income" as defined in Section 217(d) of H.R. 10.

PENSION TRENDS AND THE SELF-EMPLOYED

FUTURE

OF THE

PENSION

100

STRUCTURE

The pension structure is immense. The future alone can reveal the extent of its influence on our economy and on our financial stability. From this review of the various components of the pension structure it is apparent that taxes play the most important role. The tax treatment of contributions to retirement plans and of the benefits after retirement revises the savings and income pattern by a redistribution of the tax burden. Tax relief to the self-employed will extend this redistribution between the productive and the nonproductive segment of our society—between the young and the aged. The tax structure changes a little under each amendment of the Internal Revenue Code. When savings, even though relatively small in amount, become tax-exempt or tax-postponed, new factors are injected into our economy with important consequences deserving of further study and research. One of the most difficult phases of the challenge of longevity is assuring equitable distribution among the aged of an appropriate portion of enlarged future production. The distribution of production in future years will depend chiefly on today's distribution of savings and capital accumulation. The greater the number of individuals with personal savings and with shares in cooperative industrial programs, the greater the assurance that a fair distribution of the production of the future will be achieved.

Notes PENSION 1

PLANS

AND

SOCIAL

SECURITY

Lucian Price, Dialogues of Alfred North Whitehead (Boston: Little, Brown & Company, 1954), pp. 55, 94. 2 Melvin W. Reder, Economic Problems of the Aged (Institute of Industrial Relations, University of California, Reprint 58,1954), p. 670. 3 George B. Buck, "Impact of Pension Plans Upon the National Economy," The Journal of Commerce, June 17,1955, 2nd section, p. 3. 4 Life Insurance Fact Book 1959 (New York: Institute of Life Insurance), p. 109. 5 Inland Steel Company v. N.L.R.B. (1948), 170 Fed. 2nd 247; also 336 U.S. 960 (1949). 6 Source: Division of the Actuary, Social Security Administration. 7 Survey of Corporate Pension Funds, 1959 (SEC Securities Act Release No. 1680 [Washington, D.C., May 31, I960]), p. 1. 8 Handbook for Pension Planning (The Bureau of National Affairs, Inc. [Washington, D.C., 1949]), pp. 2,3. 9 Donald F. Campbell, Jr., "The Social Security Act: Twenty Years Experience," The Journal of Accountancy, Vol. 102, No. 2 (August, 1956), p. 27. 10 Marion B. Folsom, "Teamwork for Individual Independence," Social Security Bulletin, Vol. 18, No. 8 (August 1955), p. 1. 11 Stephen Raushenbush, Pensions in Our Economy (Public Affairs Institute [Washington 3, D.C., 1955]), pp. 76-77. 12 Ibid., pp. 77,101. 13 Frank G. Dickinson, Reappraisal of Social Security (Bureau of Medical Economic Research, American Medical Association Bulletin No. M-91 [Chicago, March 5, 1955]), p. 3. 14 Roger F. Murray, Statement to Senate Committee on Finance, June 18, 1959, Hearings Before Senate Committee on Finance on H.R. 10, 86th Cong., 1st Sess. (Washington, D.C.: Government Printing Office, 1959), p. 211.

PENSION

T R E N D S AND T H E

SELF-EMPLOYED

102

15

Alvin D. Lurie, "Qualified Pension and Profit Sharing Retirement Plans for Small Companies," Proceedings of New York University 12th Annual Institute on Federal Taxation, Vol. 12 (Albany, N.Y.: Matthew Bender and Co., Inc., 1954), p. 328. 16 See Appendices G and H. 17 Lurie, p. 329. 18 5 U.S.C.A., §2254. 19 Robert J. Myers, "Actuarial Cost Estimates for Long Range Social Insurance Benefits," The Proceedings, Conference of Actuaries, Vol. IX (1959-60), p. 332. 20 "Analysis of the Social Security System," Report of the Special Committee on Social Security of the House Committee on Ways and Means, 83rd Cong., 1st Sess. (Washington, D.C.: Government Printing Office, 1954), p. 155. 21 Raushenbush, pp. 40,101. 22 Walter W. Kolodrubetz, "Characteristics of Pension Plans," Monthly Labor Review, Vol. 81, No. 8 (August, 1958), p. 849. 23 Robert Tilove, Pension Funds and Economic Freedom (New York: The Fund for the Republic, 1959), p. 19. 24 Ibid., p. 18. 25 Employee Benefit Plan Review (Chicago: Charles D. Spencer & Associates, Inc., January, I960), p. 16.

LEGISLATIVE 1 2 3

4 5 6 7

Leslie M. Rapp, "The Quest for Tax Equality for Private Pension Plans: A Short History of the Jenkins-Keogh Bill," Tax Law Review, Vol. 14, No. 1 (November, 1958), p. 60. Ibid., p. 61. Also see Appendix F for associations supporting the Keogh bill. The Chicago Bar Association was represented by the author, who presented its statement in favor of the bill to the Committee in person at the hearings on July 15,1959. Hearings Before Senate Committee on Finance on H.R. 10, 86th Cong., 1st Sess. (Washington, D.C.: Government Printing Office, 1959), p. 325. See Appendix F. Rapp, p. 65. Hearings, 1959 p. 240. Spencers Retirement Plan Services (Chicago: Charles D. Spencer & Associates, Inc., 1960), p. 22.2.

FINANCING 1 2 3

PROPOSALS

METHODS

John B. St. John, "Financing a Pension Plan," Handbook for Pension Planning (The Bureau of National Affairs, Inc. [Washington, D.C., 1949]), p. 83. H.R. 4371, 82nd Cong., 1st Sess. (1951). Carlysle A. Bethel, "New Developments in Pension and Retirement ProfitSharing Trusts," The Trust Bulletin, Vol. 32, No. 4 (December, 1952), p. 9.

103

Notes 4 5 6 7 8 9 10

11 12 13 14 15 16 17 18 19 20

Jay V. Strong, Employee Benefit Plans in Operation (Bureau of National Affairs, Inc. [Washington, D.C., 1951]), p. 87. St. John, p. 114. Joseph F. Myles, A Cost Analysis of the Principal Methods of Financing Pension Plans (New York: Stonier Graduate School of Banking, 1954), p. 61. St. John, pp. 128,133. Spencer's Retirement Plan Services (Chicago: Charles D. Spencer & Associates, Inc., 1960), p. 42.1. See p. 22, supra. Richard G. Moser, "Using a Group of Employers as a Unit in Pension Planning," Proceedings of New York University 14th Annual Institute on Federal Taxation, Vol. 14 (Albany, N.Y.: Matthew Bender and Co., Inc., 1956), p. 1143. See Appendices D and E. Hearings Before Senate Committee on Finance on H.R. 10, 86th Cong., 1st Sess. (Washington, D.C.: Government Printing Office, 1959), p. 22. Life Insurance Fact Book 1959 (New York: Institute of Life Insurance), pp. 36-38. The Tally of Life Insurance Statistics (New York: Institute of Life Insurance, December, 1959). Roy M. Gidney, "National Trust Earnings Are Up," Trusts and Estates, Vol. 95, No. 11 (November, 1956), p. 1020. Robert Tilove, Pension Funds and Economic Freedom (New York: The Fund for the Republic, 1959), p. 84. Spencers, pp. 40.1-43.1. Laurence J. Ackerman, "Financing Pension Benefits," Harvard Business Review, Vol. 34, No. 5 (September, October, 1956), p. 74. Frank L. Griffin, Jr., Funding Pension Plans Under Todays Economy, Paper given before the 41st Mid-Winter Trust Conference at New York, February 9,1960, p. 10. Pension and Other Employee Welfare Plans, A Survey of Funds Held by Banks in New York State (New York State Banking Department, 1955), p. 12.

IMPACT OF REGULATIONS 1 2 3 4 5 6 7 8 9 10

STATUTES

AND

Austin Wakeman Scott, The Law of Trusts (Boston: Little, Brown & Co., 1959), §62.10 (6). Christian M. Lauritzen II, "Perpetuities and Pension Trusts," Taxes—The Tax Magazine (Chicago: Commerce Clearing House), Vol. 24, No. 6 (June, 1946), p. 526. Scott, § §369.2,375.2 (footnote 32). Restatement of Trusts, §62 Comment k. Scott, §62.10. Ibid., §112 (footnote 21). Ibid., §62.11. Ibid., §401.9. Restatement, §156 (1). 28 Minn. Stats. Ann., §501.11 (6).

PENSION

T R E N D S AND T H E

SELF-EMPLOYED

104

11 Cal. Civ. Code, §715.3. 12 41 New York Consol. Laws (Personal Property), § 13-D. 13 IU. Rev. Stat., ch. 3, § §601-2 (1959). 14 See Chapter VII for a review of investment powers and limitations. 15 See Appendix B, III, for owner-employee restrictions in the Senate versions of the bill.

METHODS OF TRUST 1

2 3 4 5

2 3

THE

QUALIFIED

FUND

IN

OUR

ECONOMY

Leonard E. Morrissey, "Dispute Over the Variable Annuity," Harvard Business Review, Vol. 35, No. 1 (January-February, 1957), p. 84.

SUMMARY 1

FOR

Board of Governors of the Federal Reserve System, Regulation F: Trust Powers of National Banks (1955), Sec. 10(a). Ibid., Sec. 10(c). Section 17 covers the terms and conditions under which common trust funds may be and are operated. Ibid., Sec. 11(a). S. 59 also includes this exemption. See Appendix C. Survey by the Bank of New York, 1959.

PENSIONS 1

MECHANICS ADMINISTRATION

Letter of May 27, 1959, to Senate Committee on Finance from Committee on Employee's Trusts, Trust Division, American Bankers Association, as quoted in Hearings Before Senate Committee on Finance on H.R. 10, 86th Cong., 1st Sess. (Washington, D.C.: Government Printing Office, 1959), p. 258.

INVESTING 1

AND

AND

CONCLUSION

Survey of Corporate Pension Funds, 1959 (Securities and Exchange Commission, Release No. 1680 [Washington, D.C., May 31, I960]). "The Cost of Depreciating Money," First National City Bank Monthly Letter (New York), December, 1956, p. 143. Cecil P. Bronston, Richard J. Frankenstein, Jr., and Charles D. Spencer (Publisher) of Chicago, Leslie M. Rapp of New York, and their associates.

Appendix

A

OUTLINE OF MAIN PROVISIONS OF THE KEOGH BILL AS PASSED BY THE HOUSE OF REPRESENTATIVES (86th Cong., 1st Sess.-1959) The following represents a condensed question-and-answer review of the highlights of H.R. 10 as passed by the House of Representatives.

I. Who is eligible? Any individual subject to the self-employment tax under the Social Security Act, including doctors and ministers, A. Who does not receive during the year any benefit derived from an employer contribution under a tax-exempt or qualified pension or profit-sharing plan, or B. For whom no such employer contribution is made during the year. II. How much can he deducted from gross income as a retirement deposit? A. If under age 50, 1. 10 per cent of net earnings from self-employment, or 2. $2,500, whichever is less, for each year.

PENSION TRENDS AND THE SELF-EMPLOYED

106

B. If over age 50 (on the effective date of the act), 1. The 10 per cent and $2,500 limitations are increased 1 / 1 0 for each year of age over 50. (E.g., if age 60 on effective date, annual limit of deduction would be 20 per cent of net earnings, but not over $5,000.) C. These retirement deposits are deductible 1. If paid during the taxable year (or 3% months thereafter), and 2. If the aggregate lifetime deductions do not exceed 20 times the maximum annual deduction, or $50,000, reduced by 1 / 2 0 for each year, if any, in which the individual a. Received any benefit payment, or b. Acquired any nonforfeitable rights from an employer contribution to a qualified plan. III. Who receives retirement deposits? Retirement deposits must be made to a restricted retirement fund, or as premiums under a restricted retirement policy. A. A restricted retirement fund for one or more selfemployed individuals must be 1. Administered by a trust company or bank as trustee, 2. Established under a retirement plan or trust instrument with provisions: a. For the exclusive benefit of the participating members of the plan or their designated beneficiaries; b. For tax exemption under Sec. 501(a) I.R.C.; c. That a member's interest shall be nonassignable except he may designate a beneficiary, transfer his interest to another restricted retirement fund, or purchase a pure endowment or annuity policy including no life insurance protection, or purchase a face amount certificate; d. That distribution of the member's interest must start not later than age 70 and be completed be-

Appendix

107

fore he is 80, or within five years of his death before age 70; e. That investments are limited to stock or securities listed on a registered exchange, stock of a regulated investment company under Sec. 8511.R.C., government bonds, or face-amount certificates, and shall include no stock or securities of a corporation in which its members own as much as 10 per cent of the voting stock; and f. In pure endowment or annuity policies (without life insurance) or in face-amount certificates; g. That the trustee is required to return any deposit by a member in excess of his allowable deduction; h. That the trustee shall not engage in any prohibited transactions which involve certain dealings with any member of the plan; i. That the trustee shall file such returns and information as may be prescribed by the Secretary, and the member shall furnish to the trustee certain information as so prescribed. B. A restricted retirement policy shall 1. Be issued to a self-employed taxpayer as the insured by a domestic life insurance company; 2. Be primarily an annuity or endowment policy, but may provide life insurance benefits if they do not extend beyond age 70M; 3. Provide for payment of the policy value a. To the insured not later than age 70/2, or b. To the insured or to him and his wife jointly, as an annuity beginning not later than age 70/2, and with no minimum or certain term extending beyond his life expectancy; 4. Be nonassignable and owned by the insured with full rights to change beneficiary and select any of above annuity options with life insurance protection ceasing after age 70&-,

PENSION TRENDS AND THE SELF-EMPLOYED

108

5. Be identified as a restricted retirement policy in such manner as code regulations may prescribe; 6. Include a face-amount certificate (an investment contract or other security requiring the payment of a stated or determinable amount at a fixed or determinable date or dates at least two years after issuance). Such certificate shall be treated as an annuity. IV. What is the income tax treatment of amounts received from restricted retirement funds? A. All payments are included in gross income when received, except that distribution of an annuity policy purchased by the fund on his life is not taxed until annuity payments are received under the policy, and his basis in the fund shall be zero. B. If received by the individual after age 65: 1. Payments are included in gross income in year received. 2. If the entire amount is received in one taxable year, the tax will be five times the increase in tax resulting from including Vs of this amount in gross income. This /s averaging rule applies to the estate or other beneficiary of a deceased self-employed individual who receives his entire interest in one year. 3. The tax cannot be less than if his only income was the amount received during the year deducting only his personal exemptions. 4. The retirement income credit is not allowable on amounts received from the fund. C. If an individual receives before age 65: 1. An amount less than $2,500, the tax is 110 per cent of tax attributable to the inclusion of this amount in his gross income; or 2. An amount in excess of $2,500, tax is 110 per cent of the increase in total taxes which would arise if it had been received equally in the taxable year and the four preceding years.

Appendix

109

3. If the individual knowingly makes contributions in excess of his allowable deductions, or if he engages in any prohibited transactions, such as the sale of his own securities to the fund, his entire interest in all restricted retirement funds shall be immediately included in his gross income. D. After the death of the individual: 1. A lump sum payment in a single year will be taxable to the estate or other beneficiary under the same % averaging rule. 2. Other amounts received by a beneficiary will be taxable as income in respect of the decedent, and if appropriate, an estate tax deduction will be allowed. V. What income taxes are payable on amounts received under restricted retirement policies? A. If received by an individual after age 65: 1. Amounts will be taxed under the annuity rules (Sec. 72 I.R.C.) with these exceptions: a. No portion of the premiums allocable to the cost of life insurance or benefits other than the endowment or annuity type of restricted retirement benefits shall be taken into account in computing the basis or treated as part of the cost of the annuity; b. That part of the premiums paid for the type of annuity or endowment benefits permitted for restricted retirement policies which were not deductible (paid in low income year, or before policy became a restricted retirement policy) will be treated as part of the consideration paid for the annuity; c. Amounts received before the annuity starting date will be included in gross income to the extent they do not exceed the total of previous deductions; d. The three year income spreading provision for endowment policies will not apply under Sec. 72 (e)(3).

PENSION TRENDS AND THE SELF-EMPLOYED

110

2. If his entire interest in all policies is received in one taxable year, it will be taxable under the Js averaging rule. 3. The tax cannot be less than if his only income was the amount received during the year less only his personal exemption. 4. The retirement income credit is not allowable on the amounts received from the policy. B. If an individual receives before age 65: 1. An amount less than $2,500, the tax is 110 per cent of tax attributable to the inclusion of this amount in his gross income; or 2. An amount in excess of $2,500, tax is 110 per cent of the increase in total taxes which would arise if it had been received equally in the taxable year and the four preceding years; 3. Amounts borrowed on the annuity or endowment policy in excess of one annual premium, such amounts will be included in gross income, except cash values built up before policy became a restricted retirement policy; 4. An option elected involving life insurance or other than endowment or annuity benefits permitted for a restricted retirement policy, such cash values are includable in gross income, except any portion of such cash values built up before the policy became a restricted retirement policy. C. After the death of the individual: 1. Amount of death benefits not exceeding cash value before death will be included in gross income to the beneficiaries if the insured received a tax deferment with respect to this value, except that this may be deferred if taken as an annuity by the surviving spouse; 2. The pure life insurance portion of the death benefits, if any, will not be treated as gross income;

111

Appendix

3. A lump sum payment in a single year will be taxable to the estate or other beneficiary under the same % averaging rule; 4. Other amounts received by a beneficiary will be taxable as income in respect to the decedent, and, if appropriate, an estate tax deduction will be allowed.

Appendix

B

OUTLINE OF MAIN PROVISIONS OF H.R. 10 AS REPORTED TO THE SENATE BY ITS COMMITTEE ON FINANCE (86th Cong., 2nd Sess.-1960)

The following presents a condensed question-and-answer review of the highlights of the Senate amendments to H.R. 10 as reported to the Senate by its Committee on Finance: I. Who is eligible? Any individual subject to the self-employment tax under the Social Security Act, including doctors and ministers.

PENSION TRENDS AND THE SELF-EMPLOYED

112

The bill would also apply to employees of self-employed persons and corporate owner-employees (including anyone who owns more than 10 per cent of the business), provided the plan includes all such employees who have been employed for three years or more. II. How much can be deducted as "earned income" under a qualified plan for a self-employed individual or a corporate owner-employee? A. The limits remain at $2,500 or 10 per cent of "earned income," which means income derived from personal services, not from a return on capital. The additional deductions for individuals who are age 50 or over will not be allowed. The maximum lifetime deductions will be eliminated. The $2,500-10 per cent limit may be increased if all contributions are fully vested, provided the self-employed person may not deduct in excess of % of the amount which he contributes for his employees. B. These contributions to a qualified plan are deductible 1. If the plan meets the present tax exempting requirements of the Internal Revenue Code as to nondiscrimination of benefits and coverage for employees, and 2. If the self-employed individual also sets up a retirement plan for any employees he may have, and 3. If such contributions are deposited with a bank or trust company as trustee, invested in annuities with an insurance company, or invested in a proposed new series of United States government bonds. Pooling of funds for investment would be permitted. III. What constitutes a qualified plan? A qualified plan must include these provisions in addition to those which the law requires of all employee retirement plans: A. If it is a trusteed plan, the trustee must be a bank or trust company. B. Benefits to an owner-employee must not be payable be-

Appendix

113

fore age 59% except on account of permanent disability. C. In the case of profit-sharing and stock bonus plans, employees' rights must be nonforfeitable during the existence of the plan and on its termination with full vesting for all covered employees if owner-employees are included. D. The plan must have a definite formula for determining the amount of annual contributions, as once required under Treasury regulations. E. Social security adjustments and credits are reduced where self-employed and owner-employees are covered. F. Excess contributions must be returned to the contributor and any income thereon is taxable. G. Any assignment or pledge or loan of any portion of a trust or contract is treated as a distribution and any repayment thereof is treated as a new contribution. H. If an owner-employee dies, his entire interest must be distributed within five years, or used to buy an immediate annuity for his beneficiaries. I. If two or more businesses are controlled by an owneremployee they must be considered as a single business in applying the nondiscriminatory rules. J. In the case of a corporation, contributions for its owneremployees may not exceed the amount contributed for its other employees with the usual vesting and nondiscriminatory provisions; or they may not exceed an amount which would provide the cost of a life annuity commencing at age 64% and paying each year the equivalent of ?s of the average annual compensation during the ten years immediately preceding retirement, or age 64/2, whichever is earlier. K. A distribution to a self-employed individual or an owner-employee must commence no later than age 70}L Nonowner-employees must receive distribution no later than age 70% or retirement, whichever is later. Treasury regulations will specify how such distributions may be

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

114

made over the life of the employee, or over the lives of the employee and his spouse. L. Forfeitures cannot be applied to increase the benefits any employee would otherwise receive under the plan. M. The trustee shall not engage in any prohibited transactions, as provided in the present law with additional restrictions where the plan covers owner-employees having more than a 50 per cent interest in the business. Such an owner-employee may not borrow any part of income or corpus of the trust, nor buy from or sell property to the trust, nor charge fees for personal services to the trust. IV. What is the definition of an "owner-employee"p New requirements are introduced for qualification of retirement plans which cover owner-employees. They are proprietors, partners with more than a 10 per cent interest in the partnership, and corporate employees who own more than 10 per cent of the stock or voting power of a corporation. Ownership interest includes any interest owned by the owner-employee's spouse, minor children, ancestors, or lineal descendants. V. What is the bond purchase plan? In addition to the usual trust or annuity plan a new bond purchase plan is permitted under which a self-employed employer may purchase for himself and his employees a new type of United States government bond. The plan could be established under a trust or without using a trust. These new bonds must be issued in the names of the individual employees or their beneficiaries, must be nontransferable and may not be redeemed by the individual until he has reached age 59% or has become disabled or deceased. There will be no interest or investment yield until redemption, and interest will be allowed on the bonds no later than five years after death. Principal and interest on the bonds will be included in the employee's gross income at the time they are redeemed. No income tax is payable when a bond

Appendix

115

is distributed to an employee, but the proceeds of the bond would be taxable upon redemption. VI. What are the limitations and tax treatment on distributions from qualified retirement plansP A. Any contributions for life insurance coverage would not be deductible. Retirement benefits paid to individuals from qualified plans would be taxable as ordinary income. If such benefits are derived from nondeductible contributions, the distributees would be entitled to recover their capital invested in a retirement contract free of tax. B. Distributions of retirement benefits must begin not later than age 70%, or when an employee retires, if it is later. An owner-employee's benefits must start no later than age 70%. C. Estate and gift tax exemption is not permitted to a selfemployed person but is still applicable to an employee with respect to any employer contributions made for him. The $5,000 death benefit exclusion is not available to the beneficiary of a deceased self-employed person. D. Capital gains treatment will apply to lump sum distributions made to regular employees including owneremployees, to the extent of the portion of the distribution attributable to employer contributions made on his behalf. Such treatment would not apply to a selfemployed individual receiving distribution after age 59M or disability, nor to his beneficiary after his death. In these funds the tax is determined under the % averaging rule—compute the tax on % of the amount of the lump sum distribution and multiply that figure by 5. E. Premature distributions refer to those made before an owner-employee reaches age 59/2. Excess distributions are those either willfully made or distributions in excess of the benefits provided under the plan. Premature and excess distributions are subject to a penalty which will increase the taxes due and payable. If the distribu-

P E N S I O N TRENDS AND T H E

SELF-EMPLOYED

116

tion subject to penalty is $2,500 or more, an owneremployee's tax would be increased to not less than 110 per cent of the total increase in tax which would have been due if this amount had been distributed pro rata over the five years ending with the year of distribution. If the distribution subject to penalty is under $2,500, the increase in tax due on this amount would be increased by 110 per cent. As a further penalty on a premature distribution, an owner-employee is disqualified from participating in any retirement plan for five years following the year in which such distribution was made.

Appendix C OUTLINE OF MAIN PROVISIONS OF H.R. 10 AS PASSED BY THE HOUSE OF REPRESENTATIVES IN 1961 WITH NOTATIONS OF THE PRINCIPAL VARIATIONS UNDER S. 59 AS INTRODUCED IN THE SENATE (87th Cong., 1st Sess.-1961 ) The following presents a condensed question-and-answer review of the highlights of the new Keogh bill, the Self-Employed Individuals' Tax Retirement Bill of 1961. The new bill contains

Appendix

117

certain provisions from the bill as reported to the Senate by the Senate Finance Committee in 1960 (Appendix B), but all reference to corporate plans and corporate owner-managers has been omitted. The principal differences between H.R. 10 and S. 59 as introduced by Senator George A. Smathers (Florida) are noted. I. Who is eligible? Any individual who has self-employment earnings from a trade or business, and his employees, are eligible. Special rules apply to an owner-employee or partner who owns more than 10 per cent interest in the trade or business. II. How much can be deducted by a self-employed individual for himself and his employees? A. The limits remain at $2,500 or 10 per cent of his "selfemployment earnings" in one year. (In S. 59, the limits are increased to 20 per cent of his "earned income" up to a maximum deposit of $5,000, but only 50 per cent of that amount would be deductible, with a lifetime limitation of $50,000.) Contributions in excess of these limits may be made under certain circumstances by an owner-employee, one who owns at least a 10 per cent interest in the business. B. These contributions to a qualified plan are deductible: 1. If the plan meets the present tax exempting requirements of Sec. 401 of the Internal Revenue Code as to nondiscrimination of benefits and coverage for employees, and 2. If the self-employed individual with more than three (three or more under S. 59) employees includes his employees in the plan and makes nonforfeitable contributions for them, and 3. If such contributions are invested with a bank or trust company as trustee, used to purchase annuities with an insurance company (or restricted retirement policies under S. 59), or invested in a proposed new

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

118

series of United States government bonds. Pooling of funds for investment would be permitted. (In S. 59, similar deduction rules are applied under the procedures set up for restricted retirement funds and restricted retirement policies in the 1960 House-passed bill. See Appendix A, III.) III. What constitutes a qualified plan? A qualified plan must include these provisions in addition to those which the existing law now requires of all employee retirement plans: A. If it is a trusteed plan, the trustee must be a bank or trust company. The trust must meet the usual rules applicable to qualified employee trusts under Sec. 401. (In S. 59 two of the recommendations of the Committee on Employee Trusts of the American Bankers Association were included: (1) Permissible investments were extended to conform to regulations of the Federal Reserve Board, including collective investment funds; and (2) documentary stamp taxes were eliminated. See Chap. VII, pp. 77,79.) B. Benefits to an owner-employee must not be payable before age 59/2 (64M in S. 59) except on account of permanent disability. C. Profit-sharing plans must have a "definite formula" for contributions by the employer for his employees and full vesting provisions for them. D. Nondeductible contributions by owner-employees up to the 10 per cent or $2,500 limit are permitted if the same rate is available to employees, and income thereon is not taxable until withdrawn. E. Any assignment or pledge or loan of any portion of a trust or contract is treated as a distribution and any repayment thereof is treated as a new contribution. F. If an owner-employee dies, his entire interest must be distributed within five years, or used to buy an immediate annuity for his beneficiaries.

Appendix

119

G. If two or more businesses are controlled by an owneremployee they must be considered as a single business in applying the nondiscrimination rules. H. A distribution to a self-employed individual or an owner-employee must commence no later than age 70M. Nonowner-employees must receive distribution no later than age 70% or retirement, whichever is later. Treasury regulations will specify how such distributions may be made over the life of the employee, or over the lives of the employee and his spouse. I. Forfeitures cannot be applied to increase the benefits any employee would otherwise receive tinder the plan. J. The trustee shall not engage in any prohibited transactions, as provided in the present law with additional restrictions where the plan covers owner-employees having more than a 50 per cent interest in the business. Such an owner-employee or a relative may not borrow any part of income or corpus of the trust, nor buy from or sell property to the trust, nor receive fees for personal services to the trust, and the trust must not make any of its services available on a preferential basis to such person. IV. What is the bond purchase plan? In addition to the usual trust or annuity plan a new bond purchase plan is permitted under which a self-employed employer may purchase for himself and his employees a new type of United States government bond. The plan could be established under a trust or without using a trust. Contributions must be used to buy these bonds for the individual employees or their beneficiaries. The bonds may not be redeemed by the individual until he has reached age 59% (age 64% under S. 59) or has become disabled or is deceased. Principal and interest on the bonds will be included in the employee's gross income at the time they are redeemed. No income tax is payable when a bond is distrib-

PENSION TRENDS AND THE SELF-EMPLOYED

120

uted to an employee, but the proceeds of the bond would be taxable upon redemption. V. Can mutual funds be used? A "custodial account" may be treated as a qualified trust if the custodian is a bank or trust company and contributions are invested only in stock of "open end" mutual funds qualifying as regulated investment companies under Sec. 851. VI. What are the limitations and tax treatment on distributions from qualified retirement plans? A. Any contributions for life insurance coverage would not be deductible. Retirement benefits paid to individuals from qualified plans would be taxable as ordinary income. If such benefits are derived from nondeductible contributions, the distributees would be entitled to recover their capital invested in a retirement contract free of tax. B. Distributions of retirement benefits must begin not later than age 70%, or when an employee retires, if it is later. An owner-employee's benefits must start no later than age 70%. C. Estate and gift tax exemption is not permitted to a selfemployed person but is still applicable to an employee with respect to any employer contributions made for him. The $5,000 death benefit exclusion is not available to the beneficiary of a deceased self-employed person. D. Capital gains treatment will apply to lump sum distributions made to regular employees to the extent of the portion of the distribution attributable to employer contributions made on his behalf. Such treatment would not apply to a self-employed individual receiving distribution after age 59% (age 64M under S. 59) or disability, nor to his beneficiary after his death. In these cases the tax is determined under thefive-yearaveraging rule —compute the tax on Vs of the amount of the lump sum distribution and multiply that figure by 5.

Appendix

121

E. An excess contribution, an amount greater than the permitted deductible and nondeductible contributions, must be returned, and the income earned thereon will be taxable to the self-employed person for whom it was made. If it is not repaid within six months after notification of the excess, the person involved is taxed on the income on his entire share in the fund. If the excess contribution is willfully made, his whole share must be distributed to him. F. Premature distributions refer to those made before an owner-employee reaches age 59% (age 64M under S. 59). Premature distributions are subject to a penalty which will increase the taxes due and payable. If the distribution subject to penalty is $2,500 or more, an owneremployee's tax would be increased to not less than 110 per cent of the total increase in tax which would have been due if this amount had been distributed pro rata over the five years ending with the year of distribution. If the distribution subject to penalty is under $2,500, the increase in tax due on this amount would be increased by 110 per cent. As a further penalty on a willful excess contribution or premature distribution, an owner-employee is disqualified from participating in any retirement plan for five years following the year in which such distribution was made. VII. What information will be requiredP Treasury regulations will further clarify these requirements. Owner-employees must furnish the trustee or insurance company with such information as may be prescribed in these regulations. An employee for whom bonds are purchased must furnish information to his employer or to the trust, and to the Internal Revenue Service.

Appendix

D

ILLUSTRATIVE PROVISIONS OF A DECLARATION OF TRUST BY A BANK OR TRUST COMPANY CREATING A COLLECTIVE QUALIFIED OR RESTRICTED RETIREMENT FUND FOR SELF-EMPLOYED INDIVIDUALS The following contains illustrative provisions for consideration by attorneys for a bank or trust company by which it may set up a restricted retirement trust to hold contributions from qualified individuals for collective investment. It was prepared to reflect the requirements of H.R. 10 as passed by the House of Representatives in 1959 and 1960. It also is adaptable to the provisions of the new S. 59, introduced by Senator Smathers in 1961. It would require more revision in order to conform to the rules applicable to Section 401 plans as specified in the new H.R. 10 introduced and passed by the House in 1961. An agreement of this type has been submitted by the Committee on Employees Trusts, Trust Division, American Bankers Association, to the Committee on Pension and Profit Sharing Trusts of the Real Property, Probate and Trust Law Section of the American Bar Association. This Committee took the matter

123

Appendix

under consideration but the changes in the proposed law have postponed further action. There will be a variance in the documents used depending on the ingenuity of the attorneys, the nature of the final legislation, the different circumstances involved and the particular group of self-employed individuals which the plan is intended to serve. (Name of bank or trust company) RESTRICTED RETIREMENT TRUST FOR SELF-EMPLOYED INDIVIDUALS DECLARATION OF TRUST The Bank and Trust Company, herein called the Trustee, hereby declares that it will receive, hold, invest and reinvest, and distribute retirement funds for self-employed individuals according to the following terms and conditions: 1. Trust Fund. This trust, hereinafter referred to as the Retirement Trust, is established as a Restricted Retirement Fund for self-employed individuals under the Self-Employed Individuals' Retirement Act, hereinafter referred to as the Act. 2. Participation. This trust is for the exclusive benefit of persons who shall qualify as self-employed individuals under the Act. To evidence their intention to participate in this Retirement Trust, such persons shall apply for participation in substantially the following manner: The undersigned hereby: (a) States that he is familiar with, and agrees to be bound by the terms and conditions of, the Restricted Retirement Trust, created by the Declaration of Trust executed by the Bank and Trust Co. the day of , 196 ; (b) Represents that he is a "self-employed individual" under the Internal Revenue Code as amended by the "Self-

PENSION TRENDS AND THE SELF-EMPLOYED

124

Employed Individuals' Retirement Act," and that he will not deposit monies in the said Retirement Trust in excess of the amount deductible by him under that Act. (The application form may quote the pertinent provisions referred to.) (c) Deposits by check (in cash) $ as his initial retirement deposit with the understanding that such sum, as well as subsequent deposits, will be invested by the Trustee along with the funds of other participants on the next valuation date of the Retirement Trust. Signature Date 3. Retirement Deposits. The Trustee shall receive retirement deposits from Participants, in an amount of at least $100 (or other amount) for credit to the account of the depositing Participant. The Trustee shall accept or retain only those deposits conforming to the then limits and conditions set by the Act, but shall be under no duty to inquire, beyond the statement of the Participant, as to the relationship of any deposit to the Participant's net earnings from self-employment. If a Participant with less than $5,000 (or other amount) in his account shall fail to make a deposit for three consecutive years, the Trustee, in its discretion, shall terminate his participation, and (a) transfer his interest to another Restricted Retirement Fund, (b) purchase for and deliver to the Participant a restricted retirement policy as defined in the Act, or (c) distribute such interest to him in cash. 4. Accounts of Participants. The Trustee shall maintain full records and books of account with a separate account for each Participant. Valuations of the Participants' accounts shall be made quarterly on the day of , showing the market values of the securities held, and the

Appendix

125

earnings, gains and losses, and market adjustments since the last preceding valuation date. The interest of each Participant shall be in the ratio that his account value bears to the total valuation of all Participants' accounts, and shall include his retirement deposits and the income and other adjustments attributable thereto. Any distributions to the Participant shall reduce the balance in his account. All assets of the Retirement Trust shall be owned exclusively by the Trustee, and no Participant shall have any individual ownership thereof. (If units are to be used instead of dollar value, this section would be changed.) 5. Distributions a. Upon Attainment of Requisite Age. The interest of each Participant in the Retirement Trust shall be distributed to the Participant between the dates on which he attains the age of 64M and 70, as the Participant shall direct: (1) in a lump sum, or (2) in installments over a period of years not extending beyond the Participant's 80th birthday, or (3) in the purchase of a Restricted Retirement Policy as defined in the Act. b. Upon Death. Upon the death of a Participant his interest shall be distributed to the beneficiary theretofore designated by the Participant, or if such beneficiary is not living or if no beneficiary is designated, then such interest shall be applied to the purchase of an immediate annuity for his surviving spouse which will be payable for her life (or a term certain not extending beyond her life expectancy) which annuity policy will be immediately distributed to such surviving spouse. If the Participant shall have died without leaving any designation of beneficiary, or a spouse surviving him, his entire interest in the Retirement Trust shall be distributed to his estate. Any distribution to a spouse of the decedent shall be completed within five years of his death.

PENSION TRENDS AND THE SELF-EMPLOYED

126

c. Other Withdrawals. The Trustee shall refund any amount paid in by a Participant in excess of the amount deductible by him under the Act together with all income attributable to such excess. The Trustee may rely on the written request of the Participant in making such refund. All other distributions prior to age 64% shall be made upon the written request of the Participant subject only to the restrictions and limitations as to taxability and disclosure as provided under the Act. (Other provisions may be included here as counsel may determine; e.g., written notice from Participant to Trustee must be in written form satisfactory to the Trustee at least 30 days before the valuation date, and in the absence of satisfactory direction, the Trustee may determine the distribution method and date; payment to a Participant or his beneficiary who is lost or cannot be located after three (or other) years from the date of mailing notice to his last known address, may be made in the same manner as if the Participant were deceased.) 6. Assignment by Participant. The Participant, at least 60 days prior to a quarterly valuation date, may direct the Trustee to, and the Trustee upon such direction shall, transfer all or any part of the Retirement Trust to another Restricted Retirement Fund designated in such direction. Except as provided in the preceding paragraph, neither the Participant nor any beneficiary of this trust shall have any right to alienate, encumber, assign, or hypothecate any part of his or her interest in the Trust in any manner, nor shall such interest of the Participant, nor of his beneficiary, be subject to claims of his or her creditors, or be liable to attachment, execution, or other process of law. 7. Powers and Rights of Trustee. Powers. The Trustee shall have the following powers, rights and duties in addition to those vested in it elsewhere in this Declaration of Trust or by law: a. To invest and reinvest the principal and income as a

Appendix

b.

c.

d. e. f. g.

127

single fund without distinction between principal and income in such bonds, notes, debentures, mortgages, equipment trust certificates, stock in regulated investment companies, preferred or common stocks, or in common trust funds or other types of collective investment funds created and administered in accordance with Regulation F of the Board of Governors of the Federal Reserve System, or in such other property, real or personal, either within or without the United States, as the Trustee may deem advisable without being limited by any statute or rule of law regarding type, amount, proportions, or diversification of investments by Trustees; provided, however, that no investment shall be made which would disqualify the Retirement Trust under the Act. (The provisions of the law as ultimately enacted by Congress will be determinative of the investment powers included in the Declaration of Trust.) To keep such portion of the Retirement Trust in cash as the Trustee in its discretion may determine without liability for the amount thereof, nor for any interest thereon. To purchase or sell any other property, real or personal, at public or private sale for such prices and upon such terms as may be deemed proper, and no purchaser shall have any liability to see to the application of the purchase money. To settle, compromise or abandon all claims and demands in favor of or against the Retirement Trust. To borrow money, with or without security, for the Retirement Trust. To vote with respect to all securities and property in person or by proxy. To consent to, and take any action in connection with, any plan of lease, merger, consolidation, exchange, foreclosure or reorganization, affecting securities held hereunder at any time; to deposit stocks under voting agreements; to subscribe for stock or bond privileges; and to

PENSION TRENDS AND THE SELF-EMPLOYED

128

exercise or dispose of any right it may have as the holder of any security. h. To lease, repair, alter or improve any property, real or personal. i. To hold any securities or other property in the name of its nominee, or in such form that title will pass by delivery. j. To exercise any of the powers and rights of an individual owner and to do all other acts in its judgment necessary or desirable for the proper administration and management of any property of the Retirement Trust, and for the preservation and distribution of the assets of the Trust, although such powers, rights, and acts are not specifically set forth herein. (The Trustee's powers will vary considerably from state to state and in keeping with the preferences of each bank or trust company and its Counsel.) 8. Responsibility of Trustee. The Trustee shall incur no personal liability for any act reasonably taken or omitted by it as Trustee in good faith with respect to the Retirement Trust, and the Trustee shall be indemnified and saved harmless out of the assets of the Trust from and against any and all claims, losses, damages, expenses, and liabilities to which the Trustee may be subjected by reason of any such act taken or omitted, including all expenses reasonably incurred in its defense. 9. Trustee's Compensation. The Trustee shall receive reasonable compensation for its services. The Trustee may pay itself such compensation from the assets of the Retirement Trust. 10. Expenses of Litigation. If any Participant or beneficiary brings legal action against the Trustee, the result of which shall be adverse to the party bringing the suit, or if any dispute shall arise as to the person or persons to whom payment or delivery of any funds shall be made by the Trustee, the cost to the Trustee of defending such suit shall be charged to such extent as is possible to the account of the Participant

Appendix

11.

12.

13.

14.

15.

129

whose interest is in issue, and only the excess, if any, shall be included in the expenses of the Retirement Trust. Releases. Prior to making any payment or distribution hereunder, the Trustee may require such releases or other documents from any lawful taxing authority and from the Participant or his beneficiary, as the Trustee shall reasonably deem necessary for its protection. Rules of Procedure. The Trustee may adopt such rules of procedure and regulations as it may deem necessary for a proper and efficient administration of the Retirement Trust or for the protection of the interests of any of the Participants. Any regulations lawfully prescribed by the Secretary of the Treasury or his delegate for the administration of Restricted Retirement Funds shall be incorporated into the Trustee's rules of procedure. Annual Audit. The Trustee shall at least once each year cause an independent certified public accountant to audit the Retirement Trust. The report of such audit, except as such report may concern the interest of any Participant other than the inquiring Participant, shall be available for inspection at the office of the Trustee during regular business hours by any Participant. The reasonable expenses of such audit shall be charged to the Retirement Trust. Reports of Trustee. An annual report of each Participant's showing account as of the last day of his deposits during the year, the current value of his interest in the Retirement Trust, and a statement of the operations of the Trust, shall be prepared and mailed to each Participant. Approval of Accounts. Ninety days after the submission of each annual report to each of the Participants, such report shall be deemed approved by each Participant except as to matters, if any, covered by written objections theretofore delivered to the Trustee by any Participant regarding which the Trustee has not given an explanation, or made adjustments satisfactory to the inquiring Participant, and the Trustee shall be released and discharged as to all matters set

PENSION TRENDS AND THE SELF-EMPLOYED

130

forth in such report which are not covered by such written objections as if such report or account had been settled and allowed by a decree of a court having jurisdiction regarding such account and of the Trustee, and all persons having or claiming to have any interest in the Retirement Trust. The Trustee, nevertheless, shall have the right to have its accounts settled by judicial proceedings if it so elects, in which event the Trustee representing all Participants and their beneficiaries and estates, shall be the only necessary party. 16. Amendment or Termination a. Amendment. This Declaration of Trust may be amended from time to time by a resolution of the Board of Directors of the Trustee, or its successor trustee, but no amendment shall become effective until the day following the quarterly valuation date which is not less than 60 days after a copy of such amendment shall have been mailed to the last known address of each Participant in the Retirement Trust. The Retirement Trust shall be amended from time to time if necessary to preserve its status as a Restricted Retirement Fund under the Act. b. Resignation. The Trustee may at any time resign as Trustee of the Retirement Trust, provided it shall have mailed a copy of such resignation to the last known address of each Participant. No such resignation shall be effective until a successor trustee, qualified to act under the Act, has been appointed by the Trustee and has accepted the successor trusteeship. The retiring Trustee shall convey, assign and deliver to its successor trustee all property held in trust hereunder, together with complete records of all Participants' accounts. The receipt of the successor trustee for such records and accounts shall be a full and complete acquittance and discharge of such retiring Trustee. All right, title and interest of the Trustee in the assets of the Trust, and all powers, rights, and duties under this Declaration of Trust theretofore vested in the Trustee shall vest in such successor immediately upon

Appendix

131

its appointment and acceptance, and thereupon all further duties and liabilities of the Trustee which has been succeeded shall terminate. c. Effect on Participant. No amendment of the Retirement Trust or resignation of the Trustee may operate either directly or indirectly to deprive any Participant of his beneficial interest in the Retirement Trust as it is then constituted. Neither shall any amendment or resignation make possible the return to any Participant of any interest in the Retirement Trust contrary to the provisions of the Act, as it may be amended from time to time. 17. Miscellaneous a. Representation. The Trustee shall be deemed to represent all persons having an interest in the Retirement Trust for the purposes of all judicial proceedings affecting the Retirement Trust or any asset thereof, and only the Trustee need be made a party to any such action. b. Notices and Reports. Notices, accountings, and reports required to be given or furnished by the Trustee may be by actual delivery or by mailing by first class mail, postage prepaid, to the most recent address known to the Trustee of the person entitled thereto. The date of such actual delivery or of such mailing, as the case may be, for all purposes hereunder, shall be deemed to be the date as of which such notice, accounting, or report was given or furnished. c. Interpretation. The powers and duties of the Trustee and all questions of interpretation of this Declaration of Trust shall be governed by the laws of the State of and to the extent applicable, by the Self-Employed Individuals' Retirement Act, or any amendment thereof. d. Merger. In the event that Bank or Trust Company shall at any time merge or consolidate with, or shall sell or transfer substantially all of its assets to another corporation, state or federal, the corporation

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

132

resulting from such consolidation, or the corporation into which it is converted, or to which such sale or transfer shall be made, shall thereupon become and be substituted hereunder in the place of the said Bank or Trust Company, and shall become the Trustee hereunder with the same effect as though originally so named. In Witness Whereof, Bank and Trust Company has caused its name to be hereunto signed by its proper officers and its Corporate Seal to be hereunto affixed, this day of , 196 . Bank or Trust Company By _ Vice President Executed in counterparts. (Seal) Attest: Secretary

Appendix

E

ILLUSTRATIVE PROVISIONS OF AN INDIVIDUAL INTERVIVOS TRUST AGREEMENT BETWEEN THE SELF-EMPLOYED INDIVIDUAL AND A BANK OR TRUST COMPANY The following contains a preliminary draft of illustrative provisions for the consideration of attorneys in assisting a qualified self-employed individual to establish a trust, with provisions that the trust investments may be made in permissible assets including a common trust fund operated by the trustee, pursuant to Section 584 of the Internal Revenue Code and Regulation F of the Federal Reserve Board. This form has also been submitted to the Committee on Pension and Profit Sharing Trusts of the Real Property, Probate and Trust Law Section of the American Bar Association.

RESTRICTED RETIREMENT FUND TRUST AGREEMENT 1. Purpose.

This agreement is entered into between , as Settlor, a self-employed individual under the provisions of the Act as hereinafter defined, and

PENSION

TRENDS

AND

THE

SELF-EMPLOYED

134

Trust Company, hereinafter called "Trustee," for the purpose of establishing for the exclusive benefit of the Settlor a voluntary, restricted retirement plan qualified under the Act or under any other laws, regulations, or rulings pertaining thereto as they may from time to time exist. 2. Definitions. The following terms shall have the following meanings wherever used in this agreement: a. "Act" shall mean the Self-Employed Individuals' Retirement Act, and all subsequent amendments thereto. b. "Effective date" of this trust shall be . c. "Qualified Earnings" shall mean net earnings from selfemployment as that term is defined in the Act. 3. Trust Fund. The Settlor has delivered to the Trustee the sum of $ , being a portion of the Settlor's qualified earnings, and he intends to deliver other qualified earnings from time to time. All such amounts of money received from the Settlor, the investments purchased therewith, together with all earnings, profits, and increments which may accrue thereon, shall constitute the Trust Fund and shall be held, administered, invested, reinvested, and distributed by the Trustee as provided herein. In the administration of the Trust Fund there shall be no distinction between principal and income. 4. Powers of Trustee. The Trustee shall have all powers with respect to the management of the Trust Fund as though it were the absolute owner thereof including the following powers: a. Except as otherwise in the Retirement Trust provided, the net income and profits of the Trust shall be accumulated, added to the principal of the Trust and invested and reinvested therewith as a single fund. The Trustee is authorized to invest the Retirement Trust in such bonds, notes, debentures, mortgages, equipment trust certificates, stock of regulated investment companies, preferred or common stocks, common trust funds, or other collec-

Appendix

b.

c.

d. e. f. g.

h. i.

135

tive investment funds created and administered in accordance with Regulation F of the Board of Governors of the Federal Reserve System, or in such other property, real or personal, either within or without the United States, as the Trustee may deem advisable, without being limited by any statute or rule of law regarding type, amount, proportions, or diversification of investments by trustees, provided, however, that no investment shall be made which would disqualify the Trust Fund under the Act. To keep such portion of the Trust Fund in cash as the Trustee may determine without liability for the amount thereof, nor for any interest thereon. To purchase or sell any securities, real estate, or other property at public or private sale for such prices and upon such terms as may be deemed proper, and no purchaser shall have any liability to see to the application of the purchase money. To settle, compromise, or abandon all claims and demands in favor of or against the Trust Fund. To borrow money, with or without security, for the Trust Fund. To vote with respect to all securities and property in person or by proxy. To consent to, and take any action in connection with, any plan of lease, merger, consolidation, exchange, foreclosure, or reorganization, affecting securities held hereunder at any time; to deposit stocks under voting agreements; to subscribe for stock or bond privileges; and to exercise or dispose of any right it may have as the holder of any security. To lease, repair, alter, or improve real estate or other property. To hold any securities or other property in the name of its nominee, or in such form that title will pass by delivery.

PENSION TRENDS AND THE SELF-EMPLOYED

136

5. Liability of Trustee. The Trustee shall not be liable for any losses resulting from the investment of the Trust Fund except to the extent that such losses shall have been caused by its bad faith or gross negligence. The Trustee may rely upon any certificate, statement, or other representation made to it by the Settlor concerning any fact required to be determined under any of the provisions of this agreement or of the Act. The Trustee shall be compensated for its services in the administration and distribution of the Trust Fund and shall be reimbursed for all reasonable expenses incident thereto. All persons dealing with the Trustee are released from inquiry into the decision or authority of the Trustee and from seeing to the application of any monies, securities, or other property paid or delivered to the Trustee. 6. Distribution. a. The Trust Fund will be distributed to the Settlor as he shall direct after his attaining age 64M (1) in a lump sum prior to age 70, or (2) in installments over a period of years not extending beyond his 80th birthday, or (3) for the purchase of a Restricted Retirement Policy as defined in the Act. b. Upon the death of the Settlor the Trust Fund will be distributed to the beneficiary designated by the Settlor, or if such beneficiary is not living, or if no beneficiary is designated, his interest shall be applied to the purchase of an immediate annuity for his surviving spouse which will be payable for her life (or a term certain not extending beyond her life expectancy) which annuity policy will be immediately distributed to such surviving spouse. If the Settlor shall have died without designating a beneficiary, or without leaving a spouse surviving him, then to the legal representative of the decedent. Any distribution to a spouse of the decedent shall be completed within five years of his death.

Appendix

137

c. The Trustee shall refund any amount paid in by the Settlor in excess of the amount deductible by him under the Act together with all income attributable to such excess. The Trustee may rely on the written request of the Settlor in making such refund. All other distributions prior to age 64K may be made upon the written request of the Settlor subject only to the restrictions and limitations as to taxability and disclosure as provided under the Act. 7. Accounts. The Trustee shall keep accurate and detailed accounts of all investments, receipts and disbursements, and other transactions in the Trust Fund, and shall make annual reports concerning the Trust Fund to the Settlor showing the status of the Trust Fund. 8. Nonassignability. a. The Settlor, upon 60 days written notice to the Trustee, may direct the Trustee to, and the Trustee upon such direction shall, transfer all or any part of the Trust Fund to another Restricted Retirement Fund designated in such direction. b. Except as provided in (a) above, neither the Settlor nor any beneficiary of this trust shall have any right to alienate, encumber, assign, or hypothecate any part of his or her interest in the Trust Fund in any manner, nor shall such interest of the Settlor, nor of his beneficiary, be subject to claims of his or her creditors, or be liable to attachment, execution, or other process of law. 9. Amendment and Termination. a. In the event that it becomes necessary to amend this Trust Agreement in order that this Trust qualify as a voluntary Restricted Retirement Plan under the terms of the Act, rules or regulations issued thereunder, or any amendments thereto, the Trustee, without the consent of the Settlor, may amend this Trust Agreement to accomplish such qualification, and shall promptly notify

PENSION

TBENDS

AND

THE

SELF-EMPLOYED

138

the Settlor of such amendment. Except as otherwise specifically provided in this Agreement, this Trust shall not be subject to amendment, b. The Settlor may terminate this Trust or remove the Trustee at any time upon 60 days notice in writing to the Trustee. The Trustee may resign at any time upon 60 days written notice to the Settlor. In the event of such termination, removal, or resignation, the Trustee shall deliver the Trust Fund to another Restricted Retirement Fund as designated by the Settlor, or if none is so designated, then to the Settlor, and shall thereupon be released and discharged of its duties under this Trust Agreement. 10. Report. The Settlor shall, upon request, furnish the Trus^ tee with such information at such times and in such manner and form as may be prescribed by rules and regulations issued by the Secretary of the Treasury, or as may be required to enable the Trustee to file such returns, keep such records, make such identification of funds, and supply such information as the Secretary of the Treasury may by forms and regulation prescribe. 11. Miscellaneous. All notices to the Settlor herein provided for shall be deemed legally delivered if (a) delivered personally to the Settlor, or (b) mailed to the Settlor at his last known address. This agreement shall be binding upon the parties hereto, the beneficiaries, heirs, executors, administrators, distributees, next of kin, spouses, and assigns of the Settlor, and the successor and assigns of the Trustee. 12. Jurisdiction. The Trust has been accepted by the Trustee and will be administered in the State of , and its validity, construction and all rights thereunder shall be governed by the laws of said state. If any provision of this Trust Agreement shall be invalid or unenforceable, the remaining provisions thereof shall continue to be fully effective.

139

Appendix

In witness whereof, the Settlor and the Trust Company, as Trustee, have executed this Trust Agreement this day of A.D., 196 . Settlor Trust Company By Vice President Secretary

Appendix ASSOCIATIONS AND ORGANIZATIONS THE KEOGH BILL

F

FAVORING

American Angus Association American Association of Consulting Chemists and Chemical Engineers, Inc. American Association of Medical Clinics American Association of Small Business, Inc.

PENSION TRENDS AND THE SELF-EMPLOYED

140

American Bar Association American Brahman Breeders Association American College of Radiology American Dental Association American Farm Bureau Federation American Hereford Association American Hotel Association American Institute of Architects American Institute of Certified Public Accountants American Institute of Chemists American Medical Association American National Cattlemen's Association American Ophthalmological Society American Optometrie Association American Osteopathic Association American Patent Law Association American Physicians Foundation American Retail Federation American Shorthorn Breeders' Association American Society of Civil Engineers American Society of Industrial Designers American Society of Internal Medicine American Society of Landscape Artists American Thoroughbred Breeders' Association, Inc. American Thrift Assembly American Veterinary Medical Association American Women's Society of Certified Public Accountants Artists Managers Guild Associated Retail Bakers of America Association of Consulting Management Engineers, Inc. Association of Mutual Plan Sponsors, Inc. Association of Stock Exchange Firms Authors League of America Automotive Affiliated Representatives Bureau of Salesmen's National Associations Commercial Law League of America

Appendix

141

Conference of Actuaries in Public Practice Conference of Bar Presidents Contracting Plasterers' and Lathers' International Association Electronics Representatives Association Engineers Joint Council Holstein-Friesian Association of America Investment Bankers Association of America Investment Counsel Association of America, Inc. Junior Bar Conference, American Bar Association Maritime Law Association of the United States Mobilehome Dealers National Association National Association of Chiropodists and American PodiatryAssociation National Association of Furniture Salesmen National Association of Home Builders National Association of Investment Companies National Association of the Legitimate Theatre, Inc. National Association of Life Underwriters National Association of Men's Apparel Clubs National Association of Plumbing Contractors National Association of Real Estate Boards National Association of Retail Druggists National Association of Retail Grocers National Association of Retail Meat and Food Dealers, Inc. National Association of Tax Accountants National Association of Women's and Children's Apparel Salesmen National Association of Women Lawyers National Automobile Dealers Association National Bureau for Lathing and Plastering National Council of Appraisers and Inspectors, Inc. National Council of Salesmen's Organizations, Inc. National Fanners Union National Federation of Independent Business National Food Brokers Association National Funeral Directors Association

PENSION TRENDS AND THE SELF-EMPLOYED

142

National Grange National Liquor Stores Association, Inc. National Live Stock Tax Committee National Medical Association National Medical Veterans Society National Milk Producers Federation National Restaurant Association, Inc. National Retail Dry Goods Association National Retail Furniture Association National Shoe Travelers' Association National Shorthand Reporters Association National Small Businessmen's Association National Society of Professional Engineers National Sugar Brokers Association National Wholesale Furniture Salesmen's Association New York Stock Exchange Painting and Decorating Contractors of America Santa Gertrudis Breeder's International Smaller Business Association of New England, Inc. Society of American Florists and Ornamental Horticulturists Tax Foundation, Inc. Tile Contractors Association of America, Inc. United Shareholders of America, Inc.

Appendix G TAX-DEFERRED DOLLARS This chart shows the growth of tax-deferred dollars as compared with after-tax dollars. Note what occurs under the Keogh plan if a self-employed taxpayer (with a top tax rate of 40 per cent) sets aside $1,000 each year beginning at age 40 for the next 25 years. T A X - D E F E R R E D DOLLARS vs. TAX-DISCOUNTED DOLLARS INDIVIDUAL R E T I R E M E N T SAVINGS

Tax-deferred dollars. Out-of-pocket savings. * Tax-discounted dollars. 1

2

( Courtesy of Bank of New York, 48 Wall Street, New York, N.Y.)

PENSION TBENDS AND THE SELF-EMPLOYED

144

This chart illustrates how, over a 25 year period—to age 65, his tax-deferred dollars would grow to $41,646 before taxes. Twenty-five thousand after-tax or tax-discounted dollars, however, would amount to less than half as much—$20,717. The reason: From the original $1,000, the amount of out-ofpocket savings each year is reduced to $600 available for investment (after taking out $400 for taxes); the investment rate, in turn, is reduced to 2.4 per cent from the assumed rate of 4 per cent (after taking out 1.6 per cent for taxes)—compounded annually. Meantime, the tax-deferred dollars would be fully employed—at the full assumed rate of investment. And, because tax-deferred dollars have the further privilege of tax-free accumulation in investment (from both capital appreciation and dividend increases), their growth from year to year would be accelerated, as the upward curve of tax-deferred dollars on the chart clearly illustrates.

Appendix

H

TAX SAVINGS UNDER THE KEOGH BILL

This table shows examples of tax savings possible under the Keogh bill. Note how quickly funds grow, nurtured as they are by tax-free earnings on principal deposited.

H3 P I fa

» s

CO CL S I

55

2

S

1

I

a* g ^

13

I

g -g S? fe fL,«

t> | |

r i

o U

Q S O n 13

13 » Q

O -2 2

a S § ,

W UI

I I 1 1

g I? '3 > Pk

CS

P-l

o U W>

e«

U ai 3

|e g' S

C i H

a

ü o u M

O

a o

55 D tó H

Appendix

J

ILLUSTRATION OF THE USE OF LIFE INSURANCE UNDER H.R. 10 In order to comprehend the potential tax saving for the selfemployed individual under H.R. 10, it is necessary to know (1) his top income tax rate, and (2) the ratio of his earnings before taxes to his after tax income. To illustrate, if an individual's personal exemptions and allowable deductions total $3,000 and he is married and files a joint return, he pays a 20 per cent tax on the first $4,000 of income in excess of $3,000,22 per cent on the second $4,000, etc. If he has an income of $7,000 under these circumstances, he pays a 20 per cent tax on $4,000 or $800. As a percentage of his total income ($7,000) his over-all income tax is slightly more than 11 per cent. Earnings to Spend $100 However, the importance of the effect of income taxes on such an individual is more evident when it is recognized that to spend $100 out of his top $4,000 of income (in excess of his $3,000 exemptions and deductions) he has to earn $125. Since the tax on the $125 is 20 per cent or $25, he nets $100 after taxes.

149

Appendix

Obviously, as the individual's top income tax increases, the amount he has to earn out of the income subject to tax at his top tax rate in order to'spend $100 after taxes becomes more significant. Helps Sell Life

Insurance

Despite the fact that the Act is primarily a retirement income tax rule, it may be used to sell life insurance as such to a young man who has an immediate need for family protection as compared to retirement income. For example, assume a young married man is age 30 and his top income tax rate is 30 per cent and all the premium involved comes out of that part of his income taxed at 30 per cent. Assume that he can purchase $100,000 life paid-up at 85 for an annual premium of $2,188. In order to earn enough to net $2,188 after paying a 30 per cent tax on his gross earnings he has to earn 1.43 * times that amount or $3,129. If the value of the current life insurance protection is $243 the first year, his deduction under the bill is determined as follows: Premium Value of Insurance Protection not deductible

$2,188 243

Deductible as premium for a qualified annuity or retirement policy Amount needed to earn $243 (1.43 times $243)

$1,945 347

Gross earnings before taxes needed to pay $2,188

$2,292

Thus, the difference between a payment without the bill and under it is as follows: Without H.R. 10 Under H.R. 10

$3,129 2,292

Savings Savings on per cent basis

$ 837 27%

° A 30 per cent tax on $1.43 is 42.9