This memorandum discusses some of the principal legal issues that an employer must consider in planning an early retirement program.
Voluntary or Involuntary Program?
The first question an employer must consider is whether to use incentives for surplus employees to retire voluntarily, or to select surplus employees for involuntary termination. The legal advantages of a voluntary program are obvious--if employees select themselves for termination, the employer will have far less exposure to claims that the terminations were discriminatory under applicable labor law (that is, the terminations were based on protected characteristics such as age, national origin or sex).
The risk of claims can be further minimized through the use of a waiver of claims against the employer, as discussed below. A voluntary program does not require the employer to issue a minimum 60 days' advance written notice to the employees under the federal WARN Act, as described below. Finally, voluntary programs are more humane, since the employees who are best prepared for a job loss are the ones who will volunteer to terminate.
An employer must recognize that even a voluntary program will not completely insulate the employer from claims of unlawful discrimination. This is true even if the employer requires the employees to waive claims against the employer to participate in the program. For example, employees may later claim that their decision was coerced by threats of termination if they did not "volunteer."
If the employee signed a waiver of claims, the employee can still assert that the employee did not understand the waiver or that the waiver is invalid for technical reasons. Some of the technical requirements applicable to waivers are described below.
Disadvantage of a Voluntary Program
One disadvantage of a voluntary program is that the acceptance rate is outside the employer's control. To deal with the problem of overacceptance, a well-designed voluntary program should include caps on the number of employees in critical functions who may accept the program, and should allow the employer to delay any employee's termination date to handle transitions and training of replacements if needed.
It is recommend that employers do not immediately rehire any employee who terminates under the program as an "independent contractor" since the employee's contractor status could likely be attacked by the IRS as a sham.
Identity Outside of Employer's Control
Another disadvantage of a voluntary program is that the identity of the employees who accept the program is outside the employer's control. The employer must accept the fact that the workforce remaining after the program probably will not be the same employees that the employer would have chosen itself. However, even if the employer had used an involuntary program, it may have been impossible to retain the ideal workforce due to legal restraints (such as a lack of documented underperformance by those selected for termination, which can lead to an appearance of discrimination if the terminated employees disproportionately fall into protected categories).
Pensions or Severance Benefits?
Whether a program is voluntary or involuntary, the employer may offer enhanced benefits to the terminating employees through a pension plan, a severance plan or both. The differences are as follows:
If the employer maintains a pension plan (that is, a plan that provides lifetime income after retirement), there are strong reasons to provide enhanced retirement benefits through the plan.
Pension Plan Advantages
First, the plan may have surplus assets (assets in excess of its liabilities). Providing enhanced benefits is an efficient use of the surplus assets, since it avoids the need for a current cash outlay by the employer. Even if the plan does not have surplus assets, the pension funding rules generally allow the employer to finance the enhanced benefits by increasing contributions to the plan for a period of years, unless the plan is seriously underfunded. (This does not necessarily extend to the accounting treatment for the expense of the enhanced benefits. The employer should consult its accountants concerning the effect of the program on earnings.)
Second, pension benefits may have tax advantages for the employees. If the plan allows employees to receive the present value of their pensions as a lump sum, an employee may avoid current income tax on the lump sum by rolling it over into an individual retirement account, or IRA. If the benefit is paid as a lifetime income, income taxes also are deferred since the benefits are subject to tax only as received. In addition, unlike severance benefits, pension benefits are not subject to employment taxes such as Social Security, Medicare and unemployment taxes.
Pension Plan Regulations
On the other hand, pension plans are subject to a myriad of technical regulations. An important requirement is that benefits must not discriminate in favor of "highly compensated employees," as defined by the Internal Revenue Code (generally, employees earning more than $120,000 in 2017). The eligibility for the enhanced benefit must meet this nondiscrimination requirement. Unfortunately, if eligibility is limited to relatively older or more senior employees, as is common in an early retirement program, the employees are more likely to be highly compensated. The test for nondiscriminatory eligibility is described below.
The enhanced pension benefit itself also must meet a nondiscrimination requirement. Generally, uniform benefits (for example, a uniform percentage of the employee's pay averaged over a period of three years) are considered nondiscriminatory.
Pension plans also are subject to limits on the annual benefit that can be paid. The 2017 limit (which is adjusted periodically for inflation) is $215,000 per year at age 65. The limit is substantially reduced if the pension is paid before age 65, but the employer can make up for the reduction by making cash payments to the affected employees from its own assets.
Finally, pension plans are limited in the amount of the employee's compensation that may be taken into account in calculating a benefit. The 2016 compensation limit is $265,000.
Severance plans are subject to fewer regulations than pension plans, and in any event are the only vehicle for termination payments if the employer has no pension plan.
Severance Plan Advantages
In contrast to pension plans, severance plan eligibility and benefits may discriminate in favor of "highly compensated employees." Thus, it is possible to provide a non-uniform formula that pays greater severance benefits to employees in higher level functions (the rationale being that employees in those functions normally need a longer period to find a new position). In addition, severance plans are not limited in the amount of compensation that may be considered in calculating a benefit.
Severance Plan Regulations
There are some limitations that apply to severance plans, however. Payments may be made in a lump sum or in installments, but if made in installments, they must not continue beyond the later of two years after termination or two years after the employee attains age 65. (Lengthier payments are considered "pensions" that trigger the pension plan regulations discussed above as well as other requirements that an employer would want to avoid when establishing a severance plan.) The total present value of the payments must not exceed 200% of the employee's annual compensation for the 12 months preceding termination.
Finally, payments must not be limited to employees who "retire." This requirement obviously is troublesome in the context of an early retirement program.
Although there is no authority on this point, in our view this requirement should be satisfied if the termination program extends below the group of employees who were otherwise eligible to retire under the employer's retirement plan in the absence of the program. For example, if the employer's retirement plan provides for normal retirement at age 65 and for early retirement at age 55 with 10 years of service, a program that pays severance to employees age 50 or more, or employees with as few as five years of service, would arguably meet the requirement.
The above requirements are found in Department of Labor regulations under the Employee Retirement Income Security Act of 1974 ("ERISA"). While it is possible to argue that a one-time cash termination payment is not a "plan" subject to ERISA, generally it is advantageous for an employer to embrace ERISA coverage of its program. The results of ERISA coverage include federal preemption of state law (meaning that state remedies, such as jury trials and punitive damages, are not available to claimants) and a very lenient standard of judicial review for the plan administrator's decisions in interpreting the plan.
There are a few formalities that must be observed to ensure these results, but they are not burdensome. The severance plan must be in writing and should provide that the plan administrator has absolute discretion to interpret its terms. A summary plan description must be given to the eligible employees and mailed to the Department of Labor. (Usually the plan text and summary plan description can be the same document.) Finally, the administrator must file a report on Form 5500 with the IRS and Department of Labor if there are more than 100 eligible employees.
Severance Plan Tax Considerations
Severance plans that defer payments or make payments in installments must be carefully structured to prevent current income tax on the deferred amounts under the IRS doctrine of "constructive receipt" of income. Under this doctrine, an employee is taxed on amounts in the year they are made available to the employee without restriction, even if the employee does not actually receive the amounts until a later year. This problem can be avoided by requiring the employee to elect the time of payment before the payment is earned (i.e., before the employee terminates employment) and by placing restrictions on the employee's ability to elect the precise time of payment (e.g., by requiring the employer to approve the payment election).
It is common for employers to offer additional benefits in connection with an early retirement program, such as a continuation of medical coverage with an employer contribution for a stated period. (This continued coverage is distinct from the requirement under the federal law known as "COBRA" to offer terminating employees and their dependents 18 months of continuation coverage at their own expense.)
If the employer already offers post-retirement medical coverage, it generally will modify the eligibility requirements to match those of the early retirement program. For example, if post-retirement medical coverage normally is available to retiring employees who are at least age 60 with 15 years of service, and a voluntary retirement incentive is given to all employees who are at least age 55 with 10 years of service, it would be common to extend post-retirement medical coverage to employees in the 55/10 group who retire under the program.
Other benefits may include outplacement assistance or financial planning, usually subject to a dollar maximum.
Finally, it is commonplace to fully vest the terminating employees in any benefits under the employer's qualified pension and savings plans. The Internal Revenue Service requires full vesting if a "significant" percentage of employees participating in a qualified plan terminates due to employer action. Since the percentage that triggers this rule is ill-defined, as well as the period over which the percentage reduction is measured, employers ordinarily opt to amend their plans to provide for full vesting for employees who terminate under a retirement program to the extent they were not already fully vested. This avoids the potential sanction of plan disqualification in the event the employer failed to vest the employees when required, and typically the cost is very low since one would expect most of the eligible employees to be vested already.
Waivers of Claims Against the Employer
An employer may require a waiver of claims in exchange for voluntary or involuntary termination benefits. To be enforceable, a waiver must be knowing and voluntary, so it is important for the employee to thoroughly understand the rights he or she is giving up in exchange for the termination benefits and for the employer not to exert pressure on the employee to sign the waiver.
In addition, there are certain formalities established by statute that the employer must follow in order for the waiver to be a valid release of claims under the federal Age Discrimination in Employment Act ("ADEA"). These formalities include providing the employee with a minimum period of 45 days in which to consider whether to sign the waiver and, after signing, a minimum period of seven days in which to revoke it.
The employee also must be informed of the job titles and ages of all employees eligible or selected for the program, and the ages of all employees in the same job classification or organizational unit who are not eligible or selected for the program. This information is usually provided via an attachment to the waiver form. Finally, the employee must be specifically encouraged to seek the advice of an attorney before signing the waiver.
Under the federal Worker Adjustment and Retraining Notification ("WARN") Act, covered employers must give 60 days' written notice of plant closures or mass layoffs, as defined in the Act, to affected employees, their bargaining agents (if represented by a union) and the applicable state dislocated worker units. These requirements do not apply if the employer pursues a reduction in its workforce through a voluntary program.
Covered employers generally are those employing 100 or more full-time employees. Plant closings are defined as the shutdown of a single site of employment, or one or more facilities or operating units, where 50 or more full-time workers lose employment. Mass layoffs are defined as a reduction in force causing an employment loss for 33% of an employer's workforce, where that percentage is at least 50 employees. If the number of affected workers is 500 or more, the 33% requirements does not apply.
The remedy for inadequate notice under the WARN Act is back pay and benefits for each day of the violation, up to 60 days. An employer can offset severance pay that it provides to its employees against this liability, but only if the severance pay plan was not a preexisting obligation of the employer and the severance pay is unconditional (i.e., the employer does not require a waiver of claims in exchange for the severance pay).
Test for Nondiscriminatory Eligibility for Enhanced Pension Plan Benefits
The IRS regulations impose a mathematical test to demonstrate nondiscriminatory eligibility for an enhanced pension benefit. The test compares the ratio of highly compensated employees eligible for the enhanced benefit to the ratio of non-highly compensated employees eligible for the enhancement. Each ratio is determined by including in the denominator all of the nonunion U.S. workforce of the employer and its affiliates (using 80% or greater ownership as the test for affiliation).
If the non-highly compensated eligible employees' ratio meets a threshold percentage of the highly compensated eligible employees' ratio, the eligibility is considered nondiscriminatory. The threshold percentage is set forth in the regulations and varies from 20% to 50% based on the overall concentration of non-highly compensated employees in the employer's and affiliates' workforce (more non-highly compensated employees results in a lower threshold).
The eligibility requirements also must be nondiscriminatory under all of the facts and circumstances. For example, if limits are imposed on the number of non-highly compensated employees who will be accepted in a voluntary program, this fact would limit the effective availability for these employees and must be taken into consideration under the facts and circumstances test.