Small Retirement Plans Could Need a Financial Statement Audit Too…

It’s Not Fair!

“But my plan’s brokerage account investments don’t affect the participants!”

or

“I didn’t have to allocate any profit-sharing dollars, and an audit of my pooled plan would penalize me for my generous selection of excellent investments.”

Unfortunately for the business owner in the above two examples, they wear two hats, one of them being that of a plan participant, with the same protections that apply for a retirement plan governed by the Employee Retirement Income Security Act of 1974 (ERISA), including an audit of the plan’s financial statements. In most cases, a small plan can claim a waiver of the audit requirement, but it depends on:

1. the type of assets the plan holds, including the owners’ participant accounts;
2. whether a regulated financial institution has custody of the plan’s assets;
3. whether the full value of any non-qualifying plan assets is 100% covered by a fidelity bond; and
4. whether additional disclosures about the assets and the fidelity bond are distributed to participants in the Summary Annual Report.

This blog will explain the rules for each of these conditions. As a sneak preview, non-qualifying plan assets often include real estate investment partnerships (REITs), stocks or bonds held outside of an eligible financial institution, hedge funds, digital assets, coin collections, collectibles, statues, sculptures, paintings, other artworks, horses or other animals. We have audited a few small plans that had some of these non-qualifying plan assets.

Whether a fiduciary invests in non-qualifying plan assets for a plan that is not participant-directed or a few participants, even one, invests through their brokerage account, those assets count. It’s often possible to avoid the audit, but not without meeting additional conditions, such as additional bonding, which could prove to be costly enough that the audit is a better option.

Conditions for a Small Plan to Claim an Audit Waiver

A pension plan filing as a small plan because the plan had fewer than 100 participants at the beginning of the plan year, or because the plan administrator elected to use the 80-120 exception, is eligible for an audit waiver if the plan meets the conditions of 29 CFR 2520.104-46.

In addition to being a small pension plan filing the Schedule I, there are three basic requirements for a small pension plan to be eligible for the audit waiver:

1. As of the last day of the preceding plan year, at least 95% of a small pension plan’s assets must be qualifying plan assets (explained below) or, if less than 95% are qualifying plan assets, any person who handles non-qualifying plan assets must be bonded in an amount at least equal to the value of the non-qualifying plan assets.
2. The plan must include additional information in the Summary Annual Report (SAR) furnished to participants and beneficiaries.
3. In response to a request from any participant or beneficiary, the plan administrator must furnish without charge copies of statements the plan receives from the regulated financial institutions holding or issuing the plan’s qualifying plan assets and evidence of any required fidelity bond.
   • The individual account statements from the regulated financial institutions can be delivered by affiliates of the regulated financial institutions, other unaffiliated service providers, or the plan’s administrator.
     • For example, a statement prepared by the regulated financial institution, on the institution’s letterhead including contact information that a participant could use to confirm the accuracy of the information in the statement with the regulated financial institution could be given to the plan’s administrator or its recordkeeper for distribution to the plan participants and beneficiaries.
     • However, a statement prepared by the plan’s administrator, even if based on data from the regulated financial institution, would not meet the audit-waiver condition.

Qualifying Plan Assets Defined

Qualifying plan assets are:

• Any asset held by certain regulated financial institutions;
  • The account must be a trust or custodial account, such as plan assets held in bank custodial, common or collective trust or separate trust accounts are qualifying plan assets.
  • Securities held by a broker-dealer for the plan in an omnibus account are qualifying plan assets.
  • Checking and savings accounts that create a debtor-creditor relationship between the plan and the bank are also qualifying plan assets for the audit waiver condition.
  • Plan assets in a safe deposit box, even with a regulated bank or trust company, are not qualifying plan assets.

• Only the following institutions are “regulated financial institutions” for purposes of the audit waiver conditions:
  • Banks or similar financial institutions, including trust companies, savings and loan associations, domestic building and loan associations, and credit unions.
  • Insurance companies qualified to do business under the laws of a state;
  • Organizations registered as a broker-dealer under the Securities Exchange Act of 1934;
  • Investment companies registered under the Investment Company Act of 1940; or
  • Any other organization the US Treasury department authorized to act as a custodian for individual retirement accounts under Internal Revenue Code section 408.
• Shares issued by an investment company registered under the Investment Company Act of 1940 (for example, mutual fund shares);
• Investment and annuity contracts issued by an insurance company qualified to do business under the laws of a state;
• Qualifying employer securities, as defined in ERISA section 407(d)(5); and
• Participant loans meeting the requirements of ERISA section 408(b)(1), whether or not they have been deemed distributed.
• In the case of an individual account plan, any assets in the individual account of a participant or beneficiary over which the participant or beneficiary has the opportunity to exercise control and with respect to which the participant or beneficiary is furnished, at least annually, a statement from a regulated financial institution describing the plan assets held or issued by the regulated institution and the amount of such assets;

How to Calculate the Percentage of Qualifying Plan Assets

• Obtain the breakdown of the value of plan assets reported on Form 5500, Schedule I, Line 1a, Column (b) for the end of the prior year. The value reported as of the end of the prior year should match the value reported as of the beginning of the current plan year’s Form 5500.

• The calculation must be made as soon as the information regarding the plan’s assets at the close of the preceding plan year can be reasonably ascertained. This generally will be much sooner than the due date for filing the Form 5500 for that preceding plan year, but how is the calculation done for initial plan years, when there is no prior year Form 5500 or when a significant transfer of assets is expected after the first day of the plan year?
• In the initial plan year, the plan administrator may rely on estimates. The administrator should follow a similar method to the one described in 29 CFR 2580.412-15 for estimating the amount required for the ERISA section 412 fidelity bond for an initial plan year.
  • For example, if a plan will be investing exclusively in assets that meet the definition of qualifying plan assets, such as pooled separate accounts, insurance contracts, and mutual fund shares, fidelity bond coverage in addition to that required under section 412 would not be necessary to meet the first condition for claiming the audit waiver.
  • When a plan is initially funded through the transfer of assets from a predecessor plan, treat the new plan as not having a preceding reporting year and use the value of the assets transferred from the predecessor plan to determine whether the new plan meets the 95% percentage condition for qualifying plan assets.
  • Be mindful that some plan assets-whether non-qualifying or even qualifying-might lack a readily determined value. An asset might not trade often enough, or in a market liquid enough, that observing traded prices sets a fair value. Some assets require an appraiser’s valuation.

The ERISA Fidelity Bond Rules

The ERISA section 412 fidelity bond is not the same as fiduciary-liability coverage. Only the ERISA Section 412 fidelity bond is mandatory. The ERISA fidelity bond must meet the requirements of section 412, ( See Field Assistance Bulletin No. 2008-04 or 29 C.F.R. § 2550.412-1 and 29 C.F.R. Part 2580) such as:

• the plan must be named as an insured party;
• the bond must not include a deductible or similar feature;
• plan officials who handle plan assets can be covered by name or by title;
• service providers who handle plan assets by virtue of their duties relating to the receipt, safekeeping, or disbursement of funds, whose duties involve access to plan funds or decision-making authority that can give rise to a risk of loss through fraud or dishonesty should be covered by a fidelity bond.
• the bonding company must be on the U.S. Department of the Treasury’s Circular 570 list of approved surety companies.
• An “omnibus clause” is sometimes used as an alternative way to identify multiple plans as insureds on one bond, rather than specifically naming on the bond each individual plan in a group of plans. The required amount of coverage must apply to each plan separately.
• The plan can pay for the fidelity bond premiums out of plan assets.
• 29 CFR 2580.412-5 states that employee and employer receivable become plan assets once the funds are segregated from the employer’s assets and identified in separate books and records, special bank or investment account, or paid to a corporate trustee. However, if the plan administrator is a board of trustees or entity other than the employer establishing the plan, then receivables are not plan assets until they are received by the plan administrator.
• Commercial Crime Policies often include an ERISA rider compliant with ERISEA Section 412.
• Plans that have at least 95% qualifying plan assets must obtain a fidelity bond covering persons who handle plan funds in an amount no less than 10 percent of the amount of funds the person handles, but in no case shall such bond be less than $1,000 nor does ERISA section 412 require it to be more than $500,000, or $1,000,000 for plans that hold employer stock.
  • Handling of plan assets includes, but is not limited to:
    • physical contact (or power to exercise physical contact or control) with cash, checks or similar property;
    • power to transfer funds or other property from the plan to oneself or to a third party, or to negotiate such property for value (e.g., mortgages, title to land and buildings, or securities);
    • disbursement authority or authority to direct disbursement;
    • authority to sign checks or other negotiable instruments; or
    • supervisory or decision-making responsibility over activities that require bonding.

To satisfy the requirements of the small plan audit waiver, if more than ten percent of the plan’s assets are non-qualifying assets, persons who handle non-qualifying assets must be covered by a fidelity bond or bonds that meet the requirements of section 412 of ERISA, except that the bond amount must be at least equal to 100% of the value the non-qualifying plan assets the person handles.

• If the only non-qualifying assets that a person handles are not required to covered under a standard ERISA section 412 bond, that person would not need to be covered under an enhanced bond for a plan to be eligible for the audit waiver.
  • For example, employer and employee contribution receivables described in 29 CFR 2580.412-5 do not need to be covered by the fidelity bond
• The person handling the non-qualifying plan assets can obtain his or her own bond.
• If 100% of the value of non-qualifying plan assets is less than 10% of the value of all the plan funds a person handles, the section 412 bond covering the person will satisfy the audit waiver condition because the amount of the bond will be at least equal to 100% of the non-qualifying plan assets handled by that individual.
  • For example, a person may handle a total of $1 million in plan funds, but only $50,000 are non-qualifying plan assets. In that case, the ERISA section 412 bond covering the person should be equal to or greater than $100,000, which would be more than the value of the non-qualifying assets the person handles. For that person, the ERISA section 412 bond would also satisfy the audit waiver enhanced bonding requirement.
• The cost of increasing the fidelity bond coverage to cover the value of non-qualifying plan assets could be greater than the cost of the audit.

Summary Annual Report Disclosures

The plan administrator must include the following additional information in the Summary Annual Report (SAR) furnished to participants and beneficiaries to be eligible for the small pension plan audit waiver:

• The name of each regulated financial institution holding or issuing qualifying plan assets and the amount of such assets reported by the institution as of the end of the plan year;
• The name(s) of the surety company issuing the fidelity bond, if the plan has more than five percent of its assets in non-qualifying plan assets;
• A notice indicating that participants and beneficiaries may, upon request and without charge, examine or receive from the plan copies of evidence of the required bond and copies of statements from the regulated financial institutions describing the qualifying plan assets; and
• A disclosure stating that participants and beneficiaries should contact the Department of Labor’s Employee Benefits Security Administration (EBSA) Regional Office if they are unable to examine or obtain copies of the regulated financial institution statements or evidence of the required bond.

The enhanced SAR disclosure is not required for the following qualifying plan assets:

• Qualifying employer securities as defined in section 407(d)(5) of ERISA and the regulations issued thereunder;
• Participant loans meeting ERISA section 408(b)(1) and the regulations issued thereunder; and,
• In the case of an individual account plan, any assets in the individual account of a participant or beneficiary over which the participant or beneficiary has the opportunity to exercise control provided the participant or beneficiary is furnished, at least annually, a statement from an eligible regulated financial institution describing the assets held or issued by the institution and the amount of such assets.

Even if 95% of the plan’s assets are qualifying plan assets, to be eligible for the audit waiver, the SAR must include the required information on the regulated financial institutions holding or issuing the plan’s qualifying plan assets.

Sample SAR Template

The following example may assist administrators in composing SAR disclosures for their plans that would satisfy the regulation. Plan administrators will need to modify the example to omit bonding or other information that is not applicable to their plan.

The U.S. Department of Labor’s regulations require that an independent qualified public accountant audit the plan’s financial statements unless certain conditions are met for the audit requirement to be waived. This plan met the audit waiver conditions for (insert year) and therefore has not had an audit performed. Instead, the following information is provided to assist you in verifying that the assets reported in the Form 5500 were actually held by the plan. At the end of the (insert year) plan year, the plan had (include separate entries for each regulated financial institution holding or issuing qualifying plan assets): [set forth amounts and names of institutions as applicable] [(insert $ amount) in assets held by (insert name of bank)], [(insert $ amount) in securities held by (insert name of registered brokerdealer)], [(insert $ amount) in shares issued by (insert name of registered investment company)], [(insert $ amount) in investment or annuity contract issued by (insert name of insurance company)] The plan receives year-end statements from these regulated financial institutions that confirm the above information. [Insert as applicable –

The remainder of the plan’s assets were (1) qualifying employer securities, (2) loans to participants, (3) held in individual participant accounts with investments directed by participants and beneficiaries and with account statements from regulated financial institutions furnished to the participant or beneficiary at least annually, or (4) other assets covered by a fidelity bond at least equal to the value of the assets and issued by an approved surety company.]

Plan participants and beneficiaries have a right, on request and free of charge, to get copies of the financial institution year-end statements and evidence of the fidelity bond. If you want to examine or get copies of the financial institution year-end statements or evidence of the fidelity bond, please contact [insert mailing address and any other available way to request copies such as e-mail and phone number].

If you are unable to obtain or examine copies of the regulated financial institution statements or evidence of the fidelity bond, you may contact the regional office of the U.S. Department of Labor’s Employee Benefits Security Administration (EBSA) for assistance by calling toll-free 1-866-444-EBSA (3272). A listing of EBSA regional offices and general information regarding the audit waiver conditions applicable to the plan can be found at U.S. Department of Labor under the heading “Frequently Asked Questions”.

How to File the Audit Report for a Small Plan

The plan administrator must disclose that it is claiming the waiver by checking “yes” on Line 4k of Schedule I of the Form 5500 filed for the plan.

Small pension plans that cannot claim the audit waiver still file Schedule I, but must attach the report of an IQPA to their Form 5500. They also do not need to include schedules of assets held for investment, a schedule of reportable transactions, the Schedule C or Schedule G.

Small plan that are growing may not need to file as a large plan the first year that they have at least 100 participants as of the beginning of the year, if they take advantage of the 80-120 exception.

• The 80-120 participant rule gives the plan sponsor the opportunity to elect to file a Form 5500 for the same size of plan as it filed in the previous year, as long as the number of account balances on the first day of the plan year is between 80-120.
• This is not a one-time election. Each year, the plan sponsor must look at the number of account balances on the first day of the plan year and determine whether the 80-120 election can postpone the audit for one more year.
• The 80-120 exception is not available to first year plans because they did not file a Form 5500 in the previous year.
• Initial year filings use the number of account balances at the end of the year to determine whether they need a small plan filing or a large plan filing.
• Plans that are losing employees do not typically use the 80-120 election to choose to continue filing as a large plan.
• Do not count the forfeiture balance for this purpose.
• Do not rely on computerized counts if the plan is close to the large plan threshold
• Please refer to our previous article, “Counting What Counts, Counts the Auditors Out” for more details on the 80-120 Rule.

Only plans filing as small plans can rely on the small pension plan audit waiver.

If ERISA section 103’s command to engage an independent qualified public accountant does not apply, the plan need not meet the audit waiver conditions in 29 CFR 2520.104-46. A plan is not ERISA-governed if it is a governmental plan or is a church plan that has not elected to be ERISA governed. But don’t rely on any exclusion or exception from ERISA until you have carefully considered your employee-benefit lawyer’s advice.

Are There Other Ways to Avoid the Audit?

Owners of employers who sponsor retirement plans, both large and small, sometimes think that ERISA’s job is to protect the benefits and the rights of their employees, which do not and should not include plan assets the owner bought through the plan’s brokerage link. In addition, small pooled profit-sharing plans that do not include participant direction sometimes include investments that could trigger a financial-statement audit if their value is not properly bonded, much to the surprise of the unsuspecting plan administrator. In both instances, the plan sponsor wants to know how to get rid of me for future years, nothing personal. They enjoy our audits as much as anyone can enjoy an audit.

In several cases, I assisted or encouraged each one to collaborate with its third-party administrator and/or recordkeeper to achieve the audit waiver. Some audit-avoidance options I have witnessed in action include:

1. Obtaining the required fidelity bond for the year following the first two years that did not meet the audit waiver requirements.
2. The owner was over 59 1/2 years old, the plan’s age requirement for an in-service distribution. He completed a rollover of the non-qualifying plan assets to an IRA to distribute the non-qualifying plan assets in his account out of the plan.
3. One plan changed the pooled-plan structure to a standard 401(k) platform offered by one of the major recordkeepers, including only qualifying plan assets.

Glad I Did It, Glad It’s Over

I have enjoyed auditing a handful of small plans that failed to meet the waiver requirements. Personally, I don’t like to sell audits that are not absolutely necessary, so I am glad I have audited a handful of small plans, but I’m also glad those engagements are over. It was good while it lasted. I hope they remember me fondly someday when their companies prosper and their plans grow.