Energy Company Comments on Deferred Compensation Guidance

As requested by the Treasury Department and the Service in connection with the issuance of Notice 2005-1, we are submitting comments and concerns we have in reviewing the provisions of the American Jobs Creation Act of 2004 (Act) relating to deferred compensation (Section 409A) and the guidance provided in Notice 2005-1. As an initial matter, we would like to express our sincere appreciation for the care and practical thought that went into Notice 2005-1. We were pleased to see the extent to which the Treasury Department and the Service were willing to provide meaningful and realistic exceptions to the requirements of Section 409A without jeopardizing its underlying purposes, as well as generous transitional relief opportunities. A number of our concerns following the enactment of Section 409A were, in fact, dealt with in the notice.

We believe that, at this point, additional consideration regarding the scope of Section 409A, and to practical administrative matters, is warranted. Accordingly, our comments cover areas included in Notice 2005-1, as well as other concerns raised in connection with the enactment of Section 409A. We realize that some of the issues raised in this letter (e.g., nonqualified SERPs and key employee issues) will likely be covered in future guidance, and we are hopeful that providing you with our concerns at this time will be helpful in your consideration of these matters. Thus, we would appreciate your consideration of the following matters in finalizing guidance relating to Section 409A, and we would welcome the opportunity to discuss these, or any other related matters if appropriate.

1. Material Modification -- Amendments to Comply with §409A Provisions. Section 409A provides grandfathered status to previous deferrals. Specifically, unless a plan is materially modified after October 3, 2004, amounts which had been deferred and were vested as of December 31, 2004, may continue to be administered under their existing plan rules, even though such rules do not comply with Section 409A. Q&A 18(a) of Notice 2005-1, provides that the amendment of a plan to bring the plan into compliance with the provisions of Section 409A will not be treated as a material modification. However, the notice goes on to state that a plan amendment, or the exercise of discretion under the terms of the plan, that enhances an existing benefit or right or adds a new benefit or right will be considered a material modification even if the enhanced or added benefit would be permitted under Section 409A.

It appears reasonable that a major plan design change, like the addition of a distribution event (e.g., a hardship distribution which did not exist before) would constitute a material modification even though it would be permitted under Section 409A. However, this rule seems overly broad if applied to changes which are more technical in nature, like an amendment to merely conform a plan definition to a defined term in Section 409A. For example, depending on the plan's current definition of "change in control", an amendment to merely conform the plan's definition to the definition provided in Notice 2005-1 may create a distribution under circumstances which would not permit a distribution currently. We believe it would be overly burdensome, and not within the intent of Section 409A, to force plans to lose the grandfathered status of existing deferrals merely by conforming a plan definition to the Service's guidance. Additionally, we believe that, by directing the Service to define change in control (and other terms) for purposes of Section 409A, Congress did not intend for plan sponsors to have to administer separate definitions -- one for pre-2005 deferrals, and another one for post-2005 deferrals. Accordingly, we would ask the Service to clarify Notice 2005-1 to permit plan sponsors to conform plan definitions to Section 409A (and the Services' guidance thereunder), and perhaps make other technical kinds of conforming changes, without creating a material modification.

2. Severance Plans. Q&A 19(d) of Notice 2005-1 provides a limited exception to the requirements of Section 409A for severance plans. Specifically, severance plans which are amended on or before December 31, 2005, to conform to the provisions of Section 409A, are exempt from Section 409A if the plan: (i) is a collectively bargained plan, or (ii) covers no service providers who are key employees. In Notice 2005-1, the Service specifically asked for comments regarding the extent to which severance plans should be exempted from Section 409A coverage.

While we agree with the concept of providing an exception for severance plans, we believe that the exception should be expanded. In this connection, we believe that, in enacting Section 409A, Congress did not intend to discourage plan sponsors from maintaining broad-based severance arrangements, covering both executives and rank-and-file employees. However, the limited exception provided in Notice 2005-1 does just that. As a practical matter, it would require plan sponsors to segregate its severance plans between key and non-key employees, thus creating additional, needless administration and expense.

If the Service expanded the exception to encompass severance plans which satisfy the safe harbor provisions in ERISA regulation Section 2510.3-2(b), we believe the Service would create consistency and assurance in plan design without generating opportunities for income deferral abuse. The ERISA regulations have long given plan sponsors guidance in designing severance plans without being subjected to the onerous pension plan requirements. As you know, one of the relevant provisions under the ERISA regulations is the timing of the severance payments. By, in essence, adopting the ERISA severance plan guidelines, the Service would permit plan sponsors to continue to rely on longstanding guidance, offer severance plans to a broad-based group of employees, and limit the amount of disruption to plans that will otherwise be generated in becoming compliant with Section 409A. We believe that this broader exclusion for severance plans would not create income deferral abuse.

In addition to these broad-based severance plans, we believe that an exception should be created for individually negotiated severance arrangements. These types of arrangements are often negotiated at the time of, and in connection with, the separation of an employee. Deferring income is, at most, a subordinate issue. Rather, these arrangements are intended to provide transitional income relief (often in the form of a lump sum payment) and to settle any and all legal matters through the execution of a release of claims so that the employer and employee can part ways amicably without generating needless litigation costs. The severance benefits provided in these arrangements (as well as in broad-based arrangements) are not the type of compensation contemplated in Section 409A or in Q&A 4 of Notice 2005-1. They are not provided to a "service provider" in consideration of services to be provided to the employer. Furthermore, these arrangements would be difficult, if not impossible to administer under the restrictions of Section 409A without additional relief. In this regard, it is not clear to us how the deferral election requirements of Section 409A could be satisfied in a severance arrangement that is legitimate corporate purposes, which are unassociated with the concerns that prompted the enactment of Section 409A, and are critical to employers and their shareholders.

3. SERPs and Restoration Plans. Q&A 23 of Notice 2005-1 provides relief from the payment election requirements of Section 409A through December 31, 2005, for nonqualified deferred compensation plans (such as SERPs and restoration plans) where the election is controlled by an election under a qualified plan. In light of the need for guidance, as well as the drastic plan design and administrative issues involved in attempting to bring these types of plans into compliance with Section 409A, we were greatly appreciative of this transitional relief. We believe, however, that, in light of the nature of these types of plans (particularly where they do not involve lump sum payment options), ongoing significant relief beyond 2005 should be strongly considered.

Applying defined benefit SERPs and restoration type plans and arrangements to the restrictions of Section 409A creates multiple overly burdensome practical, administrative and financial concerns. For example, the determination, in advance of benefit accruals, of individuals who may ultimately receive a final average pay-based SERP benefit, as well as the determination of the amount of the benefit, are difficult if not impossible administratively. These sorts of determinations will also result in significant actuarial, legal and accounting expenses, with very little applicability to the kinds of abusive arrangements Section 409A was intended to cover. Additionally, from a participant standpoint, it is impractical and needlessly difficult to have to make a distribution election, years in advance of a distribution event, with respect to an unknown or uncertain benefit amount.

We believe that SERPs and restoration plans which provide for only annuity forms of payment (including lifetime annuities, joint and survivor annuities, and term certain annuities) and do not permit participants to accelerate their receipt of benefits prior to becoming eligible for retirement benefits pursuant to the underlying qualified plan, or through a lump sum distribution, should not be subject to Section 409A. These arrangements do not involve discretionary deferral elections and do not allow individual discretion as to the receipt of benefits except with respect to annuity forms of payment, which are generally subject to rules regulating qualified pension plans, and which payments are made over the life of the participant. In short, we believe these types of plans work well, and without opportunity for participant abuse under their current rules. Forcing these plans within the design confines of Section 409A would be needlessly difficult and costly. Accordingly, we would request that the Service consider providing a broad exclusion for these types of plans.

If the Service concludes that these types of arrangements should be covered by Section 409A, we would also encourage the Service to provide more flexible and realistic rules for benefit distribution elections so that plan participants are not forced to make distribution elections among various annuity payment forms years before their benefits can commence or even be determined.

4. Short-term Deferral Exception. Among the welcomed provisions of Notice 2005-1 was the exception from the definition of nonqualified deferred compensation provided in Q&A 4(c) for plans which require payment of an award no later than the later of: (i) 2-1/2 months after the end of the participant's taxable year in which the award vests; or (ii) 2-1/2 months after the end of the plan sponsor's taxable year in which the award vests. This exception contains an express caveat that it may be relied upon only until additional guidance is issued. In this connection, we believe that the short-term deferral exception is meaningful and realistic in the context of typical incentive plan designs, and provides a necessary exception to Section 409A, without jeopardizing its purposes. Accordingly, to the extent the Service issues further guidance in this area, we would suggest that it do so in ways that may add clarity to the exception and/or take into account other plan designs, but that does not limit the applicability, scope or breadth of this exception.

5. Key Employees. We understand that additional guidance will be forthcoming with respect to the rules of Section 409A relating to key employees. These rules provide a number of concerns, many of which have been addressed in other comment letters submitted both before and after the issuance of Notice 2005-1. Of particular note and concern are the determination of key employee status and the applicability of the 6-month distribution delay rule to certain types of distributions. With respect to the identification of key employees, we believe it is important that the Service promote consistency and stability by permitting employers to identify key employees on an annual basis at a specified time regardless of pay fluctuations throughout the year. This will avoid needless administrative time and expense of re-determining key employee status on an ad hoc basis with each distribution. It will also avoid unintentional penalties which would result from an inadvertent distribution to an individual who the employer did not believe to be a key employee.

Additionally, we believe that distributions made on an annuity basis from a SERP or restoration plan should not be subject to the 6-month delay rule. Because, as noted above, these plans are designed to work in coordination with the underlying qualified plan, having to delay the distributions and commence them at a different time would cause needless administrative complexity and expense.

Finally, we believe that distributions made in the normal course of a plan which satisfies the short deferral exception should be permitted without running afoul of the 6-month rule. This would, for example, allow plans to rely on the short-term deferral exception without taking special administrative steps for participants who might be considered key employees at the time of distribution.

We appreciate the opportunity to communicate with you regarding these important matters, as well as your consideration of our concerns. If you would like to discuss any of these matters, we would be happy to do so at your convenience.