In recent years, pension provision for employees has become a growing issue with governments around the world seeking to focus individuals on the need to save for retirement and provide a form of income replacement for later years. In the United States, pension provision is often made by way of 401k plans whilst in the UAE, the statutory benefit of End of Service Gratuity (Gratuity) has conceptually been interpreted as a means for non UAE nationals to provide for retirement. This article examines the interplay between 401k plans, Gratuity, and the potential to provide a 401k plan in place of Gratuity.
Article 141 of UAE Law No. 8 of 1980, as amended (the UAE Labour Law) allows an employer that operates a retirement or insurance plan to offer participation in that plan to expatriate employees in satisfaction of the employee's entitlement to Gratuity on the termination of employment. Under the legislation, an employee who is entitled to a retirement pension has the ability to choose between the more advantageous of (i) the statutory Gratuity entitlement and (ii) the pension entitlement. If the employee does not elect to participate in the retirement plan, on the termination of employment he or she will be entitled to an amount in respect of Gratuity, as calculated under Articles 132 to 134 of the UAE Labour Law (the Gratuity Amount) (assuming the employee otherwise meets all qualifying conditions for a payment).
In the United States, it is common for employers to help their employees save for retirement on a tax-advantaged basis through "defined contribution" plans, under which contributions are allocated to eligible employees' investment accounts and each employee's retirement income is based on the value of the account at the time of retirement. Employers may take income tax deductions for their contributions to the employee investment accounts and employees pay taxes only on amounts that are withdrawn from their accounts. Many of these plans allow employees to direct the investment of their accounts among specified investment options and, in some cases, allow them to invest in their employer's stock.
Contributions can be made by both employees and employers. If the plan permits, employees may make contributions on a pre-tax basis ("401(k)" contributions) or on an after-tax basis (in which case the contribution is made after taxes have been paid on the employee's compensation and the amount of the contribution is not taxable at distribution). After-tax contributions may be permitted to be made as "Roth" contributions, which allow not only the amount of the contribution but also the account earnings to be distributed tax-free. An employee's combined 401(k) and Roth contributions are subject to an annual limitation ($17,000 for 2012, plus an additional $5,500 for employees age 50 years and older). Employers may make contributions to all eligible employees, usually in proportion to compensation, but sometimes based on formulas using age or length of service. Employers may also make contributions that match, on some basis, the 401(k), Roth, or other after-tax contributions made by the employees. For instance, an employer could agree to "match" the employee's contributions up to a maximum of 2% of the employee's base salary or a set dollar amount.
While employers are not required to make contributions to employee investment accounts, many choose to do so as an employee benefit and a way of encouraging long service. In most cases where an employer chooses to make contributions to employee accounts, the contributions are subject to a vesting schedule under which employees must remain employed for a certain period of time in order to have a right to keep the portion of their account that is attributable to the employer's contributions (not more than 6 years for full vesting). Some plans allow employees to withdraw from their accounts prior to termination of employment, but usually only from employee contribution accounts. Tax law prohibits employees from withdrawing 401(k) contributions prior to termination of employment, unless the employee is at least 59 ½ years old at the time of the withdrawal.
In many cases, UAE employers with US parent companies are offering participation (or continued participation in the case of a limited term assignment in the UAE) in such plans to their UAE based employees.
The wording of Article 141 makes it clear that it is up to the employee to choose whether to participate in the retirement plan or to opt for Gratuity payment. This creates a number of practical difficulties and can pose certain risks for an employer offering participation in a 401K plan. For instance, there is no limit on the time by which the employee must make his decision and arguably, given the wording of Article 141, it is open to an employee to make a decision and later change his mind. An employee could, therefore (i) agree to participate in the retirement plan, with the employer contributing to the retirement fund during the course of employment and, later, (ii) change his mind and decide to opt for a Gratuity payment.
The situation described above can be of particular relevance in the context of 401K retirement plans (and other types of defined contribution retirement plans). Where an employee opts to participate in the employer's 401K plan and the investments from the proceeds of the member account perform well (so that the value in the account on the termination of employment exceeds the Gratuity Amount), this issue is less likely to arise. However, where the proceeds of the retirement fund have been invested and performed poorly, so that the value of the investments on the termination of employment is less than the Gratuity Amount, there is a risk that the employee would want to change his mind and opt for Gratuity. A U.S. tax-qualified retirement plan cannot provide for a clawback of the employer's contributions, so this would result effectively in a double payment for the employee (i.e. retaining retirement benefits under the plan as well as payment of the Gratuity Amount).
There are a number of steps an employer considering offering participation in a 401K plan can take to mitigate the risks identified above. It is critical that any employer wishing to rely on the provisions of Article 141 ensures that the arrangements between it and employee in relation to participation in the retirement plan and Gratuity are appropriately recorded in a written agreement between the parties from the outset. In addition, it may be possible to include a top-up mechanism to ensure the value of the member account under the retirement plan on the termination of employment is at least equal to the Gratuity Amount (bearing in mind that a top-up for highly-compensated employees may cause some plans to fail tests designed to prevent disproportionate contributions for highly-compensated employees). A U.S. tax-qualified retirement plan cannot recognize an assignment of benefits, unless the assignment is voluntary and revocable and the assignee acknowledges to the plan in writing that the assignment is not enforceable with respect to amounts not already received.1 So, an employer will not usually be able to claim repayment of the value of employer contributions if the employee participates in the plan and later claims the Gratuity Amount.
On a practical level, it is important that employers consider any risks and the possibilities for mitigating such risks before implementing arrangements for their employees.
Footnotes
1 DRAFT NOTE: See US Treasury Regulation 26 C.F.R. §1.401(a)-13(e).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.