On October 18, 2010, the IRS issued final regulations regarding hybrid defined benefit pension plans, such as pension equity plans and cash balance plans. Generally, the final regulations address the statutory requirements of the Pension Protection Act of 2006 (“PPA 2006”) and the Worker, Retiree, and Employer Recovery Act of 2008, including special vesting rules, age discrimination safe harbor, interest rate requirements as well as requirements applicable to amendments converting a traditional defined benefit formula to a statutory hybrid formula. The final regulations generally apply to plan years beginning on or after January 1, 2011. At the same time, the Treasury and IRS proposed additional regulations and that address forms of benefit payment other than lump sums, provide an alternative method for satisfying the plan conversion rules, broaden the list of permitted interest crediting rates and provide relief under benefit accrual rules.
The final regulations generally follow regulations previously proposed and transition guidance issued in 2007. This article summarizes some of the more important aspects of the final regulations as well as the proposed regulations.
Relief under Section 411(a)(13)(A)
The distinctive feature of a cash balance or a pension equity plan (PEP) is that the accrued benefit is expressed as the value of an account or, in the case of a PEP, the value of an accumulated percentage of the participant’s final average compensation. However, prior to PPA 2006, it was questionable whether such a plan could simply pay the hypothetical account balance or accumulated percentage and continue to satisfy the vesting and cashout rules under the Internal Revenue Code (“IRC”).
As a result of PPA 2006, such plans will not be treated as failing to satisfy certain IRC requirements generally applicable to defined benefit plans simply because plan terms provide that the present value of the accrued benefit is equal to the then current balance of a hypothetical account or the then current value of an accumulated percentage of the participant’s final average compensation. We refer to this relief as the section 411(a)(13)(A) relief.
Under the final regulations, section 411(a)(13)(A) relief only applies to a benefit provided under a lump sum based formula. A “lump sum based formula” is a benefit formula expressed as the current balance of a hypothetical account or as the current value of the accumulated percentage of the participant’s final average compensation. The determination as to whether a formula is a lump sum based formula is based on how the benefit is stated under the terms of the plan, not on whether the plan provides for a lump sum payment option. A lump sum based formula also includes a defined benefit plan formula “that has an effect similar to a lump sum based formula.”
The proposed regulations impose additional requirements for section 411(a)(13)(A) relief, including a requirement that at all times on or before normal retirement age, the hypothetical account balance or the accumulated percentage of the participant’s final average compensation must not be not less than the present value of the accrued benefit (or portion thereof) determined under the lump sum based formula.
Section 411(a)(13)(A) relief is not available for benefits provided under a formula that is not a lump sum based formula, so benefits provided under non-lump sum based formulas must comply with the vesting, distribution and allocation rules generally applicable to defined benefit plans.
The final regulations only address lump sum based formula benefits paid in the form of a lump sum. However, the proposed regulations would extend section 411(a)(13)(A) relief to other optional payment forms if those other forms are actuarially equivalent to the hypothetical account balance or the accumulated percentage.
Special Vesting Rules
If any portion of a participant’s accrued benefit is determined under a lump sum based formula, the plan must provide for 100% vesting of the benefit derived from employer contributions after the participant completes at least 3 years of service. This vesting requirement applies on a participant-by-participant basis and to the participant’s entire accrued benefit (not just the portion derived from the lump sum based formula). In the case of a plan in existence on June 29, 2005, the 3-year vesting rule only applies to participants with an hour of service on or after January 1, 2008.
Safe Harbor for Age Discrimination
IRC section 411(b)(1)(H)(i) prohibits any reduction in the rate of benefit accrual under a defined benefit plan because of the attainment of any age. The final regulations describe certain safe harbor plan designs that are deemed to satisfy these age discrimination rules. A plan that does not satisfy the safe harbor is required to satisfy the general age discrimination rule of IRC section 411(b)(1(H)(i).
Under a safe harbor design, a participant’s benefit accrued to date cannot be less than the benefit accrued to date of any similarly situated, younger person who is or could be a participant. A person is similarly situated to another individual if the individual is identical to that other individual in every respect that is relevant in determining a participant’s benefit under the plan -- including, but not limited to period of service, compensation, date of hire, work history and any other respect -- but excluding age.
Amendments converting a traditional defined benefit plan formula to a lump sum based formula also must satisfy the age discrimination rules. The final regulations provide guidance on what constitutes a conversion amendment. For conversion amendments adopted after June 29, 2005, the amendment will satisfy the age discrimination rules if the participant’s benefit after the conversion can be no less than the sum of the participant’s accrued benefit as of the conversion date (including any early retirement subsidy with future growth) and the participant’s accrued benefit earned after the conversion. In other words, “wear away” of the prior accrued benefit is not permitted. A plan is permitted to convert the prior accrued benefit into an account balance or an accumulated percentage; however, the plan must top up the opening account balance or accumulated percentage at benefit commencement if it is not at least equal to the present value of the prior accrued benefit at benefit commencement. Additional alternatives are addressed in the proposed regulations, including an alternative for cash balance (but not PEP) plans that does not require a subsequent comparison between the opening account balance and the present value of the prior accrued benefit.
Market Rate of Interest
Another aspect of the age discrimination requirements is that the interest credit rate under the lump sum based formula must not be greater than a “market rate of return.” The final regulations provide several indices that are deemed not to be in excess of market rate: the interest rate on long-term corporate bonds (including 1st, 2nd and 3rd segment rates under IRC section 417(e)), certain other Treasury indices (and associated margins), actual plan rates of returns and annuity contract rates. The proposed regulations also permit use of a fixed rate of return (including certain minimum rates of return) and the rate of return on certain regulated investment companies.
A plan with a lump sum based formula must specify how the plan determines interest credits and how and when (at least annually) interest is credited. The proposed regulations provide that interest credits are not required to be allocated on amounts distributed prior to the end of the interest crediting period.
The final regulations require a plan with a lump sum based formula to include a “preservation of capital” requirement, providing that interest credits will not result in a reduction of the account balance or accumulated percentage below the aggregate amount of the hypothetical allocations.
The proposed rules provide guidance on the special interest credit rules that apply upon plan termination.
Both the final and proposed rules contain special relief that would permit a plan to change the rate of crediting interest without violating the anti-cutback rules of IRC section 411(d)(6).
The effective date of the final rules on market rate of return, the time for crediting interest and the extent to which a plan may use a “greater of” two or more interest rates is delayed to plan years beginning on or after January 1, 2012. For plan years beginning prior to January 1, 2012, employers may rely on the final or proposed regulations.
Special 133⅓ Percent Test Rule
Generally, a defined benefit plan cannot “back-load” the accrual of benefits, which means the plan can not give employees disproportionately larger benefits during their last few years of service and defined benefit plan formulas must satisfy one of three accrual rules, including the 133⅓ percent rule. The proposed regulations provide special rules that will make it easier for plans with lump sum based formulas to satisfy the 133⅓ percent accrual rule.
Effective Date and Plan Amendments
As noted above, the final rules (other than certain rules regarding market interest rates) are generally effective for plan years beginning on or after January 1, 2011. In 2009 guidance, the IRS and Treasury extended the deadline for cash balance and PEP plans to adopt plan amendments to incorporate changes required under IRC section 411(a)(13) (other than section 411(a)(13)(A)) and section 411(b)(5) to the last day of the 2010 plan year. However, the preamble to the proposed regulations suggests that amendment deadline may be extended further. Specifically, the preamble provides that it is expected that when the proposed regulations are finalized, they will contain relief from the requirements of section 411(d)(6) for amendments adopted before the date the final regulations apply to the plan and the cutback is limited to the extent necessary to enable the plan to meet the requirements of section 411(b)(5).