The IRS recently issued new final and proposed regulations that provide welcome guidance to sponsors of hybrid pension plans. Hybrid pension plans, such as cash balance plans and pension equity plans, are defined benefit plans that have some of the characteristics of defined contribution plans. The popularity of hybrid pension plans has risen in large part because of their decreased cost volatility for employers and increased employee understanding (because the benefit is expressed as a lump sum), as compared with traditional defined benefit pension plans.

Under a cash balance plan, pay credits are made to a participant’s hypothetical account. This hypothetical account receives interest credits based on a rate (or rates) specified in the plan document. Under a pension equity plan, a participant accrues percentage credits. At retirement, the sum of the percentage credits is multiplied by a permitted measure of the participant’s average compensation. While a participant’s accrued benefit under a hybrid pension plan is expressed in terms of a lump sum, the benefits must be paid in the form of an annuity unless the participant (with spousal consent, if applicable) elects a lump sum.

When hybrid pension plans first became more prevalent, there was great concern that they did not comply with IRS rules for defined benefit plans, particularly with regard to vesting, benefit accrual, and age discrimination. The IRS began to address many of these concerns in the Pension Protection Act of 2006, and provided additional guidance in proposed regulations issued in 2007, in the Worker, Retiree, and Employer Recovery Act of 2008, and in proposed and final regulations issued in 2010.

New Final Regulations Responding to the many comments it received, the IRS has now issued final hybrid pension plan regulations. These final regulations are generally effective as of the first day of the plan year beginning on or after January 1, 2016, although in some cases the plan sponsor may elect an earlier effective date. The regulations finalize many of the provisions of the 2010 proposed regulations, but also make significant changes. Among the many changes to previous proposed and final regulations are the following:

Interest Crediting Rate Rules – Expansion and Clarification

  • The maximum fixed interest crediting rate is increased from 5 percent to 6 percent.
  • New variable interest rates are permitted, such as a segment of plan assets or the rate of return on a regulated investment company, if certain criteria are met.
  • For plans that use certain government bond rates or the Consumer Price Index (CPI) as the interest crediting rate with a fixed interest rate floor, the permitted annual floor is raised from 4 percent to 5 percent.
  • A plan with a variable interest crediting rate may use a cumulative floor of 3 percent instead of an annual floor.
  • There are new rules for amending the interest crediting rate, which include the benefits and subsidies that must be protected from cutback.
  • New guidance was provided regarding benefit calculations on plan termination, including annuity conversion rates, factors, mortality tables, and permissible interest crediting rates to be used for period after a plan’s termination date for plans that use an investment-based rate of return.

Special Provisions for Pension Equity Plans

  • A pension equity plan may be based on a participant’s highest average compensation, with no limitation on the averaging period; previously it had to be based on a participant’s final average compensation.
  • A reduction in accumulations under a pension equity plan is permissible to the extent it is attributable to a decrease in the participant’s final average compensation or, for a plan whose benefit formula is integrated with Social Security, results from an increase in the Social Security integration level.

Other Provisions

  • A benefit may be determined as the lesser of benefits under two formulas.
  • A participant’s accrued benefit under a hybrid pension plan formula is permitted to be actuarially equivalent (using reasonable actuarial assumptions), to the benefit payable at the participant’s annuity starting date, instead of the benefit payable at the participant’s normal retirement age.
  • The amount of a single lump sum payment under a hybrid pension plan formula must equal the accumulated benefit under that formula (except to the extent that the lump sum payment is greater to meet anti-cutback requirements).
  • As with traditional defined benefit plans, if payments do not commence by a participant’s normal retirement age, the plan must either actuarially increase the benefit or provide a suspension of benefit notice.
  • The rules cover early retirement and form of payment subsidies, multiple annuity starting dates, reemployment after a total distribution, and conversions from a traditional defined benefit formula to a hybrid plan formula.
  • The IRS will continue to study whether it would be acceptable to permit plan participants to choose an interest crediting rate from various permissible options.

New Proposed Regulations The IRS also issued proposed hybrid pension plan regulations, which allow for the adoption of an amendment by the first day of the plan year that begins on or after January 1, 2016, to prospectively amend an unacceptable interest crediting rate to one that meets the requirements of the final regulations without the amendment constituting an impermissible cutback.

The IRS asked for comments by December 18, 2014, on all aspects of the proposed regulations.

The new regulations contain many traps for the unwary.