IRS issues final regs providing guidance on hybrid defined benefit plans

The IRS has issued new final regulations providing guidance on hybrid defined benefit plans, such as cash balance plans and pension equity plans.

Background

Special accrual and vesting rules under Code Sec. 411(a)(13) and Code Sec. 411(b)(5) apply to hybrid plans that have hypothetical balances. These rules were added by the Pension Protection Act of 2006 (PPA; P.L. 109-280), as amended by the Worker, Retiree, and Employer Recovery Act of 2008 (P.L. 110-458).

Proposed regulations were issued in 2007 and finalized in 2010 (T.D. 9505). Along with the 2010 final regulations, the IRS issued proposed regulations addressing certain issues not addressed in the 2010 final regulations, and one issue under the 133 1/3 percent rule of Code Sec. 411(b)((1)(B) for defined benefit plans that adjust benefits using a variable rate that could be negative.

Scope of Code Sec. 411(a)(13)

The 2014 final regulations expand the definition of pension equity plan (PEP) formula in the 2010 final regulations to include a benefit formula expressed as a current single-sum dollar amount equal to a percentage of the participant’s highest average compensation (with a permitted look-back period for determining highest average compensation, such as the highest five out of the last ten years). In addition, a benefit formula does not constitute a lump-sum based benefit formula unless a distribution of the benefits under that formula in the form of a single-sum payment equals the accumulated benefit under that formula (except to the extent the single-sum payment is greater to satisfy the anti-cutback requirements). This expansion applies for plan years that begin on or after January 1, 2016 (or an earlier date as elected by the taxpayer).

Code Sec. 411(a)(13)(A) generally permits a plan to treat the accumulated benefit under a cash balance formula or a PEP formula as the present value of the portion of the accrued benefit determined under the cash balance or PEP formula. The 2010 proposed regulations contained three requirements that applied to the cash balance account or PEP accumulation that were structured as conditions on the availability of the relief of Code Sec. 411(a)(13)(A). In response to commenters’ objections to treating the requirements as conditions, the 2014 final regulations clarify this structure to indicate that two of the requirements are only intended to provide the same types of protections to the accumulated benefit under a cash balance formula and under a PEP formula as are afforded to the accrued benefit.

With respect to subsidies and benefits that are less than the actuarial equivalent of the cash balance account or PEP accumulation, the 2010 proposed regulations provided that the relief of Code Sec. 411(a)(13)(A) applies to an optional form of benefit that is determined as of the annuity starting date as the actuarial equivalent, using reasonable actuarial assumptions, of the cash balance account or PEP accumulation. In response to comments that subsidized benefits should be permissible, the 2014 final regulations clarify that this relief also applies to a subsidized optional form of benefit under a lump-sum based benefit formula, including an early retirement subsidy or a subsidized survivor portion of a qualified joint and survivor annuity. In particular, the 2014 final regulations provide that, with respect to benefits under a lump-sum based benefit formula, if an optional form of benefit is payable in an amount that is greater than the actuarial equivalent, determined using reasonable actuarial assumptions, of the cash balance account or PEP accumulation, then the plan satisfies the requirements of Code Secs. 411(a)(2), 411(a)(11), 411(c) and 417(e) with respect to the amount of that optional form of benefit.

However, the final regulations also provide that if an optional form of benefit is not at least the actuarial equivalent, using reasonable actuarial assumptions, of the cash balance account or PEP accumulation, then the relief under Code Sec. 411(a)(13)(A) does not apply in determining whether the optional form of benefit is the actuarial equivalent of the portion of the accrued benefit determined under the cash balance or PEP formula. Thus, payment of that optional form of benefit must satisfy the rules applicable to payment of the accrued benefit generally under a defined benefit plan.
Under the 2010 final regulations, a formula that is not a lump-sum based benefit formula that has an effect similar to a lump-sum based benefit formula is nevertheless a statutory hybrid benefit formula. As a result, such a formula is subject to the three-year vesting rule of Code Sec. 411(a)(13)(B) and the rules of Code Sec. 411(b)(5) , including the market rate of return and conversion protection requirements. However, because it is not a lump-sum based benefit formula, such a formula is not eligible for the relief of Code Sec. 411(a)(13)(A).

In general, a defined benefit formula that is not a lump-sum based benefit formula has an effect similar to a lump-sum based benefit formula if the formula provides that a participant’s accumulated benefit is expressed as a benefit that includes the right to adjustments for a future period and the total dollar amount of those adjustments is reasonably expected to be smaller for the participant than for a similarly situated, younger individual who is or could be a participant in the plan. The 2014 final regulations clarify that the right to adjustments for a future period is broadly defined to mean the right to any change in the dollar amount of benefits over time, regardless of whether those adjustments are denominated as interest credits.

However, this broad definition does not cause a defined benefit formula to be treated as having an effect similar to a lump-sum based benefit formula for a participant merely because the formula provides for a reduction in the benefit payable at early retirement due to early commencement (with the result that the benefit payable at normal retirement age is greater than the benefit payable at early retirement), provided that the benefit payable at normal retirement age to the participant cannot be less than the benefit payable at normal retirement age to any similarly situated, younger individual who is or could be a participant in the plan. This exception has the effect of excluding traditional defined benefit formulas (and other formulas that provide for mere actuarial reduction for early commencement) from treatment as a formula with an effect similar to a lump-sum based benefit formula, notwithstanding the treatment of actuarial increases in benefits over time as adjustments.

The 2010 final regulations define a lump-sum based benefit formula as a benefit formula used to determine all or any part of a participant’s accumulated benefit under which the accumulated benefit provided pursuant to the formula is expressed as the current balance of a hypothetical account maintained for the participant or as the current value of an accumulated percentage of the participant’s final average compensation. Under this rule, a benefit formula is a lump-sum based benefit formula if it expresses the accumulated benefit as a current single-sum dollar amount, regardless of whether interest credits are provided.

The IRS notes that, with respect to a plan that does not provide interest credits, there might be a question as to whether the accumulated benefit is a current single-sum dollar amount or is a single-sum dollar amount at normal retirement age. In response to a request for comments, commenters suggested that a benefit formula that expresses the participant’s benefit as a current single-sum dollar amount (for example, a PEP formula) should be treated as a statutory hybrid benefit formula, regardless of whether interest credits are provided. Because the statutory language with respect to a cash balance formula and a PEP formula does not specify that interest credits must be provided, the IRS agreed with this recommendation, and, thus, the definition of lump-sum based benefit formula continues not to require that interest credits be provided.

The IRS also agreed with commenters who recommended that plans that express the accumulated benefit as a single-sum dollar amount at normal retirement age, rather than as a current single-sum dollar amount, should not be treated as statutory hybrid plans. Accordingly, the definition of lump-sum based benefit formula continues to require that the benefit be expressed as a current single-sum dollar amount. Thus, a benefit formula that expresses the accumulated benefit as a single-sum dollar amount at normal retirement age is not a statutory hybrid benefit formula unless the formula includes the right to adjustments such that the formula has an effect similar to a lump-sum based benefit formula pursuant to IRS Reg. Sec. 1.411(a)(13)-1(d)(4)(ii).

Variable interest crediting rates

The 2014 final regulations adopt the rule in the 2010 proposed regulations regarding the application of the 133 1/3 percent rule to a statutory hybrid plan that adjusts benefits using a variable interest crediting rate that can potentially be negative in any given year. Under this rule, for plan years that begin on or after January 1, 2012, a plan that determines any portion of the participant’s accrued benefit pursuant to a statutory hybrid benefit formula (as defined in IRS Reg. Sec. 1.411(a)(13)-1(d)(4)(ii)) with a variable interest crediting rate that was negative for the prior plan year would not be treated as failing to satisfy the requirements of the 133 1/3 percent rule for the current plan year merely because the Code Sec. 411(b)(1)(B) backloading calculation is performed assuming that the variable rate is zero for the current plan year and all future plan years. However, the rule has been modified to permit a taxpayer to elect to apply it at an earlier date (so that the rule is applicable for plan years that begin on or after January 1, 2012, or an earlier date as elected by the taxpayer).

Age discrimination rules under Code Sec. 411(b)(5)

The 2014 final regulations provide special age discrimination rules, including rules with respect to the market rate of return limitation. The regulations clarify the 2010 final regulations regarding the age discrimination safe harbor. The 2014 final regulations also provide rules regarding conversion amendments, the market rate of return (including crediting interest), the use of adjusted segment rates as interest crediting rates, the rate of return on plan assets or a subset of plan assets, the rate of return on a regulated investment company or other collective investments, a permitted fixed rate, permitted annual and cumulative floors, permitted margins on government bond-based interest crediting rates, plan termination, and Code Sec. 411(d)(6) and interest crediting rates.

The preamble of the 2010 proposed regulations requested comments as to whether a statutory hybrid plan should be able to offer participants the opportunity to choose from a menu of hypothetical investment options. Because of significant concerns, the IRS continues to study the issues raised. The IRS notes that if it concludes that such plan designs are not permitted, it is anticipated that any statutory hybrid plans that permitted participant choice among a menu of investment options on September 18, 2014 pursuant to plan provisions that were adopted by September 18, 2014 would receive anti-cutback relief that would permit any such plans to be amended to provide for one or more appropriate alternative replacement interest crediting measures.

Applicability dates

The 2014 final regulations finalize the 2010 proposed regulations, effective September 19, 2014, and generally apply to plan years that begin on or after January 1, 2016 (rules that merely clarify provisions that were included in the 2010 final regulations apply to plan years that begin on or after January 1, 2011, in accordance with the applicability date of the 2010 final regulations). Prior to that, plans may rely on the 2010 final regulations, or the 2010 proposed regulations, the 2007 proposed regulations, and Notice 2007-6 for purposes of applying the relief and satisfying the requirements of Code Secs. 411(a)(13) and 411(b)(5).

Source: 79 FR 56442, September 19, 2014.

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