SOA 2010 Annual Meeting & Exhibit Oct , Session 118 PD, Statutory Hybrid Plans. Moderator: Ellen L. Kleinstuber, ASA, EA, FCA, MAAA, MSPA

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1 SOA 2010 Annual Meeting & Exhibit Oct , 2010 Session 118 PD, Statutory Hybrid Plans Moderator: Ellen L. Kleinstuber, ASA, EA, FCA, MAAA, MSPA Presenters: David R. Godofsky, FSA, EA, FCA, MAAA Sarah W. Wright, FSA, EA, FCA, MAAA

2 Oct , 2010 New York, NY SESSION 118 STATUTORY HYBRID PLANS Moderator: Ellen Kleinstuber The Savitz Organization Philadelphia, PA Presenters: David Godofsky Alston + Bird Washington, DC Sarah Wright Aon Consulting New York, NY 1

3 What is a Statutory Hybrid? Statutory hybrid benefit plan / formula Plan: same as applicable defined benefit plan in PPA Formula: either a lump sum based benefit formula or a formula that has a similar effect to such a formula Lump sum based benefit formula DB plan that expresses accumulated benefit as Hypothetical account balance (cash balance) Current value of accumulated percent of final average compensation (PEP) Whether plan pays lump sums is irrelevant 3 What is a Statutory Hybrid? Accumulated benefit Benefit accrued under terms of the plan Can be expressed as normal retirement annuity, hypothetical account or current value of accumulated percent of final average compensation Includes plans that define NR annuity as actuarial equivalent of hypothetical account or current value of accumulated percent of final average compensation Plans treated as having similar effect Indexing provided before retirement either automatically or by pattern of repeated amendments Indexed career pay plan Certain variable annuity plans But contributory portion of DB plan is not statutory hybrid plan 4 2

4 Age Discrimination Pre-PPA: litigation contending that the accrual of annuity at NRA decreases as age increases. Circuit courts started holding that the time value of money is not age discrimination right after passage of PPA. PPA eliminated age discrimination issue prospectively but only if interest rate is not greater than market. Safe harbor older employee gets no less than similarly situated younger employee (note problem with integrated or permitted disparity plans). 5 Interest Rate / Market Rate Safe harbor 96-8 plans (30 yr Treas. rate; 10 yr Treas. rate; etc.) Third segment rate. Fixed rate? Rate of return of the trust? Rate offered on variable annuities from insurers? A rate that could be duplicated with a real investment. What about greater of (e.g.:10 yr Treas but not less than 3%)? Statutory provision A plan shall not be treated as failing to meet the requirements merely because the plan provides for a reasonable minimum guaranteed rate of return or for a rate of that is equal to the greater of a fixed return or a variable rate of return What about lesser of (e.g.: 5% but not greater than 30 yr Treas) Participant choice? 6 3

5 Accrual / Backloading / NRA Rev. Rul vs. judicial decisions Can use any of 3 accrual rules but only 133.3% rule can be guaranteed to always pass? Problem areas: Low interest rates Negative interest rates Greater of formulas (note difference between court decisions and ) Temporary transition formulas A+B formulas Graduated pay credits / minimum interest rates Need to amend pay credit schedule when interest rate drops or implement minimum interest crediting rate Failsafe formulas NRA: why is low NRA attractive for cash balance plans? 62+ NRA NRA Below 55 NRA 7 Funding Issues Funding whipsaw What if interest rate = rate of return on trust? Assumed form of distribution. Assumed time of distribution. Assumed interest crediting rate vs. discount rate(s) What is accrued benefit? 8 4

6 Determination Letter Issues Backloading / minimum interest rate Whipsaw for pre-ppa periods Definition of accrued benefit Protect accrued benefit if change AE from 30 yr Treas. to fixed Small plans 401(a)(26) 9 Conversion Issues A+B benefit approach Choice issues (particularly l if choice only applies to participants over a certain age) Conversion due to change in status or corporate transactions Multiple plans 10 5

7 Variable Annuity Plans Trigger rate 5% or higher Can look like cash balance, but not subject to preservation of capital or plan termination (5 year average) rule 4.25% backloading problem Funding whipsaw or not? Lump sum whipsaw or not? Account balance vs. annuity type plan 11 Pension Equity Plans No rules in initial proposed regulations Preamble seeks input on certain questions How to apply market value restrictions Different treatment for actives vs. TVs Not clear if PEP that defines lump sum at NRA rather than at current age is a statutory hybrid plan 12 6

8 Potpourri Capital preservation rule Plan termination ti (5 year average) rule Includes annuity conversion rate 3 year vesting applicable to traditional benefit if EE has hybrid benefit 13 7

9 Cash Balance & Other Hot DB Topics 2008 Northeast Area Benefits Conference June 12 & 13, 2008 Workshop 6: 4:40 5:30 pm James E. Holland, Jr., Internal Revenue Service, TE/GE Employee Plans Sarah W. Wright, JPMorgan Background Cash Balance Plans Amendments made by section 701 of PPA are generally effective for periods on or after June 29, 2005 Special present value rules of 411(a)(13)(A) are effective for distributions made after August 17, 2006 Interest crediting restrictions and 3-year vesting rule generally effective for plan years beginning after December 31, 2007 Notice provided transitional guidance Proposed regulations issued Dec. 27, 2007 generally affirm and build on Notice Proposed to be effective January 1, 2009 (as late as January 1, 2010 for collectively bargained plans) Can be relied on in the interim Proposed funding regulations issued December 31, 2007 confirm that funding target is not the same as account balance 1 Revenue Ruling provided guidance/ relief on application of accrual rules 1

10 Key PPA Hybrid Provisions PPA Section 701 Legality of basic design confirmed Not age discriminatory No more whipsaw Generally prospective Modest ongoing plan mandates Modest future conversion mandates No-inference regarding past years 2 Key Definitions in Proposed Regulations Statutory hybrid benefit plan / formula Plan: same as applicable defined benefit plan in PPA Formula: either a lump sum based benefit formula or a formula that has a similar effect to such a formula Lump sum based benefit formula DB plan that expresses accumulated benefit as Hypothetical account balance (cash balance) Current value of accumulated percent of final average compensation (PEP) Whether plan pays lump sums is irrelevant 3 2

11 More Key Definitions in Proposed Regulations Accumulated benefit Benefit accrued under terms of the plan Can be expressed as normal retirement annuity, hypothetical account or current value of accumulated percent of final average compensation Includes plans that define NR annuity as actuarial equivalent of hypothetical account or current value of accumulated percent of final average compensation Plans treated as having similar effect Indexing provided d before retirement t either automatically ti or by pattern of repeated amendments Indexed career pay plan Certain variable annuity plans But contributory portion of DB plan is not statutory hybrid plan 4 Variable Annuity Plan Issues Variable annuity plan (VAP) defined for this purpose Plan that periodically adjusts benefits based on difference between rate of return on plan assets OR specified market indices, and the assumed interest rate (AIR) A VAP is NOT treated as having similar effect to lump sum based plan if AIR is 5% or higher VAP with low AIRs might have to raise them or follow statutory hybrid plan rules Capital preservation rule is the big issue Apparently concluded VAP with low AIR behaves too much like a cash balance or indexed career pay plan 5 3

12 Effect of Being Statutory Hybrid Plan Burdens 3-year vesting Indexing cannot be negative cumulatively Capital preservation rule No wear-away on conversions to these plans Relief Exempt from whipsaw if lump sum based formula If not lump sum based, no expectation of relief anyway Safe harbor for age discrimination 6 Age Discrimination Safe-Harbor New IRC 411(b)(5) Available to all DB plans, not just hybrids Accumulated benefit for each participant may not be less than accumulated benefit for similarly situated younger participant Accumulated benefit expressed as Annuity benefit payable at normal retirement age (traditional plan), Balance of hypothetical account (cash balance), or Current value of accumulated percentage of final average compensation (PEP) Plans that can t pass safe-harbor must rely on basic rule of IRC 411(b)(1)(H) and 1988 proposed regs. rate of benefit accrual cannot reduce because of age No changes to that section made by PPA More guidance on that section seems unlikely 7 4

13 Age Discrimination Safe Harbor Similarly Situated Employees are similarly situated if identical in every respect that is relevant for determining benefits, except age. Including: Period of service Compensation Position Date of hire Work history Any other respect 8 Age Discrimination Safe-Harbor Restrictions on Its Use Participants covered by different benefit formulas may not be compared Participant in traditional formula not compared to participant in hybrid formula Grandfathered participants Older participants in greater of or sum of different benefit formulas, then younger participants treated as covered by both formulas Example of problem plan Employees 55 and over covered in FAP, others in cash balance Problematic conversion designs Employees over 55 remain in prior formula others go into cash balance Some given choice to remain under prior formula if choice based on age Giving all choice probably ok since those electing to go into one formula are not similarly situated to those electing other formula 9 5

14 Minimum Interest Credits Cumulative negative return prohibited by PPA Preservation of capital rule Proposed regulations indicate this is one-time calculation at annuity starting date 10 Maximum Interest Crediting Rate Interest credit rates can t exceed a market rate of return Long-term investment grade corporate bonds (third segment rate) Rates defined in Notice 96-8 other than PBGC immediate rate Other rate Reasonable stand-alone or minimum fixed rate (not defined in proposed regs) Equity-based rates (not defined) Limited guidance yet on anti-cutback relief Can switch from 96-8 rates to tier 3 corporate Hope for relief to reduce rate to extend necessary to comply 11 6

15 Maximum Interest Crediting Rate Preamble discusses issues Considering as fixed rates 4% or 5% as stand alone rate 3% or 4% as minimum rate with variable rate based on 3 rd segment or 96-8 rates Set fixed rate at current variable rate under 96-8 or 3 rd segment If using return on an investment with equity component, Should be well diversified so that the capital preservation does not create a greater than market return Possibly using return on the plan trust assuming complies with fiduciary rules Cautions against using a rate other than those explicitly permitted in the proposed regulations Participant directed not addressed 12 Interest Rates After Plan Termination Under PPA, terminating hybrid plan must switch to fixed rates for interest credits / annuity conversions Average of variable rates over last five years Odd results likely for plans with equity returns No new guidance in proposed regulations 13 7

16 Interest Crediting Timing Rules If not crediting daily, same stability/ lookback rules as 417(e) But periods can differ from those used for 417(e) Some plans would have to be changed to meet these rules, hopefully with 411(d)(6) relief Must credit interest at least annually Variable rates must change at least annually If credit more frequently than annually, plan stated t rate must be nominal not effective annual rate (inferred by example in proposed regulations) May need to lower the plan stated annual rate if now treat annual rate as effective annual rate 14 Conversion Restrictions Effective 6/30/05 Minimum on A+B basis no wear-away Part A: accrued benefit at conversion Part B: cash balance with no opening balance Conversion is participant based Can be deemed to occur due to transfer from non-covered status or due to business transaction Not clear if temporary greater-of deemed deferred conversion requiring new A+B when prior plan freezes Include early retirement subsidy in Part A (frozen prior plan benefit) PPA language suggested that the subsidy should be included in the Part B cash balance benefit. 15 8

17 Minimum 3-Year Cliff Vesting No graded vesting alternative Applies to past and future years of service Applies on a participant-by-participant basis Applies to participant s entire benefit if covered at all under hybrid provisions Generally, beginning of 2008 plan year June 29, 2005 for plans that did not then exist As late as beginning of 2010 year for collective bargained plan Leaves open whether only applies to employees with hours of service after 2007 plan year Technical corrections provision would confirm this 16 Minimum Lump Sums No whipsaw calculations needed for distributions after August 17, 2006 From lump sum based formulas only Can eliminate whipsaw provisions in operation Formally amend by end of 2009 plan year Special 30-day 204(h) notice requirement Not clear if annuity conversion restrictions PPA silent but rumor that restrictions will apply 17 No guidance on effective date provision for plans that did not comply with Notice 96-8 IRS agents taking narrow view that if did not strictly comply with 96-8 safe harbor, must do whipsaw calculations Does it matter if have determination letter on plan without whipsaw provisions? 9

18 Pension Equity Formulas No special rules for PEPs in proposed regulations Preamble seeks input on a number of questions One major issue is how to apply market value restrictions Different treatment for actives vs. terminations is key issue Not clear if PEP variation that defines lump sum at normal retirement rather than at current age is a statutory hybrid plan Can be viewed as either current value with no future interest or as fully subsidized normal retirement balance 18 Funding New kind of interest rate whipsaw on hybrid plans If the distribution is the account balance, funding target is calculated by Projecting the future interest credits using reasonable actuarial assumptions and Discounting using the yield curve or alternate application Thus, the present value of a future distribution is not necessarily the current amount of a participant's hypothetical account balance. (Preamble) Other funding issues Beginning of year valuation date for plans with > 100 participants 19 10

19 Funding Example from Proposed Regulations Plan provisions: Plan is a cash balance plan that permits an immediate payment of the hypothetical account balance upon termination of employment. Hypothetical account is credited with interest at the 3rd segment rate. Actuarial assumptions for January 1, 2008 valuation: all participants will retire on the first day of the plan year in which they attain age % of participants will elect a single sum upon retirement 24-month average segment rates applicable for September 2007 (determined without the transitional rule) Non-annuitant mortality tables used for periods prior to commencement of benefits; annuitant mortality table is not applicable because assumed payment is a single sum. annual interest credits as shown below Participant is age 61 on January 1, 2008, and has a hypothetical account balance equal to $150,000 on that date. Assumed Interest Crediting Rate: 5% 6% Projected Account Balance $182,326 $189,372 Funding Target 145, , Accrual Rules IRS Previous View What have the courts said? Revenue Ruling Clarifications Testing of cash balance formulas Multiple formula testing Testing by category of participant Historical relief (through 2008): multiple formulas can be tested separately IRS press release Helps with d-letters, not necessarily ERISA lawsuits 21 11

20 IRS Previous View Cash balance plans have generally needed to satisfy the 133% rule, under which the accrual in a later year can t be more than 33% larger than the accrual in an earlier year. The IRS has been asserting, at least in recent determination letter reviews, that when two formulas operate together, the net result must be tested. When a plan offers a benefit that is the greater of two ongoing formulas, such as when a plan is converted to cash balance, but some participants continue to get the prior final average pay formula, if better, there often is a crossover point at which one formula overtakes the other. In these situations, it is usually difficult to pass the backloading rules if the formulas are tested together under the 133% rule. But when a plan offers a benefit that is the greater of a frozen amount and an ongoing g formula (i.e., wear-away approach following a plan amendment), the frozen benefit may be disregarded Graded cash balance formulas may need explicit minimum interest credits 22 Revenue Ruling : Testing of cash balance formulas In addition to the /3% rule, the fractional rule may be used for cash balance plans. Different accrual rules may be used for different groups of participants classification of employees should be reasonable RR clarifies how to apply the /3% rule to cash balance plans: interest crediting rates compensation plan amendments RR affirms the IRS previous view that where a plan has multiple ongoing formulas, they must be tested in aggregate under the 133-1/3% 1/3% rule But RR provides qualification relief for pre-2009 years allowing multiple greater of formulas to be tested separately May actually increase vulnerability to ERISA Title I lawsuits 23 For a graded cash balance plan where pay credits either increase with age or service, there is an implicit minimum interest rate needed to make sure future accruals are not more than 4/3 greater than prior accruals. RR only requires addressing the minimum interest rate issue if the plan s interest crediting rate actually falls below such threshold. 12

21 Other Determination Letter Issues IRS forcing whipsaw retroactively on calculation of lump sum prior to effective date (August 17, 2006) in the statute Even for plans that otherwise satisfy Notice 96-8 but have small minimum interest crediting rate Seems inconsistent with guidance in Notice that indicated no action would be taken in these situations until guidance on PPA effective date was issued IRS pushing for plans to define accrued benefit as normal retirement annuity determined by projecting account with interest crediting rate in effect in the current year 24 Reasonable Retirement Age PPA allows in-service distributions from a pension plan to an employee who is still working after reaching age 62 Final regulations Age 62 is deemed reasonable Ages must meet industry standard Age below 55 is presumed not acceptable; may ask IRS for determination Effective dates Plans with NRA < 40 - May 22, 2007 Plans with NRA >= 40, plan year beginning after June 30, 2008 Transition 411(d)(6) relief for plans that must increase NRA between 5/22/2007 and on or before the last day of the applicable remedial amendment period 25 13

22 2008 Gray Book QUESTION 39 - Other DB Plan Issues: Normal Retirement Age for Large Law Firms Final normal retirement age regulations were released on May 22, As a general rule, the final regulations indicate that a plan s normal retirement age cannot be earlier than the earliest age that is reasonably representative of the typical retirement age for the industry in which the covered workforce is employed. A safe harbor was provided for normal retirement ages of age 62 or older. Normal retirement ages between 55 and 62 are subject to facts and circumstances. In the legal industry, the typical retirement age can vary significantly depending on the size of the law firm. Attorneys working at large law firms (more than 500 attorneys) have very different career paths and billable hour requirements than attorneys at small law firms. Furthermore, industry trend information is not readily available. When establishing the facts and circumstances supporting the normal retirement age for a qualified retirement plan for a large law firm, would it be sufficient to reflect a normal retirement age that is consistent with the age at which full nonqualified retirement benefits are available under the firm s partnership agreements? For example, if a firm provided full non-qualified retirement benefits to a partner at the later of age 58 and 15 years of service but not later than the later of the attainment of age 65 or the fifth anniversary of plan participation, would it be reasonable to set the qualified plan s normal retirement age at the later of age 58 and completion of 15 years of partnership service but not later than the later of the attainment of age65 or the fifth anniversary of plan participation? RESPONSE The preamble to the final regulations states: If a plan's normal retirement age is earlier than age 62, the determination of whether the age is not earlier than the earliest age that is reasonably representative of the typical retirement age for the industry in which the covered workforce is employed is based on all of the relevant facts and circumstances. If the normal retirement age is between ages 55 and 62, then it is generally expected that a good faith determination of the typical retirement age for the industry in which the covered workforce is employed that is made by the employer (or, in the case of a multiemployer plan, made by the trustees) will be given deference, assuming that the determination is reasonable under the facts and circumstances. However, a normal retirement age that is lower than age 55 is presumed to be earlier than the earliest age that is reasonably representative of the typical retirement age for the industry of the relevant covered workforce absent facts and circumstances that demonstrate otherwise to the Commissioner. [Emphasis added] 26 Final 415(b) Regulations Effective date Generally, plan years beginning after July 1, % of high three years of compensation limit Subject to Section 401(a)(17) limit Affects benefits paid for late retirement Benefits at end of 2007 year are preserved Clarification that years of service prior to plan participation count 27 Related and predecessor employers All DB plans of the employer or a predecessor employer under which the participant ever accrued a benefit are a single plan Include controlled group, affiliated service group, etc Two corporations are considered a parent subsidiary group for 415 purposes if the 80% test is dropped to 50%. 14

23 Final 415(b) Regulations Definition of compensation 3 alternatives Current income (including simplified version) Federal income tax withholding W-2 Generally same as current rules Inclusive of elective deferrals For self-employed, compensation is grossed up earned income New compensation items 409A compensation 457(f) compensation Constructive receipt 28 Compensation must be paid prior to severance from employment except Pay within 2.5 months after severance from service Military pay Disability pay Final 415(b) Regulations Other DB issues Multiple annuity starting dates Reserved In the meantime, satisfy rules as of each starting date Elimination of adjustment for monthly payments Incorporation of PPA rules Extension of PFEA interest rate of 5.5% Reflects 105% of value based on applicable interest and mortality rate 29 15