IRS Issues Final and Proposed Hybrid Plan Regulations October 2010 Date Aon Hewitt 2010 Hewitt Associates LLC Brief Description: On October 18, 2010, the Internal Revenue Service (IRS) released final and proposed regulations regarding hybrid defined benefit (e.g., cash balance) pension plans. These regulations provide guidance on certain provisions included in the Pension Protection Act of 2006 (PPA), as amended by the Worker, Retiree, and Employer Recovery Act of 2008 (WRERA).
On October 18, 2010, the Internal Revenue Service (IRS) released final and proposed regulations regarding hybrid defined benefit pension plans, such as cash balance and pension equity plans. These regulations provide guidance on certain hybrid plan provisions included in the Pension Protection Act of 2006 (PPA) (P.L. 109-280), as amended by the Worker, Retiree, and Employer Recovery Act of 2008 (WRERA) (P.L. 110-458). The final regulations deal primarily with issues that were initially covered in proposed regulations published in the Federal Register on December 28, 2007, including: Safe harbor rules for the age discrimination requirements contained in Internal Revenue Code (IRC) section 411(b)(1)(H); Rules regarding amendments converting a traditional defined benefit formula to a statutory hybrid formula; Limited guidance regarding market rate of return requirements for plan interest crediting rates; and Three-year vesting requirement for plans with statutory hybrid benefit formulas. The proposed regulations deal with additional issues that were not covered in the 2007 proposed regulations, such as: Acceptable equity-based interest crediting rates; Acceptable minimum and fixed interest crediting rates; Interaction of equity-based interest crediting rates with the 133-1/3% accrual rule contained in IRC section 411(b)(1)(B); Rules regarding changes in interest crediting basis; and Requirements for converting lump sum-based benefits to other forms of payment This bulletin provides a summary of some of the key provisions of the final and proposed regulations. Please note that some plan sponsors may need to act by the end of the 2010 plan year to adopt certain required plan amendments (see Required Plan Amendments section below). Key Provisions of Final Regulations The final regulations largely follow the 2007 proposed regulations and earlier transitional guidance issued in Notice 2007-6, with certain clarifications and other changes. The final regulations are effective for plan years beginning on or after January 1, 2011. Key provisions of the final regulations include: Age Discrimination Safe Harbor The final regulations generally retain the age discrimination safe harbor provisions included in the proposed regulations, which provide that the accumulated benefit of any participant cannot be less than the accumulated benefit of any similarly situated younger participant (whether actual or only potential). They also provide guidance for hybrid plan conversions where certain participants receive the greater of a statutory hybrid formula benefit and a prior traditional formula benefit, or are given a choice between the statutory hybrid formula benefit and the prior traditional formula benefit. For example, if older participants are provided with the greater of the statutory hybrid formula benefit and the traditional formula benefit, younger participants who are considered similarly situated must receive the same greater-of benefit, a choice between the two formulas, or only one of the two formulas. Similarly, if older participants are 1
provided a choice between the two formulas, then younger participants who are similarly situated must receive either a choice between the two formulas or only one of the two formulas. Plan Conversions from a Traditional Formula to a Statutory Hybrid Formula Consistent with the proposed regulations, the final regulations define a conversion amendment as an amendment that reduces or eliminates a participant s future benefit accruals under a traditional formula and provides that all or a portion of the participant s benefit accruals following the effective date of the amendment are based on a statutory hybrid formula. The determination of whether a conversion amendment has occurred must be made on a participant-by-participant basis. A conversion amendment that is both adopted and effective on or after June 29, 2005 triggers the PPA requirement that a participant s benefit following the conversion amendment be no less than the sum of the participant s accrued benefit as of the conversion date (including any early retirement subsidy with future grow in ) and the participant s accrued benefit earned following the conversion date (the A+B minimum). If a plan sponsor provides some or all participants on the date a hybrid formula becomes effective with the greater of an ongoing traditional formula benefit and a hybrid formula benefit during a transition period (e.g., five years), then the conversion with respect to such participants is deemed to occur at the end of the transition period, and the A+B minimum must be applied following the end of the transition period rather than the date accruals commenced under the hybrid formula. The final regulations include an example where a plan provides benefits under a traditional formula for employees in one division and under a statutory hybrid formula for employees in a second division. The regulations indicate that a conversion amendment can be deemed to be effective when a participant transfers from the first division to the second division if the participant ceases accruing benefits under the traditional formula and begins accruing benefits under the statutory hybrid formula. In this situation, the date the relevant plan provisions were adopted is treated as the adoption date of the amendment. As a result, if the transfer provisions were adopted prior to June 29, 2005, then participants who transfer (whether before or after June 29, 2005) would not be subject to the A+B minimum. A plan sponsor is also treated as having adopted a conversion amendment if the sponsor adopts an amendment that coordinates a participant s benefit under a traditional plan with their benefit under a statutory hybrid plan, such as an offset of the statutory hybrid plan benefit from the traditional plan benefit. Market Rate of Return Requirements Under PPA, a statutory hybrid plan is required to credit interest at no greater than a market rate of return. In addition, a plan must provide for preservation of capital, so that a participant s benefit at commencement is no less than the sum of the principal credits received. The interest crediting provisions in the final regulations are similar to the provisions included in the 2007 proposed regulations, but clarify that different crediting rates can be used for different portions of a participant s account balance under a statutory hybrid formula. In addition, the final regulations expand the list of safe harbor interest crediting rates from the proposed regulations to include any of the three segment rates used for calculating lump sums under IRC section 417(e) or for determining minimum contributions under IRC section 430(h). The regulations provide that an interest crediting rate that is the lesser of or average of two market rates of return (e.g., the lesser of the 30-year Treasury rate and 5%) would not be considered an above-market rate of return. However, the greater of two market rates of return would generally be considered abovemarket unless specifically allowed. The regulations also clarify that the preservation of capital minimum applies to principal credits earned before the effective date of PPA, and include any opening balances. 2
Finally, the regulations also clarify that, for pension equity plans that only apply an interest crediting rate following termination of employment, those interest credits are subject to the market rate of return rules. Three-Year Vesting Requirement With regard to the three-year vesting requirement for statutory hybrid plans, the final regulations retain the requirement from the 2007 proposed regulations that three-year vesting applies to a participant s entire accrued benefit if all or a portion of the benefit is determined under a statutory hybrid formula. However, the regulations clarify that, pursuant to WRERA, the three-year vesting requirement only applies to participants with an hour of service on or after January 1, 2008. The final regulations also clarify that the three-year vesting requirement does not apply to the traditional portion of a floor-offset arrangement where the traditional formula benefit is under a separate plan than the statutory hybrid plan benefit. Key Provisions of Proposed Regulations The proposed regulations include important new guidance regarding acceptable interest crediting rates for statutory hybrid plans. The proposed regulations would be effective for plan years beginning on or after January 1, 2012. Plan sponsors can rely on the proposed regulations prior to the effective date. However, amendments to reduce a plan s interest crediting basis to comply with the market rate of return requirements would not be required until final market rate of return regulations are issued. It is not clear whether guidance on how a plan can or must reduce its above-market rate to a market rate will be included in the final regulations or some other form of guidance such as a Notice or Revenue Ruling. Public comments on the proposed regulations must be received by January 12, 2011. A public hearing on the proposed regulations is scheduled for January 26, 2011. Key provisions of the proposed regulations include: Acceptable Equity-Based Interest Crediting Rates The proposed regulations would allow the use of variable interest crediting rates based on either the actual return on plan assets or the return on a regulated investment company (RIC). In the latter case, the rate of return on the RIC must be reasonably expected to be not significantly more volatile than the broad U.S. equities market or a similarly broad international equities market. For example, an RIC that uses leverage or other strategies that would increase the RIC s risk and return profile beyond that of a nonleveraged investment generally would not meet this requirement. The preamble to the proposed regulations also requests comments on related issues, such as whether plans should be able to offer participants a choice of hypothetical investment options (including life-cycle investment options). Acceptable Minimum and Fixed Interest Crediting Rates The proposed regulations include long-awaited guidance on the acceptable minimum interest crediting rates that may be used in conjunction with the safe harbor bond-based rates allowed under the final regulations, as well as with the equity-based crediting rates allowed under the proposed regulations. In addition, the regulations provide guidance on acceptable stand-alone fixed rates of interest. Specifically, the regulations allow the use of: A minimum interest rate not exceeding 4% per year, applied during each interest crediting period to any of the safe harbor bond-based rates included in the final regulations 3
A cumulative minimum interest rate not exceeding 3% per year, applied to any of the acceptable equity-based or bond-based interest crediting rates. Note that this cumulative minimum would be applied at benefit commencement, rather than during each interest crediting period. The proposed regulations do not allow the use of a minimum that applies in each interest crediting period with equity-based crediting rates A fixed interest rate not exceeding 5% per year The minimum interest crediting rates for safe-harbor and equity-based crediting rates are important for plans that provide age- or service-based pay credits, as they may be needed for those plans to demonstrate compliance with the 133-1/3% accrual rule in IRC section 411(b)(1)(B). Interaction of Equity-Based Interest Crediting Rates with 133-1/3% Rule The proposed regulations provide that, if a plan credits interest based on an equity-based rate of return and the most recent crediting rate was negative, a rate of 0% may be used for purposes of demonstrating compliance with the 133-1/3% accrual rule. This mitigates the concern that a plan with equity-based interest credits may not be able to comply with the 133-1/3% rule even if it does not have age- or servicebased pay credits. For plans that provide a cumulative minimum interest rate of up to 3%, it is unclear whether that minimum could be used for purposes of demonstrating compliance with the 133-1/3% rule. Rules Regarding Changes in Interest Crediting Basis The proposed regulations clarify that the right to future front-loaded interest credits (i.e., interest credits that are not conditioned on continued employment) are considered part of the accrued benefit and are generally protected under IRC section 411(d)(6). The regulations provide limited guidance on changing the interest crediting rate on a prospective basis. This guidance would require a participant s benefit following the change (under the new interest crediting basis, including accruals following the date of the change) to be no less than the benefit preceding the change (under the old interest crediting basis, and excluding any accruals following the change). The preamble to the regulations indicates that the IRS expects to issue guidance in the future that will provide relief from the IRC section 411(d)(6) requirements to allow reductions in interest crediting rates to the extent needed to comply with the market rate of return requirements. The preamble also requests comments on this issue. Converting Lump Sum-Based Benefits to Other Forms of Payment The proposed regulations would clarify that the ability to distribute a participant s lump sum-based benefit in a single sum equal to their account balance without performing whipsaw calculations would be limited to situations where annuity benefits are determined under the plan as the actuarial equivalent of the account balance using reasonable actuarial assumptions. This would address the concern that a statutory hybrid plan could offer annuity benefits that are heavily subsidized relative to lump sum benefits, potentially circumventing the market rate of return rules. Required Plan Amendments As enacted, PPA required that any plan amendments needed to comply with the PPA hybrid plan rules be adopted by the end of the 2009 plan year. In Notice 2009-97, the IRS extended this remedial amendment deadline to the end of the 2010 plan year. As noted above, the final and proposed hybrid plan regulations further extend the deadline for amendments to reduce plan interest crediting rates to comply with the market rate of return rules until final regulations on market rates of return are issued. However, the IRS has not yet provided a further extension for amendments to comply with other PPA hybrid plan rules such 4
as the elimination of whipsaw calculations. While it is possible the IRS will provide such a further extension, plan sponsors will need to work with their legal counsel to draft and execute these amendments by the end of the 2010 plan year if an extension is not provided. More Information The regulations were published in the Federal Register on October 19, 2010 and are available at the following links: Final Regulations: http://edocket.access.gpo.gov/2010/pdf/2010-25941.pdf Proposed Regulations: http://edocket.access.gpo.gov/2010/pdf/2010-25942.pdf Aon Hewitt will be issuing a more detailed report on these regulations in the near future. In the meantime, please contact your local Aon Hewitt consultant with any questions regarding the regulations. * * * Aon Hewitt is not a law firm. The material in this bulletin is not meant to replace or supersede the advice of client legal counsel. 5
Contact Information Brian Donohue Senior Vice President Aon Hewitt +1.312.381.5674 brian.donohue@aonhewitt.com 6