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Session 504 - PPA Hybrid Plans: Key Provisions and Definitions Following the trials and tribulations of pension equity plans and cash balance plans over the years, the Pension Protection Act (PPA) cleared the air in regards to what is allowable and what is not allowable for new plans. The law is prospective. Age discrimination issues and whipsaw issues have been cleared up. PPA provides for 3-year vesting for hybrid plans and there are restrictions on the interest credits. Notice 2007-6 provides transitional guidance; there are proposed regulations issued 12/27/2007. Notice 2008-7 provided that “greater of” formulas provide potential back-loading issues. Section 701 of PPA contains the hybrid provisions, including accrued benefit requirements. These amendments are generally effective for periods on or after June 29, 2005. There are special present value rules of 411(a)(13)(A) that are effective for distributions made after August 17, 2006. This is commonly known as cash balance whipsaw. There is a notion that the accrual in the early years for a younger participant gets more interest than for an older participant. The law provide that this is not age discrimination under certain circumstances. For collectively bargained plans there will be later updates. There is no inference regarding past years; no positive and no negative inference. Issues will be left up to the courts and almost anything can happen. An applicable defined benefit plan as defined in PPA is a statutory hybrid plan, can have a feature that is like a cash balance plan. The formula can be either a lump sum based benefit formula or a formula that has a “similar effect.” A statutory hybrid plan or formula expresses the accumulated benefit as a hypothetical account balance or a pension equity plan. It does not matter than the plan might not pay lump sums in either case. Break down a hybrid plan into buckets or components. The new law applies differently to different types. For purposes of 411(a)(7), which provides the definition of accrued benefit, the plan needs to have the means to convert from one form to another. A key definition in the proposed regulation is the definition of accumulated benefit. This is the benefit that can be accrued under terms of the plan. It can be expressed as a normal retirement annuity, a hypothetical account or the current value of accumulated percent of final average compensation. This includes plans that define the normal retirement annuity as the actuarial equivalent of a hypothetical account or current value of accumulated percent of final average compensation. Plans that are treated as “having similar effect” are those plans where indexing is provided before retirement, either automatically or by a pattern of repeated amendments. An indexed career pay plan is an example. Certain variable annuity plans are statutory hybrids but the contributory portion of a defined benefit plan is not a statutory hybrid plan. Question # 1: Is a career average plan with past service update indexed a statutory hybrid plan? Answer: No. Question # 2: When retiree benefits are updated with cost of living, is this a statutory hybrid plan? Answer: No. A variable annuity plan (VAP) is defined as a plan that periodically adjusts benefits based on the difference between rates 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 a lump sum based plan if the AIR is 5% or greater. A VAP with low AIRs may have to raise them to follow statutory hybrid plan rules; the issue is the preservation of capital. A variable annuity plan where the assumed investment return is less than 5% is swept into a similar effect hybrid plan. There must be a capital preservation floor; there cannot be an aggregate negative adjustment. A real variable annuity allows benefits to go up and down. The effects of being a statutory hybrid plan is 3-year vesting, indexing cannot be negative on a cumulative basis; there is no wear-away on conversions; conversions must be of the form A+B. In a similar effect plan, whipsaw must still be dealt with; plan may not pay out lump sums if lump sums were not part of the original formula. One area of relief is that the formula is exempt from whip saw if the formula is lump sum based. If the formula is not lump sum based, there is no expectation of relief. The safe harbor for age discrimination is provided for statutory hybrid plans. Age Discrimination Code section IRC 411(b)(5) is new. The age discrimination safe harbor is available to all defined benefit plans, not just hybrids. The accumulated benefit for each participant may not be less than the accumulated benefit for a similarly situated younger participant. The accumulated benefit is expressed as an annuity benefit payable at normal retirement age, as in a traditional plan, the balance of a hypothetical account, as in a cash balance plan or the current value of the accumulated percentage of final average compensation in a pension equity plan. Early retirement subsidies can be ignored. Plan that cannot pass the safe harbor must rely on the “basic rule” of IRC 411(b)(1)(H) and the 1988 proposed regulations, which is that the rate of benefit accrual cannot reduce because of age. PPA made no changes to that section and more guidance on that section appears unlikely. Question # 3: Isn’t our guidance on the old 1988 regulation all of the cases that overturned Cooper v IBM? Answer: If all circuits agree, then yes. But if the question goes to the Supreme Court, it could take years. These regulations are also for the past. Employees are similarly situated if identical in every respect that is relevant for determining benefits, except for age. This includes the period of service, compensation, position, date of hire, work history and any other aspect. A question is whether we are comparing hypothetical employees or only the true employees of the employer. To use the age discrimination safe harbor, there are restrictions. Participants covered by different benefit formulas may not be compared, such as participant in a traditional formula compared to a participant in a hybrid formula. A question in regards to the regulations is whether you can convert one type of benefit to the other type of benefit so that the comparison can be made. Grandfathered participants cannot be compared. Older participants are in “greater of” or “sum of” different formulas; the younger participants are treated as covered by both formulas for comparison purposes. If one participant is allowed “choice” and a second one is not, then are they any longer similarly situated? An example of a problematic conversion design is a plan with the employees who are 55 and older in the final average plan and the other employees are in the cash balance plan. Problematic conversion designs occur when employees over age 55 remain in the prior formula and the others go into the cash balance plan. Some employees are given the choice to remain under the prior formula if the choice is based on age. Giving all employees choice is probably okay since those electing to go into one formula are not similarly situated to those who elect the other formula. Pre-retirement indexing can be disregarded only if it is based on an eligible cost of living index, or the rate of return on all plan assets (or annuity contract assets providing plan benefits). The cumulative effect of indexing cannot be negative; this is the capital preservation rule. Interest Crediting Rates: Market Rate of Return PPA has a preservation of capital rule; a cumulative negative return is prohibited. Proposed regulations indicated that this is a one-time calculation at annuity starting date. Interest crediting rates cannot exceed a “market rate of return.” A market rate of return in the statutes can be defined as the third segment rates, which is the rate from long-term investment grade corporate bonds. The rates defined in Notice 96-8 can be used as market rates of return. Reasonable stand-along rates, a minimum fixed rate or equity-based rates are not defined as acceptable market rates of return in the proposed regulations. There is limited guidance on anti-cutback relief. You can switch from Notice 96-8 rates to the third segment rate. Question 4: Is there any other guidance on minimum interest rates? Answer: In the preamble to the regulation, there is mention of an equity based return with a minimum of 3%. Guidance is missing on how high it can go. The preamble mentions using 4% or 5% as stand-alone rates, 3% or 4% as a minimum rate with the variable rate based on the 3rd segment rate or Notice 96-8 rates. You can set the fixed rate at the current variable rate under Notice 96-8 or the 3rd segment. If you are using return on investment with an equity component, the fund should be well diversified so that the capital preservation rule does not create a greater than market rate of return. You can possibly use the return on the plan trust, assuming that the trust complies with fiduciary rules. Be cautioned about using rates other than those explicitly permitted in the proposed regulations. Participant directed accounts were not addressed in the proposed regulation. Notice 96-8 rates and the associated margins were presented. These are based on the standard being the 30-year treasury rate. Some employers want to provide greater rates. Under PPA, a terminating hybrid plan must switch to fixed rates for interest credit and annuity conversions. Look back for the past five years and average to fix a rate for the future. Odd results may occur for plans with equity returns. There is no new guidance in the proposed regulations for terminating plans. The PBGC has not adjusted its rules. If daily interest credits are not given, then PPA or the regulation provide for the same stability period and look back rules as for 417(e). The periods can be different from those used for 417(e). Interest must be credited at least annually. Variable rates must change at least annually. If interest is credited more frequently than annually, the rate stated in the plan must be nominal, not the effective annual rate. This was inferred by an example in the proposed regulations. If you now treat the stated annual rate as the effective annual rate, then the stated annual rate may need to be lowered. Other Provisions Conversions Conversion restrictions that are effective as of 06/30/2005 is that the conversion must be of the form A+B, with no wear-away. A is equal to the accrued benefit at the point of conversion and B is the cash balance account with no opening balance. The conversion must be participant based, as opposed to being on a plan-wide basis. The effective date of a conversion is when the plan is amended for change. It is less clear when the conversion date occurs in a transfer situation. Many cash balance conversion keep the prior plan benefit as a minimum for a period of time. The question is when does the conversion occur? After the time period has elapsed? Or when the formula changes? A conversion can be deemed to occur due to transfer from a non-covered status or due to a business transaction. It is not clear if a temporary “greater of” conversion is deemed to be a deferred conversion requiring the new A+B form when the prior plan freezes. Multiple amendments may constitute conversion if they occur within 3 years. The early retirement subsidy should be included in Part A, the frozen prior plan benefit. PPA language suggested that the subsidy should be included in the Part B cash balance benefit. How could this be facilitated? Code section 411(d)(6) states that the subsidy should be preserved in the form it was earned. There is an opening balance alternative with extended wear-away. The open balance alternative is created without any comparison to the Part A benefit under limited circumstances. You would have to provide an opening balance that is generous enough that A+B can be disregarded. Vesting PPA requires three-year vesting as a minimum for hybrid plans. There is no graded vesting alternative. It applies to the past and future years of service and is applied on a participant-by-participant basis. It applies to the participant’s entire benefit if covered at all under the hybrid provisions. Three-year vesting is generally effective with the beginning of the 2008 plan year. For plans that did not exist on June 29, 2005, the provision is effective on that date. For collectively bargained plans, three-year vesting is effective as late as the beginning of the 2010 plan year. A question is whether this only applies to employees with an hour of service after the 2007 plan year. Technical corrections need to confirm this. Minimum Lump Sums No whipsaw calculations are needed for distributions after August 17, 2006. This applies to lump sum based formulas only. Whipsaw provisions can be eliminated operationally. The formal amendment must be adopted by the end of the 2009 plan year. There is a special 30-day 204(h) notice. What about subsidized annuity conversion rates? There is a concern about whipsaw and there is no guidance yet. PPA is silent but there are rumors that restrictions will apply. It would be nice to have a fixed annuity conversion rate, such as 7% or 8%, subject to a maximum rate. Survivor annuities must meet the most-valuable requirements. There is no guidance on the effective date of the provision for plans that did not comply with Notice 96-8. IRS agents are taking a narrow view that if the plan did not strictly comply with a 96-8 safe harbor, then whipsaw calculations must be done now. Does it matter if the plan has a determination letter on the plan without whipsaw provisions? If a participant received a distribution in the past with no whipsaw, then should the benefit be re-distributed? We need guidance. Notice 2007-6 is relevant. Pension Equity Formulas There are no special rules for pension equity plans in the proposed regulations. The preamble seeks input on a number of questions. One major issue is how to apply market value restrictions. The different treatments for actives and terminations are key issues. The issue is that the account grows with interest during employment because pay is being earned. The discontinuity occurs because there are no more account increases after termination of employment. It is not clear if a PEP variation that defines the lump sum at normal retirement rather than at the current age is a statutory hybrid plan. This variation can be viewed as either the current value with no future interest or as a fully subsidized normal retirement balance. Funding – Sarah Wright A new type of interest rate whipsaw occurs on hybrid plans. In the funding regulation, whipsaw is given back in the funding calculation. The account balance is projected with future interest credits, using reasonable actuarial assumptions and discounted back with the yield curve. The preamble to the regulation states that “thus the present value of a future distribution is not necessarily the current amount of a participant’s hypothetical account balance.” PPA’s goal of marking to market is not being accomplished with cash balance plans. It is possible that a funding target in excess of account balances could occur. There is an example from the regulation as follows: The plan is a cash balance plan that permits an immediate payment of the hypothetical account balance on termination of employment. The hypothetical account balance is credited with interest at the 3rd segment rate. Assumptions for the valuation on January 1, 2008 are as follow: - all participants will retire on the first day of the plan year in which they attain age 65 - 100% of participants will elect a single sum on 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; annuitant mortality table is not applicable because assumed payment is a single sum - Annual interest credit as shown in each scenario - Participant is age 61 on 01/01/2008 and has a hypothetical account balance equal to $150,000 on 01/01/2008
Question 5: In regards to the top 25, do we still have current liability to deal with? Answer: At the moment nothing has eliminated the top 25 restrictions Determination Letter Issues There has been a moratorium on cash balance letters of determination since 1999. A cash balance plan needs to satisfy the 133 1/3% rule because the benefit is earned over a period of time that encompasses more than 10 years of pay. To meet the 133 1/3% rule, the accrual in a later year cannot be greater than 33 1/3% larger than the accrual in an earlier year. In at least recent determination letter reviews, the IRS has been asserting that when two formulas operate together, the net result must be tested instead of each formula on its own. Often a cash balance plan offers a benefit that is the greater of two ongoing formulas, such as is the case with cash balance conversions. Some participants continue to get the prior final average pay formula, if it is better. There is often a “crossover” point at which one formula overtakes the other. In situation, it is usually difficult to pass the back-loading rules if the formulas are tested together under the 133 1/3% rule. When a plan offers a benefit that is the greater of a frozen amount and an ongoing formula, which is the wear-away approach following a plan amendment, the frozen benefit may be disregarded. Graded cash balance plan formulas may need explicit minimum interest credits. The courts have agreed with the IRS position regarding the greater of a frozen and ongoing formula. The courts have said that cash balance conversions are not age discriminatory; variable interest credits under Notice 96-8 do not constitute back-loading The courts have also rejected other back-loading arguments such as claims that variable interest credits cause violations of the 133 1/3% rule. Revenue Ruling 2008-7 was issued in regards to the testing of cash balance formulas. In addition to the 133 1/3% rule, the fractional rule may be used for cash balance plans. Different accrual rules may be used for different groups of participants. The classification of employees into groups should be reasonable. The Revenue Ruling clarifies how to apply the 133 1/3% rule to cash balance plans, in regards to interest crediting rates, compensation and plan amendments. The Revenue Ruling affirms that the IRS previous view that where a plan has multiple ongoing formulas, the formulas must be tested in the aggregate under the 133 1/3% rule. However, the Revenue Ruling provides qualification relief for pre-2009 years allowing multiple “greater of” formulas to be tested separately. This may actually increase vulnerability to ERISA Title I lawsuits. 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 133 1/3% greater than prior accruals. The Revenue Ruling only requires addressing the minimum interest rate issue if the plan’s interest crediting rate actually falls below such threshold. For final determination letter issues, the IRS is forcing whipsaw retroactively on calculation of lump sums prior to effective date (August 17, 2006) in the statute. This is applicable for those plans that otherwise satisfy Notice 96-8 but have small minimum interest crediting rates. This seems to be inconsistent with guidance in Notice 2007-6 that indicated no action would be taken in these situations until guidance on the PPA effective date was issued. The IRS is pushing for plans to define the accrued benefit as the normal retirement annuity determined by projecting the account balance with the interest crediting rate in effect in the current year. This could result in an early retirement whipsaw.
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