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Guest Article

(From the December 16, 2002 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

Treasury, IRS Issue Long-Anticipated Proposed Cash Balance Guidance

The proposed regulations, which also address a number of issues relating to the Internal Revenue Code's age discrimination rules for tax-qualified pension plans, have not been well received by participant advocacy groups. The proposals may rekindle the debate over cash balance plans in Congress.

Immediate Effect on Employers

According to a Treasury Department press release, the purpose of the proposed regulations is to "provide long-needed guidance on significant questions about cash balance plans." These questions, which relate primarily to the application of certain age discrimination prohibitions to cash balance plans and cash balance conversions, led IRS to impose a moratorium on determination letters for cash balance conversions in 1999. That moratorium remains in effect still today.

Pending a more thorough analysis of the proposed regulations and their potential impact on cash balance plans and cash balance conversions, there are several preliminary points to consider.

The preamble to the proposed regulations clearly states that the proposed regulations cannot be relied upon until adopted in final form. Even though Treasury expects it will issue final regulations sometime next year, it is far from certain that will happen. Judging by the initial media reaction to the proposals, Treasury is in for a fight with participants' rights groups and certain Members of Congress, among others. The proposed regulations do not signify an end to IRS's moratorium on determination letters for cash balance plans. The Treasury press release indicates that will not happen until the proposals are issued in final form. (See above.) Even if the proposed regulations are issued in final form, the preamble indicates they will apply on a prospective basis only. That means conversions that take place before final regulations are issued technically will not be affected by those rules. Furthermore, there is no guarantee the courts will accept IRS's interpretation of these rules, even with respect to conversions occurring after final regulations are issued.

Background

In general, IRC section 411(b)(1)(H) prohibits age-based reductions in the benefit accrual rates (including cessation of accruals) for defined benefit plan participants. Likewise, IRC section 411(b)(2) prohibits age-based reductions in allocation rates (including cessation of allocations) for defined contribution plan participants. These rules are part of the IRC's tax-qualification requirements, and there are parallel requirements in ERISA and the Age Discrimination in Employment Act (ADEA).

The IRS initially issued proposed regulations relating to sections 411(b)(1)(H) and 411(b)(2) in 1988 (the 1988 proposed regulations). However, the 1988 proposed regulations-- which have not been issued in final form-- did not address several significant issues, including determining the rate of benefit accrual in defined benefit plans and applying section 411(b)(1)(H) to cash balance plans and to cash balance conversions.

Summary of the 2002 proposed regulations

The following summary focuses primarily on the cash balance-related issues addressed by the 2002 proposed regulations. However, the 2002 proposed regulations also address a number of other issues relating to sections 411(b)(1)(H) and 411(b)(2), some of which were also addressed by the 1988 proposed regulations. This summary discusses some, but by no means all, of those issues.

Complete copies of the 2002 proposed regulations can be downloaded from the IRS's Web site, at www.irs.gov/ep. The proposed regulations also are available from the December 11 edition of the Federal Register.

Determining the Benefit Accrual Rate for Cash Balance Plans

A critical issue that the 1988 proposed regulations did not address is how to determine the rate of benefit accrual under defined benefit plans for purposes of section 411(b)(1)(H). The conventional approach-- i.e., measuring the change in the participant's accrued normal retirement benefit for the year-- creates potential problems under section 411(b)(1)(H) for cash balance plans because interest credits for younger participants compound over a greater number of years until normal retirement age than for older participants. This has led some to argue that the cash balance design is inherently age discriminatory.

The 2002 proposed regulations address this issue by providing the rate of benefit accrual under an "eligible cash balance plan" is permitted to be determined as the additions to the participant's hypothetical account for the plan year, except that previously accrued interest credits are not included in the rate of benefit accrual. In order to be an "eligible cash balance plan," a defined benefit plan must satisfy each of the following requirements:

• For accruals in the current plan year, the normal form of benefit is stated as an immediate payment of the balance in a hypothetical account. (Note, this DOES NOT mean the plan has to offer a single-sum distribution option.)

• The plan provides that, at the same time the participant accrues an addition to the hypothetical account, the participant accrues the right to future interest credits (without regard to future service) at a reasonable rate of interest that does not decrease because of the attainment of any age. These interest credits must be provided for all future periods, including after normal retirement age. An eligible cash balance plan cannot treat interest credits after normal retirement age as actuarial increases that are offset against the otherwise required accrual.

The 2002 proposed regulations also include a special rule for applying section 411(b)(1)(H) to defined benefit plans with both a traditional defined benefit formula and a cash balance formula. In general, plans with a mixed formula can test the cash balance and traditional formulas separately if--

• the cash balance formula would satisfy the requirements for an "eligible cash balance plan" if it were the plan's only formula;

• each such separately treated plan would satisfy the maximum age conditions of IRC section 410(a)(2) [section 410(a)(2) provides, "A trust shall not constitute a qualified trust under section 401(a) if the plan of which it is a part excludes from participation (on the basis of age) employees who have attained a specific age."]; and

• the eligible cash balance and traditional defined benefit formulas interact in one of the following three specific ways for current and future accruals:
  1. the plan provides that the participant's benefit is based on the sum of accruals under two different formulas (either sequentially where the cash balance formula goes into effect during the year or simultaneously where the plan provides for a participant to accrue benefits under both a traditional defined benefit formula and a cash balance formula at the same time with the participant to be entitled to the sum of the two);

  2. the plan provides a benefit for a participant equal to the greater of the benefit determined under two or more formulas, one of which is an eligible cash balance formula and the other of which is not; or

  3. under the plan, some participants are eligible for accruals only under an eligible cash balance formula and the remaining participants are eligible for accruals only under a traditional defined benefit formula or the other two specific methods.

See Prop. Treas. Reg. Sec. 1.411(b)-2(b)(2)(v), Example 6, for an explanation of how a mixed formula might violate IRC section 410(a)(2).

Cash Balance Conversions

In addition to the argument that cash balance formulas are inherently age discriminatory, some contend that cash balance conversions may violate section 411(b)(1)(H) if they cause certain participants to experience a "wear-away" period. According to this argument, the wear-away period inherently produces a lower rate of accrual for older participants. The counter to this argument is that wear-away periods are not a function of a participant's age, but instead are a function of age-neutral factors such as prior accrued benefit and interest crediting rates, et al.

The 2002 proposed regulations take the position that, "the mere conversion of a traditional defined benefit plan to a cash balance plan would not cause the plan to fail section 411(b)(1)(H)." However, the conversion must be accomplished in either of two ways, and the converted plan must qualify as an "eligible cash balance plan." Specifically, the converted plan must either--

• determine each participant's benefit as not less than the sum of the participant's benefits accrued under the traditional defined benefit plan and the cash balance account (in which case there will be no wear-away period); or

• establish each participant's opening account balance as an amount not less than the actuarial present value of the participant's prior accrued benefit, using reasonable actuarial assumptions.

For purposes of the second alternative, an interest rate assumption is not "reasonable" if it increases, directly or indirectly, because of the participant's attainment of any age. If this formula produces an opening account balance greater than a participant's accrued benefit under the prior formula, the difference is included as part of the participant's rate of benefit accrual for the plan year and is tested along with other pay credits for the year.

Nondiscrimination Testing for Cash Balance Plans

The 2002 proposed regulations also include a proposed amendment to the IRC section 401(a)(4) cross-testing rules for defined contribution plans. The purpose of the amendment is to specify when eligible cash balance plans would be able to use crosstesting for purposes of IRC section 401(a)(4).

In general, section 401(a)(4) prohibits tax-qualified plans from discriminating in favor of highly compensated employees in terms of contributions or benefits. Because certain defined contribution plans tend to favor more highly paid workers by design, current Treasury regulations allow them to be tested for compliance with section 401(a)(4) on the basis of benefits provided, as opposed to contributions. However, this so-called "crosstesting" is available only to plans that satisfy certain specific requirements.

According to the preamble to the 2002 proposed regulations, an eligible cash balance plan generally will have to satisfy a minimum allocation gateway in order to cross-test for purposes of section 401(a)(4). This minimum allocation gateway generally will require "that the hypothetical allocation rate for each nonhighly compensated employee be at least one-third of the hypothetical allocation rate for the highly compensated employee with the highest hypothetical allocation rate." As an alternative, eligible cash balance plans can satisfy the gateway if the hypothetical allocation rate for each nonhighly compensated employee is 5 percent or more, provided the highest hypothetical allocation rate for any highly compensated employee is not more than 25 percent. (If the highest hypothetical allocation rate is above 25 percent, the 5 percent factor is increased, up to as much as 7.5 percent.)

Other Issues

As noted, the 2002 proposed regulations address a number of other issues relating to sections 411(b)(1)(H) and 411(b)(2). These include:

• Age Discrimination Requirements Apply Even Before Participant Attains Normal Retirement Age. According to the preamble, some have argued that IRC sections 411(b)(1)(H) and 411(b)(2) apply only to cessations or reductions that occur after a participant attains normal retirement age. The 2002 proposed regulations (like the 1998 proposed regulations) take the position that "attainment of any age means ... growing older." As a result, the prohibitions "apply regardless of whether a participant is younger than, at, or older than normal retirement age."

• Prohibition Applies to Direct and Indirect Age-Based Reductions. The 2002 proposed regulations make clear that the section 411(b)(1)(H) and 411(b)(2) prohibitions apply to both direct and indirect age-based reductions in benefit accrual and allocation rates, respectively. In general, a reduction is directly because of the attainment of any age if, under the terms of a plan, any participant's benefit accrual or allocation rate would be higher if the participant were younger. A reduction is indirectly because of the attainment of any age if the characteristic giving rise to the reduction is a proxy for age, based on all the facts and circumstances. (An example of this would be assigning older and younger workers that perform the same work to different divisions.)

  Note that "any participant" refers to anyone who is or could be a participant under the plan. As such, a plan could violate these prohibitions even if no specific participant experiences a direct or indirect age-based reduction. The key inquiry is whether, under the terms of the plan, someone could experience a prohibited age-based reduction. According to the preamble, a mere correlation between attainment of any age and a reduction in benefit accrual or allocation rates is not enough to establish a violation of these prohibitions. Furthermore, defined benefit plans can cap the years of service or participation to be taken into account for purposes of benefit accruals without violating section 411(b)(1)(H) if the cap is applied on a uniform and consistent basis without regard to age. (A cap expressed as a percentage of compensation also is permissible.) Likewise, defined contribution plans can limit the total amount of employer contributions and forfeitures that can be allocated to participants' accounts or limit the years of credited service that can be taken into account for purposes of determining allocations for a plan year.

  The 2002 proposed regulations include a number of examples to illustrate the application of these principles with respect to defined benefit plans. See Prop. Treas. Reg. Sec. 1.411(b)-2(b)(3)(iii).

• Optional Forms of Benefits and Other Rights and Features. Under the 2002 proposed regulations, a plan would violate section 411(b)(1)(H) or 411(b)(2) if optional forms of benefits, ancillary benefits, or other rights or features otherwise provided to a participant under the plan are not provided, or are provided on a less favorable basis, with respect to benefits or allocations attributable to credited service because of the participant's attainment of any age. However, a defined plan would not fail to satisfy section 411(b)(1)(H) merely due to an age-based variance with respect to the subsidized portion of an early retirement benefit, a qualified disability benefit, or a social security supplement.

• Coordination with Other Tax-Qualification Provisions. In general, the proposed regulations provide a plan would not fail to satisfy section 411(b)(1)(H) or 411(b)(2) because of limits on accruals or allocations necessary to comply with section 415 limits or section 401(a)(4) nondiscrimination rules.

The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2002, Deloitte.

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