Guest Article

(From the June 23, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Proposed Regulations on Applying Accrual Rules to "Greater Of" Formulas

Making good on its earlier promise, the IRS on June 17, 2008 released proposed regulations on applying the IRC § 411(b) accrual requirements (aka, the "anti-backloading rules") to defined benefit plans that pay benefits based on the "greater of" two or more separate benefit formulas. 73 FR 34665 (June 18, 2008). The IRS earlier this year issued Revenue Ruling 2008-7, 2008-7 IRB 419, to clarify its position that the formulas must be aggregated in these circumstances when testing for compliance with IRC § 411(b), and to provide relief from the violations that otherwise may result to certain plans for years beginning before January 1, 2009. At that time, IRS also promised additional guidance on this issue for 2009 and later plan years was forthcoming. The proposed regulations would establish a special rule permitting separate testing of each formula.

Anti-Backloading Rules and "Greater of" Formulas

Basically, the question is how to apply the IRC § 411(b) accrual requirements to plans that provide benefits to employees based on the "greater of" two or more benefit formulas. The analysis begins with Treas. Reg. § 1.411(b)-1(a)(1), which provides:

The "alternative methods" are the 3 percent method, the 1331/3 percent method, and the fractional method. These methods are used to determine if a defined benefit plan satisfies the IRC § 411(b) benefit accrual requirements, which are designed to prevent plans from concentrating -- or "backloading" -- benefit accruals at the end of participants' careers. The benefit accrual rules are intended to preclude plan designs that circumvent the minimum vesting requirements.

When converting traditional defined benefit formulas to cash balance formulas, for example, some employers have used certain techniques to minimize or prevent any adverse effect on existing employees. One technique guarantees a class of workers will receive a benefit equal to the "greater of" the cash balance formula or a traditional defined benefit formula for a specified period of time. Clearly, this technique is intended to protect employees.

However, the IRS takes the position the pre- and post-conversion formulas must be aggregated for IRC § 411(b) testing purposes when this "greater of" approach is used. The agency cites the italicized language from Treas. Reg. § 1.411(b)-1(a) as the basis for applying this "aggregation rule" in this circumstance. Unfortunately, the aggregation rule results in a potential IRC § 411(b) violation for many of these plans.

Fortunately, the IRS issued Revenue Ruling 2008-7 earlier this year to provide relief to certain plans using the "greater of" approach for plan years beginning before January 1, 2009 only. The proposed regulations the IRS issued on June 17 would provide a special exception to the aggregation rule these plans could use to satisfy the IRC § 411(b) accrual rules in 2009 and later plan years.

Summary of Proposed Regulations

Under the proposed regulations, a special exception to the aggregation rule would be available for applying the benefit accrual requirements to plans determining participants' accrued benefits as the "greater of" two or more formulas. Basically, "eligible" plans would be permitted to test each formula separately for compliance with the 133? percent rule. If each formula satisfied the 133? percent rule on a standalone basis, the plan would satisfy the IRC § 411(b) and ERISA § 204(b) benefit accrual requirements. Note that the special exception requires the separate formulas to be tested using the 133? percent method; the proposed regulations would not permit testing of any of the formulas under the three percent or fractional methods.

A plan would be eligible to take advantage of this special separate testing exception only if each of the separate formulas uses a different basis for determining benefits. Thus, a plan offering participants the "greater of" their accrued benefits under a traditional final average pay formula or a cash balance formula would be eligible for the separate testing exception. But the exception would not be limited just to situations in which cash balance or other hybrid formulas are involved. It also would be available, for example, if the "greater of" options are a final average pay formula and a career average compensation formula.

In the case of a plan that offers benefits based on the greatest of three or more formulas, a modified version of the special separate testing exception would be available. The modified version would require all the formulas with the same basis (e.g., final average pay, career average compensation, cash balance, etc.) to be aggregated and treated as a single formula for testing purposes.

Pursuant to a proposed anti-abuse rule, the special separate testing exception would not be available to any plan the IRS determines is structured to use separate formulas with different bases simply to evade the general aggregation requirement. This anti-abuse rule might be invoked if, for example, there are only minor differences between the bases of the separate formulas.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2008, Deloitte.