Guest Article

(From the April 29, 2002 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks contained within the article have been added by BenefitsLink.)

Treasury Issues Proposed Regulations for Enhanced 204(h) Notice Requirements

The Treasury Department on April 22 released long anticipated proposed regulations relating to enhanced notice requirements for cash balance conversions and other defined benefit plan amendments that may result in a significant reduction in future benefit accrual rates for certain participants. The enhanced notice requirements were enacted last year as part of the Economic Growth and Tax Relief Reconciliation Act ("EGTRRA") and are codified at ERISA section 204(h) and new IRC section 4980F.

A public hearing on the proposed regulations, which were published in the April 23 edition of the Federal Register (67 FR 19713), is scheduled for August 15; the deadline for submitting comments to IRS is July 22.

Impact on Plan Sponsors

The impetus for the enhanced notice requirements was the recent controversy over cash balance conversions. However, it is important to note that the new rules, which apply to plan amendments taking effect on or after June 7, 2001, are not limited to cash balance conversions, and may apply in a wide variety of circumstances. Thus, sponsors of defined benefit plans and sponsors of individual account plans required to be funded under IRC section 412 who are in the process of making significant changes to their plans, or who are contemplating such changes in the near future, should pay close attention to the proposed regulations.

This is particularly true since employers and plan administrators are required to make a good faith effort to comply with the enhanced notice requirements until final regulations are issued. Plan sponsors who follow the proposed regulations should satisfy this "good faith" requirement.

Summary of Enhanced Notice Requirements

In general, before a tax-qualified defined benefit plan or money purchase pension plan (collectively referred to as "applicable pension plans") is amended to provide for a significant reduction in the rate of future benefit accrual, the plan administrator must provide a written notice [the so-called "204(h) notice"] to "applicable individuals"-- i.e., participants and alternate payees whose future benefit accrual rates "may reasonably be expected to be significantly reduced" by the amendment-- and to any employee organizations representing them. Governmental plans and church plans generally are not subject to this notice requirement.

The statute offers little guidance as to when an amendment causes a "significant reduction in the rate of future benefit accrual" [aka, a "204(h) amendment"]. However, if the amendment eliminates or significantly reduces an early retirement benefit or retirement-type subsidy, the plan administrator specifically is required to provide the 204(h) notice.

Congress specifically delegated to the Treasury Department the authority to prescribe the form and content requirements for the 204(h) notice. Beyond the general directives that the notice be written "in a manner calculated to be understood by the average plan participant" and that it provide "sufficient information ... to allow applicable individuals to understand the effect of the plan amendment," the Code and ERISA are silent on these issues. In addition, Treasury is specifically authorized to provide a simplified form of notice, or an exemption from the 204(h) notice requirement, for plans that offer participants a choice between the old and new benefit formulas or for plans with fewer than 100 participants with accrued benefits.

When notice is required, it must be provided "within a reasonable time" before the amendment's effective date. If the notice is provided before the amendment is adopted, the notice requirement will be satisfied only if there are no subsequent material modifications to the amendment.

If notice is required, but not provided, the employer (or, in the case of a multiemployer plan, the plan) may be liable for a $100 per person per day excise tax until notice is provided. Furthermore, in the case of "egregious" failures to satisfy the notice requirements, applicable individuals will be entitled to continue to accrue benefits under the pre-amendment plan unless they are better off under the new regime. An "egregious" failure, according to ERISA sec. 204(h), is one that is within the plan sponsor's control and is intentional or involves not providing most applicable individuals with most of the information they are entitled to receive. Intentional failures include those in which the plan administrator discovers an unintentional failure, but fails to promptly correct it.

Determining if a 204(h) Notice Is Required

As noted above, a 204(h) notice is required only when an applicable plan is amended, and the amendment provides for a significant reduction in the rate of future benefit accrual or significantly reduces (or eliminates) an early retirement benefit or retirement-type subsidy [i.e., the amendment is a 204(h) amendment]. Not surprisingly, the proposed regulations identify amendments that cease benefit accruals as amendments that provide for a "significant reduction" in future benefit accrual rates. Q/A-5(a) and -17(a).

Plan Provisions That Affect the Future Benefit Accrual Rate

In order to determine if a plan amendment is a 204(h) amendment, the amendment's impact on all plan provisions that affect the future benefit accrual rate, early retirement benefits, or retirement-type subsidies must be considered. Examples of plan provisions that may affect the future benefit accrual rate, according to the proposed regulations, include the following:

Thus, if a plan amendment affects any of these types of provisions, it should be scrutinized as a possible 204(h) amendment. Keep in mind, though, that this is only a starting point; the key inquiry is whether and how the amendment is expected to affect the rate of future benefit accruals under the plan.

What about amendments that lengthen vesting schedules, or eliminate participants' rights to make after tax contributions or elective deferrals? According to the proposed regulations, changes to any benefit that is not a IRC section 411(d)(6) protected benefit, or that is a 411(d)(6) protected benefit but nonetheless may be eliminated or reduced in certain circumstances described in Treasury regulations [Treas. Reg. Sec. 1.411(d)-4, Q/A-2(a) or (b)], are not taken into account for determining whether an amendment is a section 204(h) amendment. In addition to vesting schedules and rights to make elective deferrals and after tax contributions, examples of benefits that are not 411(d)(6) protected benefits include:

• ancillary life insurance protection;

• accident or health insurance benefits;

• certain social security supplements;

• the right to direct investments;

• the right to a particular form of investment (e.g., investment in employer stock or securities); and

• administrative procedures for distributing benefits.

[See Treas. Reg. Sec. 1.411(d)-4, Q/A-1(d) for a more complete list.]

Determining the Impact on the Future Benefit Accrual Rate

According to the proposed regulations, in the case of a defined benefit plan (other than a money purchase pension plan), an amendment reduces the future benefit accrual rate "if it is reasonably expected to reduce the amount of the future annual benefit commencing at normal retirement age for benefits accruing for a year." Q/A-6(b)(1).

In order to analyze the impact of an amendment on a defined benefit plan's future benefit accrual rates, the proposed regulations clarify that plans generally should refer only to the benefit form the defined benefit plan normally uses to express accrued benefits-- a single life annuity commencing at normal retirement age, for example. However, if the plan is a cash balance plan (or any other defined benefit plan that does not express accrued benefits in the form of an annual benefit commencing at normal retirement age), the plan must convert each participant's accrued benefit into an actuarially equivalent single life annuity commencing at normal retirement age. Q/A-6(b)(1).

Note that plans may not use any other optional forms of benefit available under the plan (if any) for purposes of determining the rate of future benefit accrual. In addition, ancillary benefits (i.e., certain social security supplements, disability benefits, shut-down benefits, etc.) and other rights or features (i.e., plan loans, right to direct investments, the right to make after-tax employee contributions, etc.) may not be taken into account for this purpose.

Finally, the amendment's expected impact on the rate of future benefit accruals is determined by comparing projections of the amount of the annual benefit commencing at normal retirement age under the pre- and post-amendment plans. Q/A-8(b). Whether the expected reduction (if any) is "significant" is to be determined "based on reasonable expectations taking into account the relevant facts and circumstances at the time the amendment is adopted." Q/A-8(a).

Rules Relating to Money Purchase Pension Plans

For money purchase pension plans, the proposed regulations specify that an amendment reduces the rate of future benefit accrual "only if it is reasonably expected to reduce the amounts allocated in the future to participants' accounts for a year." Q/A-6(b)(2). However, this does not include changes to the plan's investments or investment options. Q/A-6(b)(3). The amendment's expected impact on the rate of future benefit accruals is determined by comparing projections of amounts to be allocated in the future to participants' accounts under the pre- and post-amendment plans. Q/A-8(b).

Early Retirement Benefits and Retirement-Type Subsidies

According to the proposed regulations, "an amendment reduces an early retirement benefit or retirement-type subsidy only if it is reasonably expected to eliminate or reduce an early retirement benefit or retirement-type subsidy." Q/A-6(c).

The proposed regulations' examples of plan provisions that may affect early retirement benefits or retirement-type subsidies include:

• the right to receive payment of benefits after severance from employment and before normal retirement age; and

• actuarial factors used in determining optional forms for distribution of retirement benefits.

Q/A-7(a).

But, the proposed regulations specify that a 204(h) notice is not required for an amendment that reduces or eliminates benefits or subsidies that create significant burdens for a plan and its participants, as permitted under EGTRRA. Q/A-8(c). The EGTRRA added language to IRC section 411(d)(6)(B) directing the Treasury Department to issue regulations permitting the elimination of such protected benefits as long as no participant's rights are adversely affected in more than a de minimis manner.

If a 204(h) Notice Is Required, When Must it Be Provided, and to Whom?

According to the proposed regulations, the general rule is that a 204(h) notice must be provided at least 45 days before the amendment's effective date. Q/A-9(a). If the plan administrator reasonably expects the plan to have fewer than 100 participants who have accrued a benefit under the plan when the amendment takes effect, then the 204(h) notice can be provided as few as 15 days before the effective date. Q/A-9(b).

The proposed regulations include special timing rules for amendments adopted in connection with certain business transactions. If the 204(h) amendment is adopted in connection with an acquisition or disposition, the notice must be given at least 15 days before the amendment's effective date. Q/A-9(c)(1). Furthermore, the notice may be provided as many as 30 days after the 204(h) amendment's effective date if the amendment--

1. is adopted with respect to liabilities transferred to another plan in connection with a transfer, merger, or consolidation of assets or liabilities as described in IRC section 414(l);

2. is adopted in connection with an acquisition or disposition; and

3. significantly reduces an early retirement benefit or retirement-type subsidy, but does not significantly reduce the rate of future benefit accrual.

Q/A-9(c)(2).

As noted previously, a 204(h) notice (when required) must be provided to each applicable individual and to each employee organization that represents applicable individuals. An applicable individual is defined as any participant or alternate payee (pursuant to a QDRO) whose future benefit accrual rate, or for whom an early retirement benefit or retirement-type subsidy under the plan, is reasonably expected to be significantly reduced by the amendment. Q/A-10(b). The plan administrator must determine, based on all the facts and circumstances at the time the 204(h) notice must be provided, if a participant or alternate payee is an "applicable individual." Q/A-10(e). The proposed regulations [Q/A-10(f)] provide a series of examples plan administrators can use to help make this determination.

If a 204(h) Notice Is Required, What Information Must it Contain?

The general rule in the proposed regulations is that a 204(h) notice must be written so that it can be understood by the average plan participant and include sufficient information to allow applicable individuals to understand the effect of the plan amendment and the approximate magnitude of the expected reduction. If an expected reduction will not apply to all participants, or if the magnitude of the reduction will vary for different participants, the notice must either identify the classes of participants who are expected to be affected by the reduction or provide sufficient information to allow recipients to determine which reductions are expected to apply to them. Q/A-11(a).

A notice that does not include the proper information, or that is materially false or misleading in any way, will not be treated as a 204(h) notice. Q/A-11(a)(4).

Specifically, if the 204(h) notice requirement is triggered by an amendment that reduces future benefit accrual rates, the proposed regulations require that the notice include a narrative description of the pre- and post-amendment benefit or allocation formula, and the amendment's effective date. Q/A-11(a)(2)(i). If triggered by an amendment that reduces an early retirement benefit or retirement-type subsidy, the required narrative must describe how the early retirement benefit or retirement-type subsidy is calculated from the accrued benefit after the amendment, and the amendment's effective date. Q/A-11(a)(2)(ii). This latter requirement is illustrated by the following example from the proposed regulations.

If, for a plan with a normal retirement age of 65, the change is from an unreduced normal retirement benefit at age 55 to an unreduced normal retirement benefit at age 60 for benefits accrued in the future, with an actuarial reduction to apply for benefits accrued in the future to the extent that the early retirement benefit begins before age 60, the notice must state that and specify the factors that apply in calculating the actuarial reduction (e.g., a 5 percent per year reduction applies for early retirement before age 60).

If the narrative does not make the approximate magnitude of the reduction reasonably apparent, then additional information is required. In some cases, it may be enough to expand the narrative to further explain the difference between the old and new benefit formulas or benefit calculation. Q/A-11(a)(3)(ii). However, if the change involves a cash balance conversion, a wear-away period, or other circumstances where the magnitude of the reduction is not apparent from narrative descriptions, the proposed regulations assert the 204(h) notice must also include illustrative examples. Q/A-11(a)(3)(iii)(A).

If illustrative examples are necessary, then they must show the approximate range of the reductions. Q/A-11(a)(3)(iii)(B). Thus, in many cases multiple examples will be needed because reductions will vary for different demographic groups within the population of applicable individuals. However, examples of reductions that are expected to occur in only a very few cases generally are not necessary. In addition, if the maximum reduction occurs in identifiable circumstances and proportionately smaller reductions occur in other situations, then one example of the maximum reduction accompanied by a statement that smaller reductions also occur should be sufficient.

Illustrative examples, if required, do not have to be based on a particular form of payment. Furthermore, any reasonable assumptions regarding the representative participant's age, service, compensation, as well as interest, mortality, and salary increases, etc., can be used, but the assumptions used must be identified in the 204(h) notice. Q/A-11(a)(3)(iii)(C).

In some cases, amendments will affect classes of participants differently (the example in the proposed regulations is different benefit formulas for separate divisions). In such situations, the proposed regulations state the 204(h) notice content requirements must be satisfied for each general class of participants. This may be accomplished with a single notice, or by providing separate 204(h) notices to each of the differently affected classes of participants. Q/A-11(b)(1) and (2).

The proposed regulations include a series of useful examples [Q/A-11(c)] to clarify these requirements.

Do Special Rules Apply if Participants Can Choose Between Old and New Benefit Formulas?

Yes. According to the proposed regulations, applicable individuals with a choice between the old and new formulas must be given a 204(h) notice and also must be given sufficient information to enable them to make an informed choice. The 204(h) notice must be provided in a timely fashion (in general, 45 days before the amendment's effective date), but the additional information must be provided within a period that is reasonably contemporaneous with the deadline for making the choice so that there is time to understand and consider the information. Q/A-12. The proposed regulations do not say whether the 204(h) notice and the additional information can be provided simultaneously in the same document, but presumably everything can be combined as long as the timing requirements for both notices are satisfied.

What Are the Rules for Providing a 204(h) Notice?

The proposed regulations state plan administrators must either use a method that results in actual receipt of the 204(h) notice (for example, hand delivery to the intended recipient) or take "appropriate and necessary measures reasonably calculated to ensure that the method for providing section 204(h) notice results in actual receipt of the notice." Thus, sending the 204(h) notice via first class mail to the intended recipient's last known address is acceptable. Simply posting the 204(h) notice on a company bulletin board is not good enough. Q/A-13(a).

If certain requirements are satisfied, 204(h) notices also may be provided through electronic media. Q/A-13(c).

What if a 204(h) Notice Is Required, But Is Not Provided?

As discussed previously, if a 204(h) notice is required but not provided-- or not provided in time-- the employer may be subject to a $100 per person per day excise tax. (In the case of a multiemployer plan, the excise tax is assessed against the plan.) Plus, if the failure is "egregious," applicable individuals must be allowed to accrue benefits under either the pre- or post-amendment plan, whichever is better.

The proposed regulations clarify certain issues relating to these penalties. For example, the IRS Commissioner can waive the excise tax in any case where the employer exercised "reasonable diligence" but did not know of the failure. IRC sec. 4980F(c)(1). According to the proposed regulations, this waiver will be available only if--

1. the employer exercised reasonable diligence in attempting to deliver the 204(h) notice to applicable individuals within the required time frames; and

2. at the latest date permitted for delivery of the 204(h) notice, the employer reasonably believes that the 204(h) notice was actually delivered to each applicable individual by that date.

Q/A-15(b).

With respect to "egregious" failures to provide a 204(h) notice, the proposed regulations acknowledge potential problems that may result from the fact that plan administrators often will be required to make judgment calls about whether particular participants are "applicable individuals." Specifically, the proposed regulations state a failure to give a 204(h) notice is deemed not to be egregious if the plan administrator reasonably determines, based on the statute, the regulations, and other applicable guidance, that the reduction in the future benefit accrual rate is not significant or that an amendment does not significantly reduce an early retirement benefit or retirement-type subsidy. Q/A-14(a)(2).

However, the proposed regulations also point out that any failure to provide a 204(h) notice, whether egregious or not, may be subject to challenge under ERISA's civil enforcement scheme (ERISA sec. 502). Q/A-14(b). In addition, the excise tax also may apply in the case of non-egregious failures. Q/A-14(c).

Sale of Business and Title IV Terminations

There are several special rules relating to applying these rules in the context of the sale of a business and Title IV plan terminations. In the case of a plan terminated under ERISA Title IV, the proposed regulations specify that the 204(h) notice requirements will in no event mandate additional benefit accruals after the effective date of the termination. Q/A-17(b). However, in the case of a 204(h) amendment that is effective before the termination, then the 204(h) notice must be provided. (In this situation, the 204(h) notice may be provided with the notice of intent to terminate.) Q/A-17(c).

In the case of a sale of a business, a 204(h) notice will not be required unless a plan amendment is adopted that significantly reduces the future benefit accrual rate or significantly reduces an early retirement benefit or retirement-type subsidy. Q/A-16(a). This principle is illustrated by the following example from the proposed regulations.

Example 1. (i) Facts. Corporation Q maintains Plan A, a defined benefit plan that covers all employees of Corporation Q, including employees in its Division M. Plan A provides that participating employees cease to accrue benefits when they cease to be employees of Corporation Q. On January 1, 2006, Corporation Q sells all of the assets of Division M to Corporation R. Corporation R maintains Plan B, which covers all of the employees of Corporation R. Under the sale agreement, employees of Division M become employees of Corporation R on the date of the sale (and cease to be employees of Corporation Q), Corporation Q continues to maintain Plan A following the sale, and the employees of Division M become participants in Plan B.

(ii) Conclusion. No section 204(h) notice is required because no plan amendment was adopted that reduced the rate of future benefit accrual. The employees of Division M who become employees of Corporation R ceased to accrue benefits under Plan A because their employment with Corporation Q terminated.

Q/A-16(b).

Note that the result would be the same even if Plan B is less generous than Plan A because the reduction was not caused by a plan amendment.

Conclusion

The proposed regulations on their face seem to be less burdensome than originally envisioned. For example, the 45 day notice period is an even split between the 60 day pre-notification being pushed by some in IRS and the 30 day period employers were hoping for. However, the proposals do have several nuances, and applying them may be tricky. Any plan sponsor considering plan amendments should carefully consult the proposed regulations.

If you have questions or need additional information, please contact your Deloitte advisor.

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 questions or need additional information about this article, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Copyright 2002, Deloitte.