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(From the July 5, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
The June 20, 2005 edition of Washington Bulletin included the first part of an in-depth analysis of the proposed update to regulations under Section 415, which establishes maximum benefits and contributions under qualified plans and similar arrangements. Part One covered the regulations regarding defined contribution (DC) plans and certain miscellaneous provisions. This article will examine the proposed rules under Section 415(b), applicable to defined benefit (DB) plans.
I - Background
In order to be a Section 401(a) qualified plan, defined benefit and defined contribution plans must comply with the Section 415 benefit and contribution limits. For a defined benefit plan, the employee's annual benefit may not exceed the lesser of $170,000 (for 2005) or 100 percent of the participant's compensation. The dollar limit is adjusted annually for inflation.
As noted in the previous article, the proposed regulations largely reflect IRS guidance issued in various forms over the past 24 years. The description below includes many of those changes but does not generally call attention to provisions that are being carried over from the current regulations.
Unlike many proposed regulations, these may not be relied on by taxpayers prior to adoption in final form. In many instances, however, the proposal merely restates earlier guidance and presumably can be considered authoritative except where the IRS has indicated an intention to alter its prior rules.
II-- Plans Subject to Section 415(b)
1. Defined Benefit Plans
The proposed regulations, like the current regulations, define a DB plan in the negative; a DB plan is not a DC plan. Prop. Reg. § 1.415(c)-1(a)(2). There is rarely, if ever, any doubt as to whether a plan falls into this category. The proposed regulations resolve one borderline case by stating that Section 403(b) plans that do not provide benefits on an individual account basis are subject to the Section 415(b) limits. Note, however, that the proposed Section 403(b) regulations require most Section 403(b) arrangements (all but a special class of church plans) to operate as DC plans. See 69 FR 66075 (November 16, 2004).
Despite the characterization of certain types of plans as DB plans, in some cases, portions of benefits provided under such plans are not subject to Section 415(b), and may instead be subject to Section 415(c). These situations are discussed in more detail later in this article.
III-- Annual Benefit Testing
1. In General
The Section 415(b) limit applicable to the annual benefit from a DB plan consists of two separate testing prongs-- a dollar limit and a compensation limit. The annual benefit cannot exceed the lesser of these two limits. The dollar limit is $170,000 for limitation year 2005 and is adjusted for inflation in $5,000 increments. Section 415(b)(1)(A). The compensation limit is 100 percent of the employee's average compensation for his "high 3 years" (discussed below).
a. Accrued benefit testing
The proposed regulations include a change, of uncertain impact, to the way Section 415(b) compliance is measured. The statute states that a DB plan is not qualified if it "provides for the payment of benefits" that exceed the Section 415(b) limit. The current regulations track that language, and pertinent qualification regulations assume that benefits may accrue in excess of the Section 415(b) maximum. See Treas. Reg. §§ 1.401(a)(4)-3(d)(2)(ii)(B); 1.415-3(a)(1). As a result, practitioners have (reasonably) assumed that Section 415(b) limits only the amount paid by the plan, not accruals by participants. The proposed regulations take the contrary view, specifically stating that a plan may not provide for "the payment or accrual" of benefits in excess of the maximum permitted by Section 415(b). The preamble does not discuss the rationale for this position, and it is not clear whether its practical implications will be significant.
b. Plan aggregation and predecessor plans
Under Section 415(f), all DB plans maintained by a single employer must be treated as one DB plan. As noted in the previous article, all members of a controlled group or affiliated service group are treated as one employer, and the rules of Section 414(b), (c), (m), and (o) apply in modified form. Additionally, in applying the Section 415(b) limitation, all DB plans of the employer (aggregated) and its predecessor employers are taken into account, including terminated plans.
A defunct employer is a "predecessor" with respect to a current employer that "constitutes all or a portion for the trade or business of the former entity". Prop. Reg. 1.415(f)-1(b). It is unclear how rigorously this principle will be applied to current employers who may have acquired their interest in a current industry (and employees) through an asset sale. In the past, companies have typically paid little attention to the former plans of tangential predecessors.
a. Determining the "High 3"
The proposed regulations alter the determination of a participant's average compensation for his three highest consecutive years in two respects: First, they disregard any period during which he was not an active participant in the plan. As a result, it will no longer be possible for a semiretired business owner to establish a plan with benefits based on his higher compensation earned in the past.
Second, the proposal contains a new procedure for computing three-year average compensation for individuals who have not participated in the plan for three consecutive years. Prop. Reg. § 1.415(b)-1(a)(5)(ii). In that case, compensation is averaged over the longest single period of participation, and other periods are ignored. The length of service is expressed in full and fractional years, except that the denominator may not be less than one. Example: A was hired on July 1, 1998, became a participant on January 1, 1999, terminated employment on March 31, 2001, and was rehired on July 1, 2002. The plan terminated on December 31, 2003. He thus has two periods of participation, the first (1/1/99-3/31/01) 2-1/4 years long and the second (7/1/02- 12/31/03) of 1-1/2 years. Only the first is used to compute average compensation for section 415(b) purposes. Total compensation received during the period is divided by 2.25, and the result is high-three average compensation.
Addressing an area of longstanding uncertainty, the proposed regulations state that the section 401(a)(17) limitation on compensation that a plan may take into account applies to section 415(b). Normally, the 401(a)(17) limit (currently $210,000) is higher than the 415(b) dollar limit, but the latter ratchets upward if benefit commencement is delayed past age 65 and thus will be higher for older participants.
While no properly drafted plan will base benefit accruals on compensation in excess of the 401(a)(17) limit, actuarial adjustments for late commencement may increase the amount due to a participant above that figure. The proposed regulations, if adopted, could therefore lead to significant benefit cutbacks for participants who begin receiving their pensions at later ages.
The imposition of the 401(a)(17) limit on top of the 415(b) limit does not mean that no participant will ever be able to receive an annual payment in excess of the former. Under Section 415(d)(1)(B), the 100 percent of compensation limit is adjusted for cost-of-living increases after separation from service. Prop. Reg. §1.415(d)-1(a)(2). Hence, post-retirement increases, e.g., ad hoc COLA's, may lead to a benefit of more than 100 percent of the compensation cap.
b. Severance pay
As noted in the previous article, the proposed regulations state that Section 415 compensation generally does not include payments made after termination of employment, except for regular compensation, commissions, bonuses, overtime, shift differential and cashouts of accrued leave that could have been used if employment had continued (and such amounts are paid within 2-1/2 months of termination). As a result of these changes, items such as severance pay cannot be included in section 415 compensation and, by implication, cannot be included in the section 414(s) compensation used for testing benefit accruals under section 401(a)(4).
3. Excluded Benefits
Some defined benefit plans include mandatory employee contributions that fund part of a plan benefit. The benefit attributable to those contributions to a plan is not part of the benefit subject to the Section 415(b) limits; rather, the contributions are subject to Section 415(c) limits on "annual additions." Mandatory employee contributions include amounts contributed as a condition of employment, as a condition of plan participation, or as a condition of obtaining employer-contributed benefits. (The term "mandatory" is slightly misleading, since participants may be given the option of forgoing the contributions and receiving lesser benefits.) Only aftertax contributions fall within this category. Employee contributions "picked up" by a governmental employer under §414(h)(2) are employer contributions for tax purposes, and benefits attributable to them are limited by Section 415(b). Prop. Reg. § 1.415(b)-1(b)(2).
A defined benefit plan may also permit employees to make voluntary contributions. Contributions are denoted as voluntary (as distinct from mandatory) if they are allocated to a separate account in the plan, and do not affect the benefit provided under the plan's primary defined benefit formula. Voluntary contributions to a defined benefit plan are, like mandatory contributions, tested under Section 415(c).
Benefits attributable to rollovers are not subject to the Section 415(b) limits, because they were taken into account in applying Section 415 to the plan under which they accrued. On the other hand, benefits attributable to plan-to-plan transfers are always taken into account for Section 415(b) purposes by the transferee plan. If the transfer is from outside the employer's controlled group, they are also taken into account by the transferor (reasonable, because each controlled group has a separate Section 415 limit). To avoid double counting, a plan disregards benefits that it transfers to another plan within the same group.
4. Commencement Age-Based Adjustments
The limitations set forth in the statute apply (with some exceptions noted below) to benefits in the form of a straight life annuity commencing between ages 62 and 65. Benefits that start earlier or later, or that are paid in a different form, must be normalized to the economic equivalent of a straight life annuity. To make the limitation consistent without regard to the form or timing of benefits, Section 415(b) requires that the dollar limit be decreased for benefits commencing earlier than age 62, increased for benefits commencing after a participant turns 65, and suitably adjusted for payments in a form other than an annuity for the participant's life without survivor benefits.
The proposed regulations specify how to adjust for both limits, incorporating a concept that occurs at several points throughout the regulations: A participant's Section 415(b) limit reflects the lesser of the benefit as determined under the plan's assumptions or determined under statutory assumptions. In the case of benefits that commence before a participant turns 62, the dollar limit will be the lesser of (a) the full limit reduced to the same extent that a hypothetical benefit beginning at age 62 would be reduced under the plan's actuarial factors if it instead commenced at the participant's current age; or (b) the full limit reduced in the same manner using statutory assumptions (five percent interest rate and the 94 GAR mortality table prescribed by Revenue Ruling 2001-62). Prop. Reg.§ 1.415(b)-1(d).
The adjustment for post-65 commencement is determined similarly, comparing an annuity beginning at age 65 in an amount equal to the dollar limit to one beginning at the participant's current age, adjusted using the less favorable of plan or statutory assumptions. Because the benefit will be paid over a shorter period, this calculation results in an increase in the dollar limit above the current $170,000.
5. Mortality Adjustment
In general, if a DB plan benefit is forfeitable upon death, the adjustment for early or late commencement must take the risk of mortality into account. If someone who starts receiving his pension before age 62 had waited, he might have died in the interim and suffered a forfeiture. Conversely, one who delayed his annuity starting date until after age 65 has survived the risk of death and forfeiture. In the first case, then, the benefit is more valuable, thanks to the avoidance of the potential forfeiture, a fact that should be reflected by reducing the section 415(b) limit. The second case is the opposite; there the limit should be increased. If there is no forfeiture upon death, as is often the case in cash balance plans, a mortality adjustment is neither required nor permitted. The proposed regulations retain this general rule, but make the mortality adjustment optional if: (a) a qualified preretirement survivor annuity (QPSA) is provided to all participants without charge; and (b) the same treatment is applied to payments beginning before age 62 and after age 65. Prop. Reg. § 1.415(b)-1(d)(2)(ii). The second requirement ensures that an employer cannot ignore a mortality adjustment where it would reduce the limit (for annuities beginning before age 62) and apply it where it would give participants higher benefits (for annuities beginning after age 65).
6. Benefit Form Adjustments
As noted, the nominal section 415(b) limit is based on an annuity payable for the participant's life only, with no survivor benefits. The proposed regulations specify how to convert a benefit payable in a different form into a straight life annuity in order to compare it to the Section 415(b) limit. The new methodology differs slightly from that normally used in the past.
a. Conversion method differences
In general, when benefits are distributed in a form other than a straight life annuity, they must be converted into an actuarially equivalent straight life annuity commencing at the same age (pursuant to IRS rules and guidance on interest rate and mortality assumptions). The conversion methodology depends on whether the distribution form is subject to Section 417(e)(3) (essentially, single sum and installment payment options) and those that are not subject to Section 417(e)(3).
A lump sum or series of installment payments is converted to an equivalent straight life annuity using the same factors that would be used to convert the participant's accrued benefit into a lump sum cashout, that is, the more favorable to the participant of the factors specified in the plan or those required by Section 417(e)(3) (the "GATT interest rate" and 94 GAR mortality table). If the equivalent annuity exceeds the Section 415(b) limit (after adjustment for the participant's age at commencement), the benefit must be cut back until it complies with Section 415.
The conversion of non-417(e)(3) benefit forms into an equivalent straight life annuity follows a simpler procedure. The straight life annuity to which the participant is entitled under the terms of the plan at his current age is compared to the equivalent annuity calculated using the statutory factors (five percent interest and 94 GAR mortality), and the higher figure is then compared to the age-adjusted Section 415(b) limit. In effect, the proposed regulations treat all benefit forms as actuarially equivalent under the terms of the plan, which is a useful simplification even if not strictly accurate.
b. Disregarded Survivor and Ancillary Benefits
Both the current and proposed regulations specify that certain valuable features are ignored in converting a benefit into straight life annuity form for Section 415(b) testing. Treas. Reg. § 1.415-3(c)(2). Excluded are the value of the surviving spouse's annuity when benefits are paid in qualified joint and survivor annuity (QJSA) form and the value of benefits "not directly related to retirement benefits," such as death and disability benefits. Thus, for example, a participant can receive a benefit of $170,000 a year beginning at age 62 in the form of a qualified joint-and-100% survivor annuity, even though that form is worth considerably more than a straight life annuity in the same amount. Similarly, no adjustment is necessary for ancillary life insurance benefits. The proposed regulations do require that the actuarial value of Social Security supplements (temporary benefits payable between retirement and attainment of eligibility for Social Security benefits) be taken into account, because, although they are classified for most purposes as ancillary benefits, they represent a source of retirement income. It does not matter whether the supplement is a "QSUPP" described in Treas. Reg. §1.401(a)(4)- 12. Prop. Reg. § 1.415(b)- 1(c)(4).
7. Adjustment for Prior Distributions
The proposed regulations include rules for properly testing the annual benefit when a participant has more than one "annuity starting date." The most common situation involving multiple annuity starting dates arises when a participant received a cashout of his accrued benefit on separation from service, then returned and accrued further benefits with the same employer. A participant who starts receiving benefits at or after normal retirement but does not separate from service may also have multiple annuity starting dates as a consequence of continued benefit accrual. Any previous distribution from the plan (except distributions repaid following reemployment to reinstate credited service) must be converted into the actuarial equivalent of a straight life annuity. Prop. Reg. § 1.415(b)-2(a). The conversion must be made using either plan or statutory factors, whichever produces the greater amount. The statutory factors are those used for lump sum cashouts if the prior distribution was in the form of a lump sum; otherwise, a five percent interest rate and the 94 GAR mortality table are used. The conversion reflects only the amount paid in the past. The form of payment is considered only for the purpose of determining the applicable statutory actuarial assumptions.
8. $10,000 Safe Harbor
Section 415(b)(4) creates a safe harbor under which a benefit is deemed to satisfy Section 415(b) testing. The safe harbor applies if the total "benefits payable" to a participant under all of an employer's defined benefit plans for a particular limitation year do not exceed $10,000 (and the participant does not participate in any of the employer's defined contribution plans). The proposed regulations provide that the $10,000 limit applies to the actual amount distributed during the year-- not the adjusted value of the benefit as a straight life annuity. For example, a lump sum payment of more than $10,000 will not fall within the safe harbor even if it is based on an accrued benefit of less than $10,000 per year. In addition, benefits attributable to mandatory contributions, which would not normally be tested under Section 415(b), are taken into account. Prop. Reg. § 1.415(b)-1(f).
9. Interaction of Section 415 and Benefit Suspension Rules
If a DB plan does not provide that active employees have the right to begin receiving benefits at the plan's normal retirement age, it must issue "suspension of benefits" notices to participants who reach that age. 29 C.F.R. § 2530.203-3. A failure to issue such a notice is ordinarily a minor problem, because it can be remedied by actuarial adjustment to the benefit. However, if a participant who works past normal retirement age has already accrued the maximum benefit permitted by Section 415(b), adjusting his benefit upward to correct a notice failure may be impossible Hence, it is important that he either have the right to benefit commencement at normal retirement age or be given a timely suspension notice. If neither is done, the plan will have a qualification failure, requiring correction under one of the EPCRS programs.
Under Section 415(b), as amended by EGTRRA, a participant is permitted to accrue a benefit equal to the full dollar limit as of age 62, without reduction, but any increase to this dollar limit does not take place until after the participant has attained age 65. If, as a result of this rule, a participant accrues no benefit after age 62, the proposed regulations indicate that this participant should receive a suspension of benefits notice, or commence receiving a distribution, even if the participant has not yet retired. Prop. Reg. § 1.415(a)-1(f)(6).
IV - Proposed Effective Date
The proposed regulations would apply to limitation years beginning on or after January 1, 2007. Plans may not rely on them pending adoption in final form; however, much of the proposal simply incorporates less formal guidance and presumably reflects the current IRS view of the law. As an exception to the general rule, the provisions dealing with compensation paid after separation from service may be relied on immediately, if desired.
|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 articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Bart Massey 202.220.2104, Elizabeth Drigotas 202.879.4985, Diane McGowan 202.220.2077, Taina Edlund 202.879.4956, Martha Priddy Patterson 202.879.5634, Laura Edwards 202.879.4981, Tom Pevarnik 202.879.5314, Mike Haberman 202.879.4963, Carlisle Toppin 202.220.2067, Stephen LaGarde 202.879-5608, Tom Veal 312.946.2595, Deborah Walker 202.879.4955
Copyright 2005, Deloitte.
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