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Guest Article

Deloitte logo

(From the August 22, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Final Anti-Cutback Regulations


The Treasury Department and Internal Revenue Service (IRS) on August 12, 2005 issued final (70 FR 47109) and proposed (70 FR 47155) regulations relating to the IRC § 411(d)(6) anti-cutback rule. The final regulations provide guidance on the limited circumstances in which defined benefit plan sponsors can amend their plans to eliminate early retirement benefits, retirement-type subsidies, and optional forms of benefit from defined benefit plans. 69 FR 13769 (March 24, 2004). The proposed regulations would enhance the final regulations by permitting plan sponsors to eliminate certain optional forms of benefit that have not been used for two or more years. Additionally, the proposed regulations would clarify the interaction between the anti-cutback rule and the IRC § 411(a) vesting rules.

The final regulations are effective immediately, and generally apply to amendments adopted and effective after August 12, 2005. Exceptions to this general effective date are detailed below.

The following summary of the final and proposed regulations is general in nature, and is intended only to highlight key provisions. Future Washington Bulletins will address more specific issues that may arise upon closer examination of the regulations.

Background

In general, IRC § 411(d)(6)(A) prohibits plan amendments that have the effect of reducing participants' accrued benefits. This so-called "anti-cutback rule" prohibits, for example, retroactive changes to a defined benefit plan's benefit accrual formula if the change would cause any participant's accrued benefit to be reduced. The anti-cutback rule does not prevent plan sponsors from changing their plans to reduce future benefit accruals.

Additionally, IRC § 411(d)(6)(B) specifies plan amendments that eliminate or reduce an early retirement benefit or retirement-type subsidy, or eliminate optional forms of benefit, with respect to benefits attributable to service before the amendment, are treated as reducing accrued benefits. However, the IRC directs Treasury to issue regulations permitting plan sponsors to amend their plans to reduce or eliminate early retirement benefits and retirement-type subsidies that create significant burdens or complexities for the plan and its participants, so long as the amendment does not adversely affect the rights of any participant in a more than de minimis manner. The IRC also gives Treasury authority to issue regulations permitting plan sponsors to eliminate optional forms of benefit.

(IRC § 411(d)(6)(E) generally permits defined contribution plan sponsors to eliminate forms of distribution as long as a single-sum payment is available. The Treasury and IRS issued final regulations pursuant to this provision earlier this year.)

The final regulations update existing regulations under IRC § 411(d)(6); clarify several issues raised in litigation involving the anti-cutback rule; define the terms "early retirement benefit" and "retirement-type subsidy"; and provide exceptions for eliminating optional forms of benefit, and reducing or eliminating early retirement benefits and retirement-type subsidies, with respect to previously accrued benefits. They also provide guidance on complying with ERISA § 204(h) notice requirements in certain circumstances. Except for some minor modifications, the final regulations are similar to the proposed regulations Treasury and IRS issued in 2004.

Definitions

Under the final regulations, an early retirement benefit is defined as "the right, under the terms of a plan, to commence distribution of a retirement-type benefit at a particular date after severance from employment with the employer and before normal retirement age." As the definition implies, early retirement benefits with different terms relating to timing are treated as different early retirement benefits.

A retirement-type subsidy is defined as "the excess, if any, of the actuarial present value of a retirement-type benefit over the actuarial present value of the accrued benefit commencing at normal retirement age or at actual commencement date, if later, with both such actuarial present values determined as of the date the retirement-type benefit commences." The regulations define a "retirement-type benefit" as the "payment of a distribution alternative with respect to an accrued benefit" or the "payment of any other benefit under a defined benefit plan (including a qualified social security supplement (QSUPP) as defined in § 1.401(a)(4)-12) that is permitted to be in a qualified pension plan, continues after retirement, and is not an ancillary benefit."

Ancillary benefits are not protected by the anti-cutback rule. The regulations identify the following as ancillary benefits:

  • a Social Security supplement under a defined benefit plan (other than a QSUPP);
  • a disability benefit payable under a defined benefit plan (to the extent that the benefit exceeds the benefit otherwise payable), but only if the total benefit payable in the event of disability does not exceed the maximum qualified disability benefit, as defined in IRC § 411(a)(9);
  • a life insurance benefit;
  • a medical benefit described in IRC § 401(h);
  • a death benefit under a defined benefit plan other than a death benefit which is part of an optional form of benefit; or
  • a plant shutdown benefit or other similar benefit in a defined benefit plan that does not continue past retirement age and does not affect the payment of the accrued benefit, but only to the extent that such plant shutdown benefit, or other similar benefit, is permitted in a qualified pension plan.

According to the preamble to the final regulations, "benefits that are contingent on the occurrence of certain events, such as a plant shutdown or involuntary separation, and that continue after retirement are retirement-type subsidies that are protected under section 411(d)(6)(B), both before and after the occurrence of the contingency." As a result, these shutdown benefits cannot be reduced or eliminated with respect to service prior to the applicable amendment date, even if the contingency has not yet occurred. This is consistent with the position the Third Circuit Court of Appeals took on this issue in 2000.

Significantly, the rule relating to shutdown benefits applies only to amendments adopted after December 31, 2005. The IRS will not disqualify a plan merely because the plan sponsor adopts an amendment to eliminate or reduce a shutdown benefit if the amendment is adopted and effective prior to the occurrence of the shutdown.

Redundancy Exception

The final regulations provide two limited exceptions to the general rule that a plan sponsor generally may not amend its plan to eliminate optional forms of benefit with respect to previously accrued benefits. Both exceptions generally are designed to ensure participants continue to have certain options available if a plan eliminates one or more optional forms of benefit, and both require delayed effective dates.

Under the first exception, known as the "redundancy rule," such an amendment generally will not violate the anti-cutback rule if--

  • the optional form of benefit being eliminated is redundant with respect to a retained optional form of benefit; and
  • the amendment does not apply to an optional form of benefit with an annuity commencement date that is earlier than the number of days in the maximum QJSA explanation period after the amendment is adopted (i.e., 90 days after the amendment is adopted).

In order for an optional form of benefit to be redundant with respect to a retained optional form of benefit, the latter must be available to the participant and in the same "family" of optional forms as the form of benefit being eliminated. Also, a participant's rights with respect to the retained optional form of benefit may not be subject to materially greater restrictions-- such as eligibility conditions or right to designate a beneficiary, et al-- than the optional form being eliminated.

The proposed regulations outline six different families of optional forms of benefit.

  1. Joint and contingent options with continuation percentages of 50 percent to 100 percent. An optional form of benefit is within this family if it provides a life annuity to the participant and at least a 50 percent survivor annuity.
  2. Joint and contingent options with continuation percentages less than 50 percent. An optional form of benefit is within this family if it provides a life annuity to the participant and a survivor annuity that is no more than 50 percent of the participant's annuity.
  3. Term certain and life annuity options with a term of 10 years or less. An optional form of benefit is within this family if it is a life annuity with a payment guarantee of no more than 10 years.
  4. Term certain and life annuity options with a term in excess of 10 years. An optional form of benefit is within this family if it is a life annuity with a payment guarantee of more than 10 years.
  5. Level installment payment options over a period of 10 years or less. An optional form of benefit is within this family if it provides for substantially level payments to the participant for a fixed period of at least two years and a payment guarantee of no more than 10 years if the participant dies before the end of the fixed period.
  6. Level installment payment options over a period of more than 10 years. An optional form of benefit is within this family if it provides for substantially level payments to the participant for a fixed period with a payment guarantee in excess of 10 years if the participant dies before the end of the fixed period.

Optional forms of benefit that do not fit within any of the specified families are grouped in separate families with other optional forms that would be identical but for actuarial factors or annuity starting dates. Plan sponsors also may disregard differences with respect to social security leveling features, refund of employee contribution features, or retroactive annuity starting date features for purposes of determining if optional forms of benefit are members of the same family.

However, if the plan sponsor eliminates an optional form that includes a social security leveling feature or a refund of employee contributions feature, the retained optional form of benefit also must include that feature. Likewise, if the plan sponsor eliminates an optional form that does not include a social security leveling feature or a refund of employee contributions feature, the retained optional form of benefit may not include that feature. Similarly, if the plan sponsor eliminates an optional form that does not include a retroactive starting annuity date feature, the retained optional form may not include that feature.

If the plan sponsor uses the redundancy exception to eliminate a "core option," the retained optional form of benefit must be identical to the eliminated core option. (The four core options are specified in the "Core Option Exception" section, below.) For purposes of determining if the optional forms are identical, plan sponsors can disregard differences in actuarial factors, annuity starting dates, social security leveling features, refund of employee contributions features, and retroactive annuity starting date features.

Additional requirements may apply to amendments eliminating an early retirement benefit or reduce a retirement-type subsidy. Specifically, the additional requirements apply if the retained optional form either has a different annuity starting date than the eliminated optional form or, as of the "applicable amendment date," the actuarial present value of the retained optional form is less than the actuarial present value of the eliminated optional form. In these cases the regulations will permit the amendment only if, in addition to all the other requirements for the redundancy exception--

  • the eliminated optional form creates significant burdens and complexities for the plan and plan participants; and
  • the elimination does not adversely affect the rights of any participant in more than a de minimis manner.

Whether the optional form creates significant burdens and complexities for the plan and participants is a facts and circumstances determination. Relevant factors include whether the annuity starting dates under the plan considered in the aggregate are burdensome or complex, whether the effect of the amendment is to reduce the number of categories of early retirement benefit, whether the amendment eliminates one or more generalized optional forms, and whether the amendment replaces a complex optional form of benefit with a simpler form.

The de minimis requirement is satisfied if the retained optional form's annuity starting date is within six months of the annuity starting date for the eliminated optional form, and the actuarial present value of the eliminated optional form does not exceed that of the retained optional form by more than a de minimis amount. A reduction in actuarial present value is of no more than a de minimis amount if the reduction does not exceed the greater of two percent of the present value of eliminated optional form's retirement-type subsidy (if any) prior to the amendment or one percent of the participant's compensation for the prior plan year or the participant's average compensation for his or her high three years.

Core Option Exception

The second exception generally permits plan sponsors to eliminate optional forms of benefit if, after the amendment, each of four specific "core" options remain available, and if the eliminated optional form remains available for at least four years after the amendment is adopted. The core options are--

  • a straight life annuity with level payments during the participant's life and no death benefit;
  • a joint and contingent annuity with a life annuity for the participant and a 75 percent survivor annuity for the participant's beneficiary;
  • a 10-year certain life annuity with guaranteed payments for 10 years even if the participant dies before the end of that period; and
  • the most valuable option for a participant with a short life expectancy, meaning the optional form of benefit for each annuity starting date that is reasonably expected to result in payments having the largest actuarial present value in the case of a participant who dies shortly after the annuity starting date.

The regulations provide a "safe harbor hierarchy" for satisfying the most valuable option for a participant with a short life expectancy requirement. If the plan has a single-sum distribution option with an actuarial present value at least as great as that of any eliminated optional form of benefit, the plan can treat that option as the most valuable for each annuity starting date if it is available at all annuity starting dates, even if it was not available before the amendment.

If the plan does not have a single-sum distribution option that satisfies these requirements, it can use a joint and contingent annuity if the continuation percentage is at least 75 percent and at least as great as the highest continuation percentage available before the amendment. Finally, if the plan cannot use either the single-sum or joint and contingent annuity safe harbor, it could treat a term certain and life annuity with a term certain of at least 15 years as the most valuable option.

This exception does not apply to amendments eliminating an optional form including a single-sum distribution option that applies to 25 percent or more of the participant's accrued benefit as of the date the optional form is eliminated. Also, if the form being eliminated is the most valuable option for a participant with a short life expectancy, the exception applies only if an identical optional form is being retained. For purposes of determining if a retained form is identical, the plan can disregard actuarial factors used to determine distribution amounts, annuity starting dates, social security leveling features, refund of employee contribution features, and retroactive annuity starting date features.

As with the redundancy exception, additional rules may apply to amendments eliminating an early retirement benefit or retirement-type subsidy.

Proposed Utilization Exception

As noted, the Treasury Department and IRS on August 12, 2005 also issued proposed regulations that would create a utilization test plan sponsors could use to eliminate or reduce certain early retirement benefits, retirement-type subsidies, or optional forms of benefit. The utilization test would apply only if (1) the generalized optional form was available to at least 100 participants during the prior two plan years (the "look-back period"), and (2) no participant elected any optional form of benefit within its generalized optional form during the look-back period. The utilization exception could not be used to eliminate core options.

If finalized, the utilization test would be available for amendments adopted after December 31, 2006. Plan sponsors may not rely on the proposed utilization test unless and until it has been adopted in final form.

204(h) Notice Requirements

Under IRC § 4980F(e) and ERISA § 204(h), defined benefit plan sponsors must give plan participants advance notice of any amendments providing for a significant reduction in the rate of future benefit accrual or eliminating or reducing any early retirement benefits or retirement-type subsidies. The regulations clarify how those rules apply to changes permitted by these regulations.

Other Matters

The final regulations stake out the IRS's position on several controversial court decisions involving the anti-cutback rule. In 2003 the Fourth Circuit Court of Appeals ruled a plan sponsor could add a COLA for existing retirees and then take it away without violating the anti-cutback rule. The final regulations contradict this ruling by providing anti-cutback protection applies "to a participant's entire accrued benefit as of the applicable amendment date, without regard to whether the entire accrued benefit was accrued before a participant's severance from employment, or whether some portion of the accrued benefit was the result of an increase pursuant to a plan amendment adopted after the participant's severance from employment."

In another case, the Ninth Circuit Court of Appeals in 2001 ruled a plan amendment providing for an actuarial offset of early retirement benefits received by a rehire upon subsequent retirement violates the anti-cutback rule even though the amendment, combined with a simultaneous change to the plan's benefit formula, caused a net increase to the participant's retirement benefits. The final regulations dictate a different result by requiring the amendments to be treated as a single amendment for purposes of the anti-cutback analysis.

The proposed regulations would clarify the interaction between the anti-cutback rule and vesting requirements, in accordance with a 2004 Supreme Court decision. The Supreme Court ruled a multiemployer plan amendment that imposed a new suspension of benefit requirement on current and future early retirees violated the anti-cutback rule to the extent it applied to benefits accrued before the amendment. The proposed regulations would be effective retroactive to June 7, 2004, the date of the Supreme Court's decision. (Earlier this year the IRS issued plan qualification relief for plans that adopted similar amendments, before the Supreme Court's decision.)


Deloitte logoThe 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, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2005, Deloitte.


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