Guest Article

(From the January 8, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Begins to Open the Gates of "Cash Balance Jail"

The IRS finally is ending its seven year moratorium on processing determination letter applications and examination cases involving conversions from traditional defined benefit plan designs to cash balance and other hybrid plan designs. In Notice 2007-6 the IRS announced that it is beginning to process the determination letter applications and examination cases with respect to these "moratorium plans," subject to certain restrictions. The notice also provides interim guidance on changes the Pension Protection Act (PPA) of 2006 (P.L. 109-280) made to the age discrimination and certain other tax-qualification rules for cash balance and other hybrid plans.

Overview of PPA Provisions Relating to Cash Balance and Hybrid Plans

Like all defined benefit plans, cash balance and other hybrid plans must comply with IRC § 411(a) [minimum vesting standards] and 411(b) [benefit accruals] and other tax-qualification requirements. However, there has been substantial controversy over the proper methods for applying the vesting and accrual rules to cash balance and other hybrid plans. The PPA amended these provisions (and made parallel amendments to ERISA and the Age Discrimination in Employment Act (ADEA)) to clarify the legal status of these plans.

New IRC § 411(a)(13) provides certain cash balance and other hybrid plans -- which the notice refers to as "statutory hybrid plans" -- do not violate the minimum vesting standards solely because they define the present value of any participant's accrued benefit as the balance in a hypothetical account or as an accumulated percentage of the participant's final average compensation. Thus, instead of following the IRS Notice 96-8 methodology of projecting the hypothetical account balance forward to normal retirement age, converting that to an annuity, and then using the 30-year Treasury rate to calculate the present value, these plans can simply use the hypothetical account balance to pay pre-retirement lump sums. This corrects the so-called "whipsaw" problem that occurs under the Notice 96-8 methodology when the plan's interest crediting rate is higher than the 30-year Treasury rate.

The PPA also added new IRC § 411(b)(5) to specify rules for applying the age discrimination standards to defined benefit plans in general, and to statutory hybrid plans in particular. According to IRC § 411(b)(1)(H), a defined benefit plan -- including a cash balance or other hybrid plan -- may not provide for age-based reductions in a participant's rate of benefit accrual.

Under IRC § 411(b)(5), a defined benefit plan generally does not violate this requirement if a participant's accrued benefit to date ("accumulated benefit"), determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated, younger individual who is or could be a participant. For purposes of applying this test, a plan can express a participant's accumulated benefit as an annuity payable at normal retirement age, the balance of a hypothetical account, or the current value of the accumulated percentage of the employee's final average compensation. Also, Notice 2007-6 states a plan can determine a participant's accumulated benefit "as the balance of a hypothetical account or the current value of the accumulated percentage of the employee's final average compensation even if the plan defines the participant's accrued benefit as an annuity at normal retirement age that is actuarially equivalent to such balance or value."

Plans also do not violate IRC § 411(b)(1)(H) solely because they provide for indexing of accrued benefits.

For statutory hybrid plans, additional rules apply under IRC § 411(b)(1)(H). First, these plans' interest crediting rates may not exceed a "market rate of return." Second, in the case of defined benefit plans amended after June 29, 2005, to convert to statutory hybrid plans ("conversion amendments"), there may not be any "wear-away" of any participant's pre-amendment accrued benefit. Finally, there are special rules for projecting variable interest crediting rates in the case of terminating statutory hybrid plans.

The PPA also imposes stricter vesting requirements on statutory hybrid plans. Specifically, these plans must provide for 100 percent vesting after three years of service. Other defined benefit plans can use five-year cliff vesting or a three to seven year graded vesting schedule.

These provisions generally are effective for periods beginning on or after June 29, 2005. However, in the case of plans in existence on June 29, 2005, the special vesting rules for statutory hybrid plans apply to years beginning after December 31, 2007. Other special effective date rules are discussed below.

Definition of "Statutory Hybrid Plan"

A threshold issue addressed in Notice 2007-6 is what does, and what does not, constitute a "statutory hybrid plan." Echoing the definition provided in new IRC § 411(a)(13)(C), and exercising the regulatory authority granted by that section, Notice 2006-7 specifies a statutory hybrid plan is "either a lump sum based plan or a plan that has a similar effect to a lump sum based plan." According to the notice, a "lump sum based plan" is a "defined benefit plan under the terms of which the accumulated benefit of a participant is expressed as the balance of a hypothetical account maintained for the participant or as the current value of the accumulated percentage of the participant's final average compensation, and includes a plan under which the accrued benefit under the terms of the plan is calculated as the actuarial equivalent of such a hypothetical account balance or accumulated percentage." The key is how the plan expresses the participant's accumulated benefit. The simple fact that a plan provides a lump sum distribution option does not make it a "lump sum based plan."

The notice also provides a plan is a "statutory hybrid plan" by virtue of having a "similar effect to a lump sum based plan" if it "provides that a participant's accrued benefit (payable at normal retirement age) is expressed as a benefit that includes automatic periodic increases through normal retirement age that results in the payment of a larger amount at normal retirement age to a similarly situated participant who is younger." This includes a plan that expresses the accrued benefit as an indexed annuity. It does not include:

"Whipsaw" Fix

As noted, new IRC § 411(a)(13) corrects the whipsaw problem for certain cash balance and other hybrid plans, effective for distributions made after August 17, 2006. The fix generally applies to statutory hybrid plans. However, the notice specifies it does not apply to benefits under statutory hybrid plans "that are expressed neither as the balance of a hypothetical account maintained for a participant nor as the current value of the accumulated percentage of a participant's final average compensation."

The notice clarifies that plan sponsors can retroactively amend their plans to apply the whipsaw fix to all distributions made after August 17, 2006 without violating the IRC § 411(d)(6) anti-cutback rule. However, this special relief is available only if --

Significantly, if a plan sponsor amends its plan to take advantage of the whipsaw fix -- whether retroactively or prospectively -- the notice states the amendment results in a significant reduction in the rate of future benefit accrual and thus is subject to the IRC § 4980F notice requirement. The IRC § 4980F notice generally must be provided at least 30 days before the amendment's effective date. If the amendment is retroactive, Notice 2007-6 specifies the IRC § 4980F notice must be provided at least 30 days before the earliest date on which the plan is operated in accordance with the amendment.

The IRS plans to issue regulations interpreting the IRC § 411(a)(13) effective date "shortly."

What Is a "Market Rate of Return"?

Statutory hybrid plans with interest crediting rates exceeding a "market rate of return" will violate the IRC § 411(b)(1)(H) age discrimination rules, as discussed above. The statute does not define "market rate of return," but Treasury and IRS plan to issue guidance on that issue sometime in 2007. Until then, Notice 2007-6 specifies the following safe harbors for meeting the market rate of return requirement:

Conversion Amendments

In the case of conversion amendments adopted after June 29, 2005, plans may not provide for any wearing-away of a participant's accrued benefit. Thus, new IRC § 411(b)(5)(B)(iii) specifies the accrued benefit of any participant under the terms of the plan as in effect after the conversion amendment may not be less than the sum of:

The participant's pre-amendment accrued benefit must include the value of any early retirement benefit or retirement-type subsidy for which the participant is eligible at retirement. In order to satisfy this requirement, the notice states the plan must credit the participant's accumulation account or similar account with the amount of the early retirement benefit or retirement-type subsidy in the year the participant retires. For this purpose, the retirement date is the participant's annuity starting date.

The PPA (§ 702) directs Treasury and IRS to issue regulations for applying these conversion amendment rules to groups of employees "who become employees by reason of a merger, acquisition, or similar transaction." Notice 2007-6 states IRS expects to issue such regulations "not later than August 17, 2007." Until then, the notice provides a safe harbor that plans can use in this situation to avoid running afoul of the wear-away prohibition. Specifically, each participant's accrued benefit under the amended plan may not be less than the sum of:

The pre- and post-conversion amendment accrued benefits must be determined as if provided under separate, independent plans -- e.g., without any benefit offsets.

IRS Beginning to Process Determination Letters for Hybrid Plans

As noted, Notice 2007-6 states the IRS is beginning to process determination letters and examination cases for moratorium plans. Generally, the IRS will review moratorium plans to determine whether accruals relating to post-conversion service violate IRC § 411(b)(1)(H). Also, the IRS will not treat a moratorium plan as failing to meet the age discrimination rules merely because it provides that interest credits through normal retirement age are accrued in the year of the related hypothetical allocation. However, certain special rules will apply when processing these applications and cases.

Significantly, if the conversion amendment was adopted prior to June 30, 2005, the IRS will not review the plan to determine if it satisfies IRC § 411(b)(1)(H). Thus, the determination letters these moratorium plans receive "will not consider, and may not be relied on with respect to, whether such a conversion satisfies the requirements of [IRC §] 411(b)(1)(H), as in effect prior to the addition of [IRC §] 411(b)(5) by PPA '06, including the effect of any wearaway." If the conversion amendment was adopted after June 29, 2005, it must satisfy the rules for conversion amendments discussed above.

The notice also states the IRS will not process any moratorium plans that do not use the Notice 96-8 methodology for distributions made before August 18, 2006 until the IRS issues guidance on the effective date of the PPA's whipsaw fix. As discussed, the IRS plans to issue this guidance "shortly."

Comments

The IRS is seeking comments on the transitional guidance provided in Notice 2007-6, as well as on a number of specific issues listed at the end of the notice. Comments must be submitted by April 16, 2007.

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, 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, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.