Guest Article

(From the May 07, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Updated 415 Regulations -- an In-Depth Review (Part 2 of 2)

A recent Washington Bulletin included the first part of an in-depth analysis of the recently finalized regulations under IRC § 415, which establishes maximum benefits and contributions under qualified plans and similar arrangements. Part One covered defined contribution (DC) plans and some miscellaneous provisions. This article will primarily examine the rules under IRC § 415(b), which apply to defined benefit (DB) plans, as well as other portions of the regulations that apply to DB plans.

I - Background

Section 401(a) qualified plans must comply with IRC § 415's limitations on benefits and contributions. For a DB plan, a participant's annual benefit may not exceed the lesser of $180,000 (for 2007; adjusted annually for inflation) or 100% of his high three years' average compensation.

As discussed in the previous article, the newly finalized regulations largely reflect IRS guidance issued in various forms over the past 26 years. (The prior version of the regulations was published in 1981). The description below includes many of those updates but does not call attention to all provisions that are being carried over from the post-1981 guidance. We have focused on points where the final regulations differ from the pre-existing guidance and represent a change in the law, or where the final regulations differ from the proposed regulations issued in 2005.

II -- Plans Subject to IRC § 415(b)

1. Defined Benefit Plans

The 2007 final regulations, like the 1981 final regulations, define a DB plan in the negative; a DB plan is any plan that is not a DC plan. Treas. Reg. § 1.415(b)-1(a)(2). There is rarely, if ever, any doubt as to whether a plan falls into this category, though it should be noted that cash balance plans are DB plans for this purpose, even though they resemble DC plans in many respects. The proposed regulations resolve one borderline case by stating that IRC § 403(b) plans that do not provide benefits on an individual account basis are subject to the IRC § 415(b) limits. However, the 2004 proposed IRC § 403(b) regulations (yet to be finalized) require most IRC § 403(b) arrangements (all but a special class of church plans) to operate as DC plans. See 69 FR 66075 (November 16, 2004). If the final 403(b) regulations adopt this proposal, very few 403(b) arrangements will be considered DB plans subject to IRC § 415(b).

In some cases, DB plans include defined contribution elements that are subject to the DC plan limitations (IRC § 415(c)), rather than IRC § 415(b). These situations are discussed in more detail later in this article.

III -- Annual Benefit Testing

1. In General

The IRC § 415(b) limit for DB plans 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 $180,000 for limitation years ending in 2007 and is adjusted for inflation in $5,000 increments. IRC § 415(b)(1)(A). The compensation limit is 100% of the employee's average compensation for his "high 3 years" (discussed below). IRC § 415(b)(1)(B).

a. Accrued benefit testing

The final regulations include a change, of uncertain impact, to the way IRC § 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 IRC § 415(b) limit. The 1981 final regulations tracked that language, and pertinent qualification regulations assume that benefits may accrue in excess of the IRC § 415(b) maximum. See Treas. Reg. §§ 1.401(a)(4)-3(d)(2)(ii)(B); 1.415-3(a)(1) (1981). As a result, practitioners had (reasonably) assumed that IRC § 415(b) limits only the amount paid by the plan, not accruals by participants. The 2007 final 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 IRC § 415(b). Treas. Reg. § 1.415(b)-1(a)(1). The preamble does not discuss the rationale for the change in position.

In the past, it was possible for a defined benefit plan to provide for accruals to a participant in excess of the IRC § 415(b) limitation while he was working, then limit distributions to the IRC § 415 limit in effect for the year of payment. If the plan provided for post-retirement cost of living adjustments to the IRC § 415 limit, so that the participant could receive increases in his benefit payments in subsequent years, up to his accrued benefit. The new regulations preclude this tactic in the future. They do, however, include a "grandfather" rule for excess benefits that accrued during limitation years prior to the effective date of the regulations. However, if the participant has accruals for limitation years after the effective date of the regulations, the total accruals will be subject to limitation. Treas. Reg. § 1.415(a)-1(g)(4). In certain cases, this can result in a temporary freeze on additional benefit accruals, until the IRC § 415 limit has increased sufficiently to cover all benefits accrued to date. As discussed in more detail below, the application of this rule will have particular impact on a participant who earns compensation at or above the IRC § 401(a)(17) limit.

The limitation on accruals will not affect governmental and church plans (except for church plans that have voluntarily elected coverage under ERISA). As before, they will only be required to comply with IRC § 415(b) at the time benefits are paid. Treas. Reg. § 1.415(b)-1(a)(7)(iii).

b. Plan aggregation and predecessor plans

Under IRC § 415(f), all DB plans maintained by a single employer must be treated as a single DB plan. All members of a controlled group under the rules of IRC § 414(b) and (c), all members of an affiliated service group under IRC § 414(m), and all employers aggregated under IRC § 414(o) are treated as one employer. Treas. Reg. § 1.415(f)-(1)(a). For this purpose, the rules of IRC § 414(b) and (c) are modified to require only 50 percent control in order for an employer to be aggregated as part of a parent-subsidiary group, rather than the 80 percent ordinarily required. Also aggregated with the group's plans are terminated plans and plans that were maintained by any predecessor employer. Treas. Reg. § 1.415(f)-1(a).

Applying IRC § 415(b) to plans that no longer exist or maintained by entities that are no longer part of the controlled group (and perhaps never were) can be tricky. The final regulations include special rules for a number of situations. The most important are these:

The final regulations include rules intended to ensure that the process of aggregating plans does not result in double counting benefits accrued after any transfers of benefits from a predecessor employer's plan to a successor plan. Treas. Reg. § 1.415(f)-1(b)(2), (c)(1) and (d).

2. Compensation

a. Determining the "High 3"

IRC § 415(b) limits a participant's annual benefit to 100 percent of his average compensation for the period of three consecutive years (calendar years by default, though a plan may adopt any other 12-month period) for which his total compensation is highest. If a participant has been employed for less than three years, his average for his period of employment is used, with total compensation divided by length of service, expressed in years and fractions of a year (except that the divisor can never be less than one). Treas. Reg. §1.415(b)-1(a)(5)(ii). Example: A was hired on July 1, 2007, became a participant on January 1, 2008, and terminated employment on September 30, 2009. His period of employment, 7/1/07-9/30/09, was 2.25 years long, during which he earned a total of $180,000. Therefore, his "high 3" compensation is $180,000 divided by 2.25, or $80,000.

If an employee has a break in service, his period of absence may be ignored for the purpose of this calculation, as if his employment had been uninterrupted. Treas. Reg. §1.415(b)-1(a)(5)(iii). Example: B was hired on January 1, 2001, terminated employment on December 31, 2005, and was rehired on January 1, 2008, then terminated again on December 31, 2009. He was paid $80,000 a year during the first period of employment and $125,000 a year after returning. His high-3 average is based on the years 2005, 2008 and 2009, during which he earned a total of $330,000, an average of $110,000 a year. This rule need not be applied where it would result in a decrease in average compensation, which can occur where the plan makes cost-of-living adjustments to average compensation after separation from service.

The 2005 proposed regulations included a more profound change to the calculation of "high-3 average compensation." They disregarded all periods of service during which the employee was not an active participant in the plan. This rule would have most severely affected self-employed individuals who set up DB Keogh plans late in life, since self-employment income in earlier years, which might be well above current levels, would have had to be excluded in computing high-3 compensation. The Pension Protection Act of 2006 (P.L. 109-280) amended IRC § 415(b) to nullify this change. Accordingly, it was dropped from the final regulations.

b. Interaction with the IRC § 401(a)(17) Compensation Limit

Reversing the general understanding of practitioners, the final regulations, like the proposed version, limit IRC § 415 compensation to the maximum amount that may be taken into account for other plan purposes under IRC § 401(a)(17). Nominally, the IRC § 401(a)(17) limit ($225,000 in 2007) is higher than the IRC § 415(b) dollar limit (currently $180,000), but the latter ratchets upward if benefits start after age 65 and exceeds the 401(a)(17) limit by age 70. By age 75, it is nearly $300,000.

While no properly drafted plan will base benefit accruals on compensation in excess of the IRC § 401(a)(17) limit, actuarial adjustments for late commencement may increase the amount due to a participant above that figure. Before the new regulations, he would have received the lesser of his actuarially adjusted accrued benefit or the age-adjusted IRC § 415(b) limit. In the future, annual payouts will be limited to the three-year average of IRC § 401(a)(17) maximum compensation, likely to be a far lower figure. The preamble to the final regulations confirms that this result was intended.

Fortunately, the new rule operates only prospectively. An example in the regulations illustrates that a participant who retires on January 1, 2008, may collect a benefit based on the age-adjusted dollar limit at that time, if the plan's provisions so provide. He will not, however, be able to accrue any further benefits until the IRC § 401(a)(17) limit rises above his grandfathered benefit.

The IRC § 401(a)(17) limit does not affect the adjustment of the a participant's IRC § 415(b) compensation for cost-of-living increases after separation from service, as permitted under IRC § 415(d)(1)(B) and Treas. 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.

c. Severance pay

As discussed in the previous article, the final regulations generally exclude from IRC § 415 compensation payments made after severance from employment. Excepted from this ban are regular compensation, commissions, bonuses, overtime, or shift differential, if paid within 2-1/2 months of severance or by the end of the limitation year in which the severance occurs, whichever is later. Cashouts of accrued sick, vacation, or other leave, and the payment of certain nonqualified deferred compensation may also be included, but only if paid within the time limit described and expressly included in IRC § 415 compensation under the terms of the plan. Treas. Reg. §1.415(c)-2(b) and (c). Excluded items of post-severance pay may not be included in IRC § 415 compensation and, as a result, are also excluded from the IRC § 414(s) compensation used for testing benefit accruals under IRC §401(a)(4) and from other definitions of "compensation" that take IRC § 415 as their starting point.

3. Benefits excluded from the IRC § 415(b) Limits

Some DB plans require participants to make contributions, either as a condition of employment or as a prerequisite to accruing all or part of their benefits under the plan. Benefits attributable to these mandatory contributions are not limited by IRC § 415(b); rather, the contributions themselves are subject to the IRC § 415(c) limits on "annual additions." This rule does not apply to employee contributions "picked up" by a governmental employer under IRC § 414(h)(2), which are treated as employer contributions for tax purposes. The benefits attributable to them are limited by IRC § 415(b). Treas. Reg. §§ 1.415(b)-1(b)(2)(ii)(A); 1.415(c)-1(a)(2)(ii)(B).

A DB plan may permit employees to make voluntary contributions, which 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 DB plan are, like mandatory contributions, tested under IRC § 415(c). Treas. Reg. § 1.415(b)-1(b)(2)(iv).

Benefits attributable to rollovers are not subject to the IRC § 415(b) limits, because they were taken into account in applying IRC § 415 to the plan under which they accrued. The final regulations further clarify that benefits attributable to "elective transfers" are treated like rollovers for this purpose.

Benefits attributable to plan-to-plan transfers are generally taken into account for IRC § 415(b) purposes by the transferee plan. The transferor plan ignores them if the two plans are required to be aggregated for IRC § 415 purposes. (The net effect of aggregation is, of course, to make it unimportant which plan is regarded as providing the transferred benefit; the key point is to count it only once.) Where no aggregation is required, the transferor determines the participant's IRC § 415(b) benefit at the time of the transfer in the same manner as if it had terminated at that point. That amount must henceforth be taken into account in its IRC § 415(b) calculations, though that fact will make a difference only in rare circumstances.

4. Adjustments for early or late benefit commencement

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. Treas. Reg. §1.415(b)-1(b)(1)(i)(B). To make the limitation consistent without regard to the form or timing of benefits, IRC § 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. Treas. Reg. §§1.415(b)-1(a)(4) and 1.415(b)-1(c).

The final regulations specify how to adjust both the dollar and the compensation-based limits. There are two methods of adjustment, one based on statutory assumptions and the other on plan factors. The method that produces the lower limit must be used. The assumptions under the first method are a five percent interest rate and the "applicable mortality table" (currently the 94 GAR table prescribed by Revenue Ruling 2001-62). No mortality adjustment may be made unless benefits are forfeitable on death. (They usually are, but cash balance plans frequently, and others now and then, have full death vesting.) A plan that doesn't charge participants for qualified preretirement survivor annuity coverage may elect to make no adjustment for mortality, but the election must be applied not only before age 62, when it increases the IRC § 415(b) limit, but also after age 65, when it has the opposite effect.

The alternative, plan-based method reduces the IRC § 415(b) limit (for early retirement) or increases it (for late retirement) by the same proportion that the participant's pension would be adjusted if he retired and began receiving it immediately. The proportionate adjustment is calculated from age 62, for early retirement, or age 65, for late retirement. This method cannot be used for any age at which no immediate annuity would be available upon separation from service at that time. Treas. Reg. § 1.415(b)-1(d) and (e). Thus, where the plan does not offer immediate annuities available upon separation from service, only the statutory method can be used.

5. Benefit Form Adjustments

As noted, the nominal IRC § 415(b) limit is based on an annuity payable for the participant's life only, with no survivor benefits. The final regulations specify how to convert a benefit payable in a different form into a straight life annuity in order to compare it to the IRC § 415(b) limit. The new methodology differs slightly from that commonly used in the past.

a. Conversion method

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). IRC § 415(b)(1)(B). The conversion methodology depends on whether the distribution form is or is not subject to IRC § 417(e)(3) (which applies primarily to single sum and installment payment options).

A lump sum or series of installment payments is converted to an equivalent straight life annuity using whichever of the following sets of factors produced the largest annuity: (i) the plan factors for converting annuities to lump sums, (ii) the "applicable mortality table" and a 5.5 percent interest rate, or (iii) 95.24 percent (1/1.05) of the annuity produced by using the conversion factors prescribed by IRC § 417(e), which are based on the applicable mortality table and average yields on an index of high-grade corporate bonds. IRC § 415(b)(2)(E); Treas. Reg. § 1.415(b)-1(c)(3). If the equivalent annuity exceeds the IRC § 415(b) limit (as adjusted for the participant's age at commencement), the benefit must be cut back to comply with IRC § 415.

The conversion of other 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 IRC § 415(b) limit. Treas. Reg. § 1.415(b)-1(c)(2). In effect, the final 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 1981 and 2007 final regulations specify that certain valuable features are ignored in converting a benefit into straight life annuity form for IRC § 415(b) testing. Treas. Reg. § 1.415-3(c)(2) (1981); Treas. Reg. § 1.415(b)-1(c)(4).

Thus, for example, a participant can receive a benefit of $180,000 a year beginning at age 62 in the form of a qualified joint-and-100 percent 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 2007 final 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. Treas. Reg. § 1.415(b)-1(c)(4)(ii).

6. Adjustment for Prior Distributions

The 2005 proposed regulations included complex 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. The proposed regulations generally spelled out how previous distributions from the plan should be taken into account. Prop. Reg. § 1.415(b)-2(a). This part of the proposal drew heavily negative comments, in response to which the IRS removed it from the final regulations and reserved the issue for future guidance. Treas. Reg. § 1.415(b)-2(a). In the meantime, practitioners are given a simplified rule: Plans merely have to be sure that the limitations of IRC § 415 are met at each annuity starting date, taking into account all benefits provided up to that point and to be provided in the future. Treas. Reg. § 1.415(b)-1(b)(1)(iii).

7. $10,000 Safe Harbor

IRC § 415(b)(4) creates a safe harbor under which a benefit is deemed to satisfy IRC § 415(b) testing 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 final 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 IRC § 415(b), are taken into account. Treas. Reg. § 1.415(b)-1(f).

8. Interaction of IRC § 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 IRC § 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 begin receiving benefits 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. The correction is likely to consist of nothing more than the IRS's agreement to the retroactive issuance of the suspension notice (the alternative is to require the payment of additional benefits to a very highly compensated participant), but it is far easier and less expensive to issue a timely notice in the first place. Treas. Reg. § 1.415(a)-1(f)(7).

IV -- Cost of Living Adjustments

The IRC § 415(b) dollar limit is adjusted each calendar year to reflect cost-of-living increases, with changes rounded down to the next lowest $5,000. The adjusted limitation is effective for all limitation years ending within the calendar year. For example, the $180,000 limit for the year 2007 applies to the year running from June 1, 2006, through May 31, 2007, of a plan that uses a May 31 plan and limitation year. The final regulations introduce one wrinkle: The limit that applies to an actual distribution (as opposed to the limit for benefit accrual or other purposes) is the one for the calendar year in which the distribution is made. To illustrate: A participant in a plan with a May 31st limitation year terminates employment and receives a lump sum distribution on June 30, 2008. The IRC § 415(b) limitation for calendar year 2008 is, let's assume, $185,000 and $190,000 for 2009. The plan's limit for the period from June 1, 2008, through May 31, 2009, is $190,000, but the distribution made on June 30, 2008, must observe the $185,000 limit in effect for that calendar year.

Similarly, post-retirement benefit increases to reflect increases in the IRC § 415(b) limit may not begin until January 1st. The adjustment isn't accelerated for non-calendar year plans.

The limitation based on 100 percent of "high 3" compensation is also adjusted for cost-of-living increases by multiplying the figure as of termination of employment by a factor announced annually by the IRS. The rules governing this adjustment parallel those for adjustments to the dollar limit.

A plan may incorporate cost of living adjustments by reference. Under the final regulations, the default rule is that cost of living adjustments cease when benefits commence. Therefore, a specific plan provision is necessary to apply the increases to participants who are in pay status.

V - Effective Date

The final regulations will apply to limitation years beginning on or after July 1, 2007. A good faith interim amendment must be adopted by the due date, including extensions, of the employer's tax return for its tax year with or within which ends the first limitation year to which the new rules apply. The remedial amendment period depends on where the plan falls in the Revenue Procedure 2005-66 determination letter cycle.

These amendments would be an excellent occasion to take advantage of the ability to incorporate IRC § 415 by reference rather than try to paraphrase it in extenso. Plan provisions are necessary only where the plan sponsor wishes to adopt a rule other than the regulations' defaults (e. g., include cashouts of accrued leave in IRC § 415 compensation or adjust the limitations for cost-of-living increases after benefits commence) or where no default exists (e. g., the order in which benefits are reduced to avoid violations of the maximum limitations).

As referenced in III. 1., above, the regulations "grandfather" preexisting accrued benefits that exceed the IRC § 415(b) maximum. Only accruals as of the last day of the last limitation year ending before July 1, 2007, are protected, and only if accrued pursuant to plan provisions adopted and in effect before April 5, 2007 (the date on which the regulations were published in the Federal Register). It is thus too late to adopt last minute benefit enhancements to take advantage of the grandfather rule.

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, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.