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Guest Article

Deloitte logo

(From the January 7, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Proposed Regulations on Hybrid Plans


IRS issued proposed regulations relating to new Code Sections 411(a)(13) and 411(b)(5), which were added by PPA to enable cash balance and other hybrid plans to satisfy age discrimination and certain other qualification requirements. The regulations incorporate the transitional guidance provided in Notice 2007-6, adopt new terminology to take into account situations where more than one benefit formula is utilized by a plan, and provide additional guidance, taking into account public comments received. 72 FR 73680 (December 28, 2007).

2009 Effective Date But Interim Reliance Allowed

The regulations are proposed to be effective for plan years beginning on or after January 1, 2009 (or, if later, the effective date that applies to collectively bargained plans under PPA). /1/

However, prior to that time, plans are permitted to rely on the regulations to demonstrate compliance with 411(a)(13) and 411(b)(5) after the statutory effective date. /2/

Code §411(a)(13) -- Special Vesting Rules

411(a)(13) provides special rules for "applicable defined benefit plans," which are plans that provide benefits under a "statutory hybrid benefit formula." A statutory hybrid benefit formula is a benefit formula that is either a "lump-sum based benefit formula" or a formula that is not a lump-sum based formula but which has an effect similar to a lump-sum based formula.

Lump-Sum Based Benefit Formulas Will Not Violate Certain Qualification Requirements

With regard to lump-sum based benefit formulas, 411(a)(13)(A) provides that an applicable defined benefit plan will not, merely because it utilizes such a formula, violate the qualification requirements for:

  • minimum vesting under 411(a)(2), provided that the 3-year maximum vesting period under 411(a)(13)(B) is satisfied,

  • the allocation of accrued benefits between employer and employee contributions under 411(c), or

  • the cash-out of accrued benefits with respect to employer contributions under 417(e).

The proposed regulations clarify that a "lump sum based benefit formula" means a formula, which is used to determine all or any part of a participant's accumulated benefit, which expresses the benefit 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. Consistent with Notice 2007-6, the regulations provide that a benefit formula is lump-sum based depending on how the accumulated benefit is expressed under the plan terms and not whether a lump sum optional form of payment is provided. The regulations clarify that:

  • A formula does not fail to be lump-sum based simply because the plan states that the accrued benefit is an annuity payable at normal retirement age that is actuarially equivalent to a hypothetical account balance.

  • A formula is not lump-sum based merely because the participant is entitled to a benefit that is at least equal to the benefit attributable to employee after-tax contributions.

411(a)(13)(A) applies only to the benefit under the lump-sum based benefit formula. Therefore, if the present value rules of 417(e) apply to a form of payment, and the plan provides benefits under a formula that is not a lump-sum based benefit formula (including, for example, a plan that provides for indexing as described in 411(b)(5)(E)), then the plan must provide a methodology to determine the projected benefit under that formula at normal retirement age for purposes of applying 417(e).

3-Year Maximum Vesting Period Required for Plans with Statutory Hybrid Benefit Formulas

A "statutory hybrid benefit formula" is defined as a lump-sum based benefit formula or a formula that is not lump-sum based but which has an effect similar to a lump-sum based benefit formula. Consistent with Notice 2007-6, the regulations provide that a formula has a similar effect if it provides an accrued benefit payable at normal retirement age (or benefit commencement, if later) which is expressed as a benefit that includes periodic adjustments (including a formula that provides for indexed benefits as described in 411(b)(5)(E)) which is reasonably expected to result in a larger annual benefit at normal retirement age (or benefit commencement, if later) for a similarly situated younger individual who could be in the plan. The regulations clarify that:

  • A formula has the effect of a lump-sum based benefit formula if the right to future adjustments accrues at the same time as the benefit that is subject to the adjustments.

  • A formula that does not provide for periodic adjustments is treated as having the effect of a lump-sum based benefit formula if it is otherwise described above and the adjustments are provided pursuant to a pattern of repeated plan amendments.

  • Post-annuity starting date adjustments of the amounts payable to the participant (e.g., cost of living increases) are disregarded in determining whether a formula is similar to a lump-sum based benefit formula.

  • Benefits properly attributable to employee after-tax contributions are not treated as having the effect of a lump-sum based benefit formula.

  • A variable rate annuity formula is not treated as having the effect of a lump-sum based benefit formula if the assumed interest rate used for adjusting the amounts payable is at least 5%. Such an annuity would not be treated as having the effect of a lump-sum benefit formula even if post-annuity starting date adjustments utilize an assumed interest rate of less than 5%.

With regard to statutory hybrid benefit formulas, 411(a)(13)(B) provides that any participant whose accrued benefit (or any portion of it) is determined under a statutory hybrid benefit formula must be 100% vested upon the completion of 3 years of service. The regulations clarify that:

  • The requirement applies on a participant-by-participant basis, and applies to the participant's entire benefit (and not just the portion under the statutory hybrid benefit formula).

  • If the participant is entitled to the greater of two benefits under the plan, and only one is determined under a statutory hybrid benefit formula, the 3-year vesting requirement applies to the participant even if the benefit under the statutory hybrid benefit formula is smaller.

  • Floor-offset arrangements are not addressed. IRS has requested public comment on the application of the 3-year vesting requirement to these arrangements.

For plans in existence on June 29, 2005, the 3-year vesting requirement of 411(a)(13)(B) does not become effective until the plan year beginning on or after January 1, 2008 (or, if later, the effective date that applies to collectively bargained plans under PPA). See Footnotes 1 & 2 for greater detail on effective dates.

IRC § 411(b)(5) -- Special Rules Relating to Age

Safe Harbor for Age Discrimination

411(b)(5)(A) provides a safe harbor for plans to satisfy the age discrimination requirements of 411(b)(1)(H) (which require that benefit accruals not be reduced on account of age). Under the safe harbor, a plan will satisfy the requirements if, as of any date, a participant's "accumulated benefit" would not be less than any similarly situated, younger participant's accumulated benefit expressed under the same formula. A participant's "accumulated benefit" is the participant's accrued benefit as expressed under the terms of the plan as of that date. The safe harbor test would be available where the benefit is expressed as:

  • an annuity payable at normal retirement age (or current age, if later), /3/

  • the balance of a hypothetical account, or

  • the current value of an accumulated percentage of the participant's final average compensation.

Under the test:

  • The comparison must be made within the same category. /4/ The safe harbor is not available for a comparison between benefits expressed as different forms. For example, a comparison can not be made between a participant whose benefit is expressed as an annuity and a similarly situated younger participant whose benefit is expressed as the balance of a hypothetical account.

    • However, where the benefit is expressed as the sum of two forms, or the greater of two forms, the safe harbor can be satisfied if the safe harbor is satisfied for each separate form. /5/

  • A comparison must be made of each possible participant in the plan to each other similarly situated, younger individual who could be a participant.

  • A similarly situated participant is one who is identical in every respect that is relevant in determining benefits under the plan, except for age. A participant who has made an election is similarly situated to another who has made the election, while a participant who has not made an election is similarly situated to another who has not.

  • The comparison is made without regard to any subsidized portion of an early retirement benefit that is included in the accumulated benefit. The subsidized portion of an early retirement benefit is the retirement-type subsidy within the meaning of Treasury Regulation Section 1.411(d)-3(g)(6) that is contingent on the participant's severance from employment and commencement of benefits before normal retirement age.

Limitation on Indexing

411(b)(5)(E) provides that indexing of accrued benefits (i.e., the periodic adjustment of the accrued benefit in accordance with a recognized investment index or methodology) will not cause the plan to fail to satisfy age discrimination rules of 411(b)(1)(H). The regulations clarify that:

  • The disregard of indexing does not apply to lump-sum based formulas.

  • The disregard of indexing does not apply if the indexing is reduced or terminated on account of the attainment of any age.

  • Only the following indexes are recognized for this purpose:

    • Indexing using an eligible cost-of-living index as described in Treasury Regulation Section 1.401(a)(9)-6, A-14(b),

    • Indexing using the rate of return on the aggregate assets of the plan, or

    • Indexing using the rate of return of the annuity contract for the employee issued by an insurance company licensed under the laws of a state.

  • The indexing can not result in a lower accrued benefit. Benefits paid in the form of a variable annuity are exempt from this requirement as long as the variable annuity adjustment is based on the rate of return of the aggregate assets of the plan or annuity contract. Therefore, the exemption from the "no loss" rule would not apply if the variable annuity adjustment is based on the rate of return of a portion of the assets of the plan.

Market Rate of Return and Preservation of Capital

411(b)(5)(B) requires a statutory hybrid plan to credit interest at a rate not in excess of a market rate of return in order to satisfy the age discrimination rules of 411(b)(1)(H). The regulations clarify that:

  • An interest crediting rate is the rate by which a participant's benefit is increased under the ongoing terms of the plan to the extent the increase is not conditioned on current service. Therefore, whether an amount is an interest credit is determined without regard to whether the amount is calculated by reference to a rate of interest, rate of return, index, etc.

  • The plan must specify the time for determining the interest crediting rate that will apply, using one of two permitted methods: (1) daily interest crediting based on permissible interest crediting rates, or (2) pursuant to a specified look back month and stability period.

  • The plan must also specify the frequency with which the interest credits are made. If credited more frequently than annually then the credit for the period must be a pro rata portion of the annual interest credit.

  • Interest credits are not treated as creating a rate of return in excess of a market rate merely because an otherwise permissible interest crediting rate is compounded more frequently than annually.

  • Interest crediting is not in excess of a market rate of return if it is adjusted at least annually and is equal to any of the following rates:

    • The rate of interest on long-term investment grade corporate bonds (as described in 412(b)(5)(B)(ii)(II) prior to amendment by PPA for plan years beginning prior to 2008, and the 3rd segment bond rate under 430(h)(2)(C)(iii) for subsequent plan year), /6/

    • The sum of any of the following rates of interest and the associated margin for that interest rate:

      Treasury Bond Interest Rate Associated Margin
      Discount Rate on 3-Month Treasury Bills 175 basis points
      Discount Rate on 12-month or Shorter Treasury Bills 150 basis points
      Yield on 1-Year Treasury Constant Maturities 100 basis points
      Yield on 3-Year or Shorter Treasury Bonds 50 basis points
      Yield on 7-Year or Shorter Treasury Bonds 25 basis points
      Yield on 30-Year or shorter Treasury bonds 0 basis points

    • The rate of increase with respect to an eligible cost of living index described in Treasury Regulations Section 1.401(a)(9)-6, A-14(b) (except that the consumer price in index in A-14(b)(2) is increased by 300 basis points).
  • IRS is examining other possible rates, including fixed rates and minimum guaranteed rates.

411(b)(5)(B)(i)(II) requires that an interest credit (of less than zero) not result in the account balance being less than the aggregate amount of contributions credited to the account. The regulations provide that this "no loss" requirement is applied at the participant's annuity starting date, and the participant's benefit must be no less than the benefit determined as of that date based on the sum of the hypothetical contributions (not including interest) credited under the plan.

Conversion Protection

411(b)(5)(B) provides that a participant whose benefits are affected by a conversion amendment after June 29, 2005, must be entitled to a benefit that is at least equal to the sum of the benefits accrued through the date of the conversion plus the benefits earned after the conversion, with no interaction between the two. The regulations provide the following alternative mechanism for compliance:

  • The plan can establish an opening hypothetical account balance as part of the conversion and keep separate track of: (1) the opening account balance and attributable interest, and (2) the post-conversion hypothetical contributions and attributable interest.

  • At benefit commencement, the plan will confirm whether the benefit attributable to the opening hypothetical account balance, payable in the optional form elected by the participant, is greater than or equal to the benefit accrued under the plan prior to the date of conversion and payable in the same generalized optional form of payment. If the same generalized optional form of payment was not available under the pre-conversion plan, the comparison is made by assuming that the pre-conversion plan had such an optional form of benefit. /7/

  • If the benefit attributable to the opening hypothetical account is equal to or greater, the plan will pay that benefit in lieu of the pre-conversion accrued benefits. If the benefit is less, the benefit attributable to the opening hypothetical account must be increased to the extent necessary to provide a benefit that is equal to the benefit accrued under the plan prior to the date of conversion. In either case, the participant will also receive the benefits attributable to post-conversion contributions.

IRS seeks comments on other alternatives that would similarly require the establishment of an opening hypothetical account balance, but not require the subsequent comparison. For example, an alternative limited to situations where the participant elects a single lump sum distribution and the pre-conversion plan did not have a single-sum option (or had an option for a single sum payable only at normal retirement age). In that case, the alternative might provide that the comparison is not necessary if:

  • The opening hypothetical account balance is equal to the present value of the preconversion benefit determined under 417(e),

  • The interest credits on the opening hypothetical account balance are reasonably expected to be no lower than the interest rate used to determine the opening hypothetical account balance, and

  • Either the plan provides a death benefit equal to the hypothetical account balance or no pre-retirement mortality decrement is applied in establishing the opening hypothetical account balance.

Conversion Amendment

The regulations clarify what constitutes a conversion amendment:

  • The determination is made on a participant-by-participant basis.

  • An amendment is a conversion amendment if: (1) it reduces or eliminates benefits that, but for the amendment, the participant would have accrued after the effective date of the amendment under a formula that is not a statutory hybrid benefit formula and under which the participant was accruing prior to the amendment, and (2) after the effective date, all or a portion of the participant's accruals under the plan are determined under a statutory hybrid benefit formula.

  • Only amendments that reduce or eliminate accrued benefits under 411(a)(7) or retirement-type subsidies under 411(d)(6)(B)(i) that would have otherwise accrued as a result of future service are considered.

  • An amendment will occur if a change in the condition of a participant's employment results in such a reduction or elimination of benefits (e.g., a job transfer from an operating division covered by a non-statutory hybrid defined benefit plan to an operating division that is covered by a cash balance formula). /8/

  • Rules apply to prohibit avoidance of the conversion protections through the use of multiple plans and employers. A conversion amendment occurs if a participant's benefits under a non-statutory hybrid plan are coordinated with a separate plan that is a statutory hybrid plan (e.g., through offset). If a participant's employer changes through merger or acquisition, the two employers are treated as one for this purpose.

  • Multiple amendments can result in a conversion amendment, even if the amendments individually would not. If an amendment to provide a benefit under a statutory hybrid benefit formula is adopted within 3 years after an amendment to reduce non-statutory hybrid benefit formula benefits, the amendments are consolidated in determining whether a conversion has occurred. /9/

/1/ The effective date for collectively bargained plans which were ratified by August 17, 2006, the date of enactment of PPA, is the plan year beginning on the earlier of (1) the later of the termination of the collective bargaining agreement or January 1, 2008, or (2) January 1, 2010.

/2/ The statutory effective date for 411(a)(13) is generally August 17, 2006. However, for plans in existence on June 29, 2005, the 3-year vesting requirement of 411(a)(13)(B) does not become effective until the plan year beginning on or after January 1, 2008 (or, if later, the effective date that applies to collectively bargained plans under PPA). Note, bills currently before the House and Senate would further limit the application of the 3-year vesting requirement to only those participants who have an hour of service after the applicable effective date. In the case of a plan other than one which was in existence on June 29, 2005 (or which was a collectively bargained plan ratified by August 17, 2006), the 3-year vesting requirement would apply to periods beginning on or after June 29, 2005. The statutory effective date for 411(b)(5) is generally June 29, 2005. However, for plans in existence on June 29, 2005, the market rate of return requirement of 411(b)(5)(B) does not become effective until the plan year beginning on or after January 1, 2008 (or, if later, the effective date that applies to collectively bargained plans under PPA).

/3/ For this purpose, the accumulated benefit may be expressed under the plan as either the balance of a hypothetical account or the current value of an accumulated percentage of the participant's final average compensation if the plan defines the participant's accrued benefit as an annuity beginning at normal retirement age that is actuarially equivalent to that balance or value.

/4/ Where the benefit is payable as an annuity, the comparison of benefits is made using such annuity. Where the benefit is payable as the balance of a hypothetical account or as the current value of an accumulated percentage of the participant's final average compensation, the comparison is made using the balance of the hypothetical account or the current value of the accumulated percentage of the participant's final average compensation, respectively.

/5/ For this purpose, a similarly situated younger participant is treated as having an accumulated benefit of zero with regard to the benefit formula that does not apply to the participant. Therefore, the safe harbor is available if an older participant is entitled to benefits under more than one type of formula even if not all those types of formulas are available to every similarly situated younger participant.

/6/ The 3rd segment bond rate is permitted to be determined with or without regard to the transition rules of 430(h)(2)(G).

/7/ For example, if the pre-conversion plan did not provide for single-sum distributions, the present value of the preconversion accrued benefit would be determined in accordance with 417(e) and would serve as the basis for comparison.

/8/ Note that in this case, in the absence of coordination between the formulas, the special requirements for conversion will typically be satisfied automatically.

/9/ If adopted more than 3 years after, the presumption is that they are not consolidated unless the facts and circumstances indicate that a statutory hybrid benefit was intended at the time of the reduction in the non-statutory hybrid benefit formula.


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 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, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2008, Deloitte.


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