Guest Article

(From the February 11, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Guidance on Applying Backloading Rules to "Greater Of" Formulas

The IRS has issued Revenue Ruling 2008-7 to explain its position on applying the antibackloading rules to certain cash balance conversions and to provide limited relief for plan years beginning before January 1, 2009. Some plans will need to be retroactively amended to take advantage of this relief.

Following is a summary of Rev. Rul. 2008-7 and the relief it provides. As noted, the relief is limited and is very fact-specific. Those interested in taking advantage of the relief should consult the terms of the revenue ruling for guidance on eligibility and the scope of the relief. The revenue ruling can be downloaded from the IRS's Web site at www.irs.gov/pub/irsdrop/rr-08-07.pdf.

Anti-Backloading Rules and "Greater of" Formulas

Basically, the question is whether cash balance plans that offer certain participants the "greater of" the benefit provided by the cash balance formula or a traditional pension formula satisfy the IRC § 411(b) accrual requirements. The analysis begins with Treas. Reg. § 1.411(b)-1(a)(1), which provides:

The "alternative methods" are the 3 percent method, the 133 1/3 percent method, and the fractional method. These methods are used to determine if a defined benefit plan satisfies the IRC § 411(b) benefit accrual requirements, which are designed to prevent plans from concentrating -- or "backloading" -- benefit accruals at the end of participants' careers. The benefit accrual rules are intended to preclude plan designs that circumvent the minimum vesting requirements.

When converting traditional defined benefit formulas to cash balance formulas, some employers have used certain techniques to minimize or prevent any adverse effect on existing employees. One technique guarantees a class of workers will receive a benefit equal to the "greater of" the cash balance formula or a traditional defined benefit formula for a specified period of time. Clearly, this technique is intended to protect employees. However, the IRS takes the position that the "greater of" approach can result in the plan being impermissibly backloaded because the pre- and post-conversion formulas must be aggregated for testing purposes.

Rev. Rul. 2008-7: Relief Provided

The revenue ruling provides relief to plans with "greater of" formulas for plan years beginning before January 1, 2009. Specifically, the IRS will not treat an eligible plan using the "greater of" approach as impermissibly backloaded for plan years beginning before January 1, 2009 if each of the formulas, standing alone, would satisfy one of the three testing methods. A plan is eligible for this relief only if either:

Additionally, a plan described in (2) above can be retroactively amended to qualify for this relief, if necessary.

Note that this relief is available only with respect to the anti-backloading rules, and does not extend to other issues under IRC § 411.

Rev. Rul. 2008-7: Facts

The revenue ruling illustrates the IRS's position using a situation in which a final average pay plan was converted to a cash balance plan effective for plan years beginning on or after January 1, 2002. An opening hypothetical account balance equal to the actuarial present value of the participant's accrued benefit determined as of December 31, 2001 was established for participants who were employees on that date. However, the conversion amendment also established special transition rules for determining certain participants' accrued benefits.

Rev. Rul. 2008-7: Analysis

As noted, in order to pass the anti-backloading rules each participant's accrued benefit must satisfy the 3 percent method, the 133 1/3 percent rule, or the fractional rule. The revenue ruling reiterates the IRS's position that all formulas applicable to a participant must be aggregated for purposes of applying any of these three methods. Thus, even if each of the pre- and postconversion formulas standing alone would satisfy at least one of these methods, "the total benefit provided by the interaction of the two formulas must accrue in a manner that satisfies at least one of the three alternative methods."

However, the revenue ruling also points out a plan can use different alternative methods for different categories of participants so long as the "different classification of participants is not so structured as to evade" the anti-backloading rules. According to the revenue ruling, "this determination of whether the different classification of participants is not so structured as to evade the accrued benefit requirements is made with consideration of which classification of participants is satisfying which of the three accrual rules. Another consideration in this determination is whether the assignment of a participant to a classification will change merely because of the passage of time."

The plan cannot satisfy the 3 percent method either before or after the conversion because benefits accrue over a period longer than 33 1/3 years. As a result, only the 133? percent rule and the fractional rule are relevant to this situation.

The revenue ruling begins its analysis by applying the 133 1/3 percent rule separately to New Participants, Non-grandfathered Participants, and Grandfathered Participants. New Participants are not a problem because they accrue benefits only under the post-conversion formula, which for 2002 satisfies the 133 1/3 percent rule. Additionally, the aggregated pre- and post-conversion formula satisfies the 133 1/3 percent rule with respect to Non-grandfathered Participants because they do not continue to accrue benefits under the pre-conversion formula for service on or after January 1, 2002.

Unfortunately, the aggregated pre- and post-conversion formula does not satisfy the 133 1/3 percent rule with respect to a subgroup of Grandfathered Participants for 2002. Specifically, the problem is with Grandfathered Participants who are at least 50 years old but not yet 55 years old on January 1, 2002. These Grandfathered Participants will continue accruing benefits under the pre-conversion formula for the first four years following the conversion because that formula will produce the larger accruals. Accruals under the pre-conversion formula will end after the fourth year, and the result will be a subsequent period of zero accruals as the accrued benefit under the post-conversion formula catches up to the accrued benefit under the post-conversion formula (i.e., a wearaway period). This wearaway period will end before these participants reach normal retirement age. In at least some cases, the positive accruals under the post-conversion formula during this period will be more than 133 1/3 percent of zero -- the rate of accrual during the wearaway period.

However, the revenue ruling goes on to show that the fractional rule is satisfied with respect to this subgroup of Grandfathered Participants for 2002. Because the revenue ruling concludes this subgroup is not a classification set up to evade the anti-backloading rules, it holds the plan can use the fractional rule for this subgroup and the 133 1/3 percent rule for all other participants to demonstrate compliance. Thus, the plan is not impermissibly backloaded for 2002. Unfortunately, as the revenue ruling points out, there is no guarantee the plan will continue to satisfy the accrual rules in future years.

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, 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.