Final Average Salary

[Guest Richard Scheer]

A Plan with a Final Average Pay formula defines average compensation as the highest 5 consecutive years within the last 10.

A Participant has the following salaries during the last 10 years:

2000 50,000

1999 45,000

1998 0

1997 0

1996 40,000

1995 35,000

1994 35,000

1993 0

1992 0

1991 30,000

What would you use for the average compensation?

Would it be 1994 - 1998? $74,000 / 5 = 14,800?

Or do you have to recognize that there are years where no salary was earned?

Any sites would be appreciated.

Thanks in advance for any help.

[FAPInJax]

I would ignore the zero salaries and use the most recent 5 year average.

[david rigby]

I would read the plan. If it does not provide answer the question, I would look for precedent. For example, the plan might state (or imply) that the last 10 years are years in which the participant earned a "year of service". If so, then the zero years would (probably) be thrown out anyway. If not, then prior examples might help. If that does not work, then the plan sponsor could make an "administrative interpretation" or a plan amendment.

[Guest Richard Scheer]

In the past, the benefits have always been caluclated using five consecutive years, even if there were zeros in those years and dividing by 5.

A participant has gone to a lawyer who says that average salary cannot include zeros in the averaging period. The lawyer has quoted an IRS agent who agrees with him, but has not given us a site to confirm this.

The lawyer says that we should be using only consecutive years without zeros. Therefore, either a three year average or a teo year average.

Does this seem right to you?

[MGB]

Many years ago, I worked on the REA/DEFRA amendments for a prototype plan. The LRM language stated to use five years. We were administering it as dropping out the zero years and bridging the full years (still use five years in the average). I tried to change the language in the prototype to stated exactly what we were doing. I fought the IRS reviewers literally for months and lost. They demanded the exact language from the LRM. We felt we had the authority to continue on using our bridging method through an administrative interpretation because the IRS's language was not what was intended.

In an individually designed plan, this language should be much clearer.

There is nothing in the law to my knowledge that would preclude you from using zeros in the average, if that is what the clear language of the document says to do. (I am willing to bet that the "lawyer" cited can not find a reference for the opinion.)

However, note that because the average is not very high by doing that, you must go back and compute an accrued benefit in earlier years and make sure that the final calculation is not less than that.

[david rigby]

I agree. Another point to note is that the zero might be the result of a termination of employment, followed by a rehire. In that case, it should be obvious that the intent of "high 5 out of last 10" refers to years in which the participant actually worked.

Unless there is precedent to prevent it, seems likely that the purpose of the plan is to exclude the zero years. This probably means you go back further to identify the last 10. Probably not a problem to amend the plan to clarify.

[Guest Harry O]

MGB -

Why is it necessary to make sure the accrued benefit did not decrease in ANY prior year? My understanding is that an accrued benefit may decrease on account of decreases in compensation. A notable exception is that the normal retirement benefit can not be less than the dollar amount of any available early retirement benefit. Is there a general rule I am not aware of that would protect the accrued benefit of a 30-year old whose salary decreases significantly at age 31?

[Guest Richard Scheer]

It is my understanding that an accrued benefit can not decrease. So the accrued benefit for the 31 year old can not be less than his accrued benefit at any prior year (based on his average salaty and years of service at that time). Generally, even if there are salary decreases in the future, the extra years of service should provide for a higher benefit.

[david rigby]

I agree with Harry O comment. An accrued benefit can decrease if it is due to a decrease in compensation. The mindset of "accrued benefit cannot go down" is an oversimplification of IRC 411(d)(6). This states that a plan amendment cannot decrease an accrued benefit.

[RCK]

I agree with Harry O also. It is not unusual for a plan with a service cap and an integrated formula to result in an accrued benefit that decreases due to an increase in the covered comp level (the breakpoint in the benefit formula). And for a plan that includes bonus in the definition of recognized compensation it is common for final average pay to decrease, occasionally by significant amounts.

[MGB]

If we assume this person had a bona fide separation from service when one of these zero years occurred, there would have been a deferred vested benefit calculated at that time.

From the previous discussion, are people saying that the amount they had coming can now decrease as the result of returning to work? That doesn't seem right.

[FAPInJax]

I was under the impression that the accrued benefit could not be reduced IF the reason for the reduction was SOLELY due to an increase in covered compensation. (I can not find the cite offhand)

[Guest Doug Goelz]

Consider Treas Reg 1.401(a)-7© and example 4 of -7©(6). To me, this implies that a participant's AB deferred to NRA is not protected from decreasing due to a decrease in final average earnings. If you ignore the early retirement provisions and apply the benefit formula at each of the ages in that example, the AB deferred to 65 decreases each year from the age 60 value. If the AB deferred to 65 was protected, the example should have shown an annual benefit of $15,000 at 65 (the age 60 value).

Notwithstanding the above, I have seen some documents which were written to prevent such a decrease. Therefore, like most issues, review the document carefully.

As far as the covered compensation query, consider Treas Reg 1.401(l)-1(B) and Code Sect 401(a)(15). I was always under the impression a participant's AB could not decrease due to increasing covered compensation. However, 401(a)(15) seems to only mention those participants in payment status and those terminated with a deferred vested benefit. Were the 1991 regs more explicit regarding actives (I don't have a copy)?