Decrease in accrued benefit due to decrease in compensation?

[Guest Carly]

It is my understanding that it is perfectly permissible for a participant's accrued benefit to decrease due to a decrease in the participant's compensation. Is this correct? I base this on the fact that under Code Section 411(d)(6), benefits are protected from reduction due to a plan amendment. There is nothing that prohibits a reduction due to simple operation of the plan (i.e. participant's compensation reducing). Is my understanding correct? Does anybody know of any IRS literature that explains this or any other literature anywhere (commentators, articles, etc.)? Any insight will be greatly appreciated.

Thank you!!

[Blinky the 3-eyed Fish]

Could you provide the specifics as to how the decrease occurred?

[Guest Carly]

For example, say a plan uses a definition of final average compensation that determines a participant's retirement benefit on the 5 high years of compensation in the last 10 consecutive years that ends in the year of termination. Say that in year 15, FAC is $50K, but in year 20, FAC is $45. Arguably this participant's accrued benefit may decrease due to the decrease in FAC.

[Everett Moreland]

See 1.411(a)-7© in general, 1.411(a)-7©(5) and 1.411(a)-7©(6) Ex. (4) in particular, and 411(b)(1)(G).

See IRS Q&A from 2001 ASPA Annual Conference:

"21. DB plan provides benefit of 3% of average annual compensation (AAC) times years of service. AAC is defined in the plan as highest 3 consecutive years of last 10 years of service. Employee goes part time and AAC goes down in such a manner that accrued benefit decreases. This does not seem to be prohibited under 411(d)(6) since an amendment did not cause the decrease. Is this correct?

"No. This is prohibited under 411(b)(1)(G)."

[david rigby]

From Gray Book, 2003-33

Other DB Issues: Reduction in Accrued Benefit

A plan defines average compensation as the average pay during the last 5 (not highest 5 of last n) years of employment.

a) If the participant took a pay cut such that his last 5-year average is less than such average determined in previous years, would it be permissible to reduce the accrued benefit solely on account of such pay cut?

b) Does it matter whether the lower accrued benefit occurred while the employee was eligible to retire early since, as evidenced by Example 4 in Reg. 1.411(a)-7©(6), a less restrictive rule applies -- a participant’s normal retirement benefit may not be less than the greatest annual benefit the participant would have been entitled to receive at any earlier age?

RESPONSE

a) No, the accrued benefit may not be reduced.

b) No, it doesn’t matter.

Copyright © 2003, Enrolled Actuaries Meeting

All rights reserved by Enrolled Actuaries Meeting. Permission is granted to print or otherwise reproduce a limited number of copies of the material on the diskette for personal, internal, classroom, or other instructional use, on the condition that the foregoing copyright notice is used so as to give reasonable notice of the copyright of the Enrolled Actuaries Meeting. This consent for free limited copying without prior consent of the Enrolled Actuaries Meeting does not extend to making copies for general distribution, for advertising or promotional purposes, for inclusion in new collective works, or for sale or resale.

Many practioners do not agree with the IRS in this regard. As Carly notes, 411(d)(6) cannot be used to support the IRS position. I don't know if 411(b)(1)(G) supports it; further study of that subsection (and its history) may be needed.

[Guest Carly]

Does anybody know where I can find the exerpt from the "Gray Book"? Is this a publication for actuaries?

Thank you for the information!

[Belgarath]

This is very interesting. I don't have any answers, although a literal reading of 411(b)(1)(G) does not, to me, support the position that the IRS appears to be taking. I wouldn't say that the reduction described is "on account of" any increase in age or service. It's on account of a decrease in pay.

Do you interpret the IRS position to be that you'd compare the highest accrued benefit under the "old" high average salary with the benefit calculated under the "new" high average salary, and you'd get the higher of the two? Or are they saying that you'd apply the highest average salary to all years of service? I'd think the former...

[david rigby]

Not sure what you mean by "excerpt". The Q&A printed above is complete as is.

Are you asking for access to the entire GrayBook? It is not available. I paid for my copy (OK, my employer paid for it).

Belgarath,

I agree with you, but I do not want to speculate which interpretation the IRS might be using.

[mbozek]

There is a case where union employees who participated in a final 5 average pay plan went out on strike for a year or because of a labor dispute. At the end of the strike some employees retired. Under the plan formula they receive a lower benefit then the benefit accrued prior to the beginning of the strike. The employees sued under ERISA for a violation of the cutback rule. The court found for the plan on the grounds that the reduction in benefits was due to the plan formula, not an amendment to the plan.

The IRS answer to Q 21 in 2001 ASPA conference is correct but not for the reason stated. The reduction would not be permitted if it would violate the terms of the plan. E.g., If the employee 3yr average comp goes down during the 10 yrs period before retirement because of part time employment the accrued benefit will still be based on the the highest salary earned during any 3 year period within the last 10 years because the plan formula does not allow for the reduced salary to be substituted for the highest 3 yr salary, not because it would be a reduction on account of age or service. After 10 yrs of part time service the accrued benefit could be reduced because it would be the result of the calculation of the benefit under the plan, not a cutback. Q 33 in the 2003 ASPA confrence is inconsistent with case law interpretion by the courts.

Its also common knowledge that the IRS does not enforce example 4 because it would prevent qualified plans from offering an increased early retirement benefit for employees who voluntarily retire during a window period after which the extra benefit will be eliminated.

[Guest Carly]

You don't happen to know the name of the case (or the time frame for its publication)? I have tried to find it, but have been unsuccessful?

Thanks

[mbozek]

Thats because it was decided as a claim for a reduction in vested benefits under ERISA 203(a) -Edwards v Wilkes-Barre Publishing, 757 F2d 52. By the way what is your interest in this issue.

[Guest Carly]

Thanks, that is actually the case I pulled. I have been asked to determine whether a participant's benefit may decrease due to going part-time. We do not want this to happen and want to make certain that it doesn't. I think what we will do is amend the plan to include language to specifically prohibit it, utilize a different definition of compensation or something. We are trying to figure it out. We have thought about amending the definition of compensation to "annualize" compensation in cases where an individual works less than 2000 hours to boost such person's comp up to where it would have been had he/she worked full time. His benefit will still not be as much as if he would've actually worked, due to the pro-rating of credited service. Thoughts?

[JanetM]

Couldn't you just amend to use the highest three year average during last 10 year period? That would keep the highest comp and not consider the part time years.

We actually use the average of the highest three during the last five for one of our plans. The years don't have to be consecutive.

[Guest Steve C]

...or add a provision that explicitly protects the accrued benefit from reduction (a ratchet effect).

By the way, while we're on this topic, note that the IRS does allow special treatment for a floor offset plan. I raised the question at the end of the "Dialogue with Treasury/IRS" session at the 2003 EA meeting. Instead of preserving the net benefit (after offset), it is the gross benefit that should be protected if compensation decreases. As a result, the net accrued benefit from the DB plan can go down.

[JanetM]

AndyH,

The plan only covers union non HCE. But now that I go back and look it is consecutive years.

[david rigby]

The comp years being averaged must be consecutive if the plan is to be a safe harbor plan.

This is part of the 401(L) safe harbor. Is it part of the 401(a)(4) safe harbor?