Minimal Accrual Rate tests on a pension equity plan (PEP)

[Guest CuriousEmployee]

A pension equity plan (PEP) provides annual percentage accruals according to the following schedule: Age < 30 (4%); Age 30-34 (5%); 35-39 (7%); 40-44 (10%); 45-49 (13%); 50-54 (16%); >=55 (18%).

Accrued Benefit is the sum of these percentages over all all years of service, times highest 3 year average compensation, converted to an annuity at Age 65.

Question: How does such a plan meet one of the 3 tests of minimal benefit accrual rate required of all DB plans? It seems to me that it fails the 3% rule on its face because the Age 65 benefit can be based on >33-1/3 years of service (and percentage accruals). It seems to fail the 133-1/3% test because accruals vary from 4% to 18%, so for example, 18% > 133% of 4%. It seems to fail the fractional rule test because it backloads the accrual so that initially the accrued benefit is less than the fractional method.

What am I failing to understand? (layperson speaking here) How does such a plan meet one of the tests?

I'd very much appreciate your suggestions!

[Andy the Actuary]

411(b)(1)(A) states (Notice 2008-7):

Section 411(b)(1)(A) provides that a defined benefit plan satisfies the requirements of the 3% method if, under the plan, the accrued benefit payable upon the participant’s separation from service is not less than (A) 3% of the normal retirement benefit to which the participant would be entitled if the participant commenced participation at the earliest possible entry age under the plan and served continuously until the earlier of age 65 and the normal retirement age under the plan, multiplied by (B) the number of years (not in excess of 33 1/3 years) of his or her participation in the plan.

[Guest CuriousEmployee]

Right. And by definition, then, wouldn't the plan fail the 3% rule because the plan accrues benefits longer than 33-1/3 years and thus you can end up with a factor grater than 100%, which is prohibited? i.e., an employee who started at Age 20 and worked until 65 would have 45 years of service. 3% x 45 = 135%. That is not allowed, right? (26 USC section 1054 (b)(1)(A)(ii) sets a 33-1/3 year limit for number of years of participation that can be counted, I believe; I'm referring also to IRS technical continuing education coursework from 2002, which used examples of cash balance plans with accrual for more than 33-1/3 years and the failed on this basis).

What am I missing? Please get back to me on this, as I want to learn. Thanks!

[Hojo]

Right. And by definition, then, wouldn't the plan fail the 3% rule because the plan accrues benefits longer than 33-1/3 years and thus you can end up with a factor grater than 100%, which is prohibited? i.e., an employee who started at Age 20 and worked until 65 would have 45 years of service. 3% x 45 = 135%. That is not allowed, right? (26 USC section 1054 (b)(1)(A)(ii) sets a 33-1/3 year limit for number of years of participation that can be counted, I believe; I'm referring also to IRS technical continuing education coursework from 2002, which used examples of cash balance plans with accrual for more than 33-1/3 years and the failed on this basis).

What am I missing? Please get back to me on this, as I want to learn. Thanks!

You're thinking too much. The 33 1/3 is the limit for the test, not the limit on the actual accrual.

[Guest CuriousEmployee]

But if the plan allows accrual for more than 33-1/3 years, isn't it going to fail the test? Please see the following:

www.irs.gov/pub/irs-tege/epch1702/pdf

On p.17-16 is Example 3. At the bottom of Example 3 (p. 17-17) is says, "Also, note that in this example, it takes more than 33-1/3 years for a participant to be fully accrued in the Plan's NRB. That, in itself, would cause the Plan to violate the 3% rule."

In any case, let's assume by coincidence the employee worked only 33-1/3 years ending at Age 55. Total accrual (as a % of average pay) would be: (8-1/3 * 4%) + 5*5% + 5*7% + 5*10% + 5*13% + 5*16% = 288.3%. In the first year the accrual would have been 4%. 4%/288.3% is 1.4%. 1.4% is less than 3% and thus the accrual in the first year is less than the required 3% minimum. (One could do the same thing for an employment ending exactly at Age 65, and get the same failure to meet minimum accrual rate rules, without getting sidetracked into other issues related to early retirement, which I ignored here).

Again, what am I missing? Thanks!

[david rigby]

A pension equity plan (PEP) provides annual percentage accruals according to the following schedule: Age < 30 (4%); Age 30-34 (5%); 35-39 (7%); 40-44 (10%); 45-49 (13%); 50-54 (16%); >=55 (18%).

Accrued Benefit is the sum of these percentages over all all years of service, times highest 3 year average compensation, converted to an annuity at Age 65.

Please clarify what you mean by "converted to an annuity". (I have a hunch, but it's not relevant, only your explanation.)

[Guest CuriousEmployee]

David,

More specifically, the product of the accrued percentages and the HC3A gives a total account balance (but this is not a cash balance plan, and there is no lump sum distribution provision). This account balance is then converted to a stream of monthly payments (what I called an annuity) by dividing it by a Benefit Conversion Factor. The BCF is a factor "used to convert the amount...to a Life Only Annuity, determined at the time of benefit commencement." The factor increases with earlier retirement, reflecting the longer period of benefit payments. For example, it is 11.4 at a benefit commencement age of 50, 10.8 at 55, 10.1 at 60 and 9.2 for Age 65 or above.

[Guest CuriousEmployee]

Everybody, maybe I'm making an elementary mistake. I was just reading some proceedings from an actuary's conference that makes me ask: Am I mistaken and just using the percentage accrual for a given year as the Age 65 benefit accrual? Should I first be multiplying it by an actuarial factor to get each year's Age 65 benefit accrual? i.e., so that early years would be multiplied by a large factor, and later years by a small factor. If this were done, I could see how the PEP could lead to a more uniform Age 65 benefit accrual. (Still not sure how it passes the 3% rule given the > 33-1/3 year accrual period; maybe someone can explain that too).

I'd appreciate a comment on whether I'm committing a fundamental error here. Thanks!