OK to Have Different Accrual Rules for First and Last Years?

[Übernerd]

This came up during d-letter review of a DB plan. Plan A requires 1,000 hours of service for a full year of credited service in all years except the participant's first and last years of participation. For those two years, Plan A requires 2,000 hours for a full year of credited service and credits partial years for anything less than that. Anything wrong with having such different rules for the first and last years?

• 2,000 hours (by itself) is fine as a minimum--the regs say so. § 2530.204-2. I can't find any guidance that says you can't use a different threshold for the first and last years.

• I don't think this constitutes an impermissible "last day" requirement for the first and last years because the participant need not be employed on any particular day, provided he/she gets 2,000 hours. § 2530.200b-1(b).

• I don't see a backloading issue--the plan uses a vanilla fixed-percentage-of-comp formula, so unless the "different rules for different years" is itself impermissible, it clearly passes the 133 1/3% test.

Nonetheless, IRS is claiming the first and last year's rules are impermissible, simply because in an other plan year a participant with 1,000 hours would get a full year. Any thoughts appreciated.

[My 2 cents]

Working on defined benefit plans, I have seen plans that provide prorata credit (proportional to 1,000 hours) for the first or last year of service, and I have seen plans that provide credit for every year (including the first and last year of service) if an only if there are 1,000 hours in the year, and I have seen plans that tie benefit accruals to a benchmark higher than 1,000 hours in a year, but I don't think I have seen any plans that require more than 1,000 hours for the first or last year but give full credit for 1,000 hours for the intervening years.

As this is disadvantageous to the participants, why does the sponsor want to do this? Examine the driving motives in light of the IRS objections.

Side note: If the plan grants partial service credit, I think that earnings must be annualized if partial credit is being given. Example: Earns $25,000 in a year with a 2,000 hours = 1 full year's accrual rule but the person only worked 1,250 hours. While you can use a service credit of 0.625 year, the formula must be applied against an annualized earnings of $40,000 (=$25,000 X 2,000 / 1,250) to keep from there being a double reduction.

[Übernerd]

Working on defined benefit plans, I have seen plans that provide prorata credit (proportional to 1,000 hours) for the first or last year of service, and I have seen plans that provide credit for every year (including the first and last year of service) if an only if there are 1,000 hours in the year, and I have seen plans that tie benefit accruals to a benchmark higher than 1,000 hours in a year, but I don't think I have seen any plans that require more than 1,000 hours for the first or last year but give full credit for 1,000 hours for the intervening years.

As this is disadvantageous to the participants, why does the sponsor want to do this? Examine the driving motives in light of the IRS objections.

Side note: If the plan grants partial service credit, I think that earnings must be annualized if partial credit is being given. Example: Earns $25,000 in a year with a 2,000 hours = 1 full year's accrual rule but the person only worked 1,250 hours. While you can use a service credit of 0.625 year, the formula must be applied against an annualized earnings of $40,000 (=$25,000 X 2,000 / 1,250) to keep from there being a double reduction.

I've never seen this system before, either. The plan language is quite old, and nobody at the sponsor recalls why it was drafted that way. They've simply been applying it written, for decades. There's no motivation whatsoever to disadvantage participants, but the problem with changing the rules retroactively (as has been requested) is that this would immediately generate a considerable amount of additional benefits for hundreds of retirees, along with an administrative nightmare tracking down former participants who received lump sums.

I agree with your side-note regarding double proration--we're already on top of that.

[Effen]

Seems to me the IRS might have a problem because this might violate the accrual rules in year 2. If a participant always worked 1000 hours, their accrual in year 1 would be 50% of their accrual in year 2. This seems like it would violate the 133% rule.

I would ask the agent for the specific provision that is being violated. If he really just "thinks" its wrong, he may back off.

It does seem like a very odd provision, and a bit unfair based on the way the other years are handled.

[Übernerd]

Seems to me the IRS might have a problem because this might violate the accrual rules in year 2. If a participant always worked 1000 hours, their accrual in year 1 would be 50% of their accrual in year 2. This seems like it would violate the 133% rule.

I would ask the agent for the specific provision that is being violated. If he really just "thinks" its wrong, he may back off.

It does seem like a very odd provision, and a bit unfair based on the way the other years are handled.

My understanding of the 133 1/3% rule is that it measures the rate of accrual (determined in this case by the percentage of compensation taken into account), not the dollar amount of the accrual for the year.

We have asked for specific provisions, but the agent isn't providing them. Instead we are being asked to "prove" that we satisfy the rules.

No argument from me that it's an odd rule! I'm just not convinced it's illegal.

[Effen]

Correct. The rate of accrual in year 2 would be 2X the year 1 rate, assuming 1000 hours worked in both.

Sometimes it is just easier to give them what they want instead of fighting with them. Run an accrual test and see if it passes. If it does, give them the test, if it doesn't, then they were right and you will need to change the formula.

[david rigby]

Just speculation: perhaps this accrual pattern was first created at a time when the plan (either thru plan definition or thru administration) used pay rate (i.e., annualized) in its calculation of average pay, rather than one of the many versions of actual pay.

Even if this is not a violation of the accrual rules (and we don't have enough information to know), it would be simplest to recognize Effen's advice: "give them what they want", especially since it's pretty difficult to justify this definition to plan participants.

For the question of retroactive application, you may want to be aggressive on this: change the plan and make it clear that is prospective. But be prepared to have the IRS insist it be retroactive to some date (such as the most recent restatement date). If the original poster does not have an ERISA attorney involved, I can recommend several.

[Übernerd]

Just speculation: perhaps this accrual pattern was first created at a time when the plan (either thru plan definition or thru administration) used pay rate (i.e., annualized) in its calculation of average pay, rather than one of the many versions of actual pay.

Even if this is not a violation of the accrual rules (and we don't have enough information to know), it would be simplest to recognize Effen's advice: "give them what they want", especially since it's pretty difficult to justify this definition to plan participants.

For the question of retroactive application, you may want to be aggressive on this: change the plan and make it clear that is prospective. But be prepared to have the IRS insist it be retroactive to some date (such as the most recent restatement date). If the original poster does not have an ERISA attorney involved, I can recommend several.

Interesting speculation about the origins of the odd provision, thanks.

We generally do advise giving the agents what they want, and there is no objection at all to changing the rule prospectively, but in this case the price tag for retroactive application is well into seven figures. No reason to go near that mess if the provision is, in fact, permissible.