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CCH® PENSION — 10/27/10

IRS Finalizes Hybrid Plan Regulations And Proposes Additional Clarifying Regulations

from Spencer’s Benefits Reports: The Internal Revenue Service has finalized Reg. Secs. 1.411(a)(13)-1 and 1.411(b)(5)-1 concerning hybrid plans such as cash balance plans and has issued proposed regulations to cover topics that are not addressed in the final regulations. Both sets of regulations appeared in the October 19 Federal Register.

The proposed regulations were issued on Dec. 28, 2007, to implement provisions of the Pension Protection Act of 2006 (PPA).

Background

A defined benefit plan (including a cash balance plan) fails to comply with the accrual requirements of IRC Sec. 411(b) if, under the plan, an employee’s benefit accrual is ceased, or the employee’s rate of benefit accrual is reduced, because of the attainment of any age. However, the PPA generally provides that a plan will not be treated as failing to meet the requirements if a participant’s benefit accrued to date, as determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated, younger individual who is or could be a participant.

IRC Sec. 411(b)(5)(B)(i) provides that a hybrid plan (including a cash balance plan) is treated as failing to meet the requirements of IRC Sec. 411(b)(1)(H) if the terms of the plan provide for an interest credit for any plan year at a rate that is greater than a market rate of return. Second, IRC Secs. 411(b)(5)(B)(ii) and (iii) contain minimum benefit rules that apply if, after June 29, 2005, an amendment is adopted that converts a defined benefit plan into a hybrid plan. In addition, IRC Sec. 411(a)(13)(B) requires a hybrid plan to provide that an employee who has completed at least three years of service has a nonforfeitable right to 100% of the employee’s accrued benefit derived from employer contributions.

Provisions Of The Final Regulations

The final regulations adopt much of what was contained in the proposed regulations. Under the final regulations, the plan can determine the present value of benefits under a lump sum-based benefit formula as the amount of the hypothetical account maintained for the participant or as the current value of the accumulated percentage of the participant’s final average compensation under that formula. IRC Sec. 411(b)(5)(G) provides that any reference to the accrued benefit means the benefit accrued to date. The final regulations refer to this as the “accumulated benefit,” which is distinct from the participant’s accrued benefit under IRC Sec. 411(a)(7). For pension equity plans (PEP), the final regulations clarify that PEP formulas that provide interest credits after the cessation of PEP accruals are permitted as long as they are subject to the market rate of return rules.

The final regulations retain the rule whereby the three-year vesting requirement is limited to plans that contain a statutory hybrid benefit formula and provide an example illustrating this rule with respect to a floor-offset arrangement where the benefit payable under a floor plan that does not include a statutory hybrid benefit formula is reduced by the vested accrued benefit payable under an independent plan that includes a statutory hybrid benefit formula. Several commentators had suggested that the three-year vesting rule apply on a plan-by-plan basis, without regard to whether a plan is part of a floor-offset arrangement, but the regulations were not changed because the offset must be limited to vested amounts under the independent plan.

Age Discrimination Safe Harbor

The final regulations provide that a plan is not treated as failing to meet the requirements of Sec. 411(b)(1)(H)(i) with respect to certain benefit formulas if, as determined as of any date, a participant’s accumulated benefit expressed under one of those formulas would not be less than any similarly situated, younger participant’s accumulated benefit expressed under the same formula. A plan that does not satisfy this test is required to satisfy the general nondiscrimination test of Sec. 411(b)(1)(H)(i). This safe harbor standard would be available only where a participant’s accumulated benefit under the terms of the plan is expressed as an annuity payable at normal retirement age (or current age, if later), the balance of a hypothetical account, or the current value of the accumulated percentage of the employee’s final average compensation.

The sum-of and greater-of benefit provisions are organized differently in the final regulations when they are expressed in two or more different forms of benefit. These provisions “are eligible for the safe harbor even where older participants receive benefits expressed in a different form than the benefits of similarly situated, younger participants, as long as younger participants are not entitled to benefits expressed in a different form than the benefits of similarly situated, older participants.” The final regulations contain a number of new examples to illustrate the safe harbor provisions.

The list of recognized investment index or methodologies required under IRC Sec. 411(b)(5)(E) has been expanded to include any rate of return that satisfies the market rate of return rules in the regulations. Formerly, only an eligible cost-of-living index, the rate of return on the aggregate assets of the plan, or the rate of return on the annuity contract issued by an insurance company for the employee were the only indexes or methodologies that could be used.

The regulations would provide guidance on the plan conversion protections. Under the regulations, a participant whose benefits are affected by a conversion amendment that occurred after June 29, 2005, generally must be provided “with a benefit after the conversion that is at least equal to the sum of the benefits accrued through the date of the conversion and benefits earned after the conversion, with no permitted interaction between these two portions. This would assure participants that there will be no ‘wear-away’ as a result of a conversion, both with respect to the participant’s accrued benefits and any early retirement subsidy to which the participant is entitled based on the preconversion benefits.”

In addition, the regulations would provide an alternative mechanism under which the plan provides for the establishment of an opening hypothetical account balance as part of the conversion and keeps separate track of: (1) the opening hypothetical account balance and interest credits attributable thereto; and (2) the postconversion hypothetical contributions and interest credits attributable thereto. Under this alternative, the plan must provide that, when a participant commences benefits, the plan will determine whether the benefit attributable to the opening hypothetical account payable in the particular optional form of benefit selected is greater than or equal to the benefit accrued under the plan prior to the date of conversion and payable in the same generalized optional form of benefit at the same annuity starting date. If the benefit attributable to the opening hypothetical account balance is greater, then the plan must provide that such benefit is paid in lieu of the preconversion benefit together with the benefit attributable to postconversion contribution credits. If the benefit attributable to the opening hypothetical account balance is less, then the plan must provide that such benefit will be increased sufficiently to provide the preconversion benefit, and the participant also must be entitled to the benefit attributable to postconversion contribution credits.

The effective date of a conversion amendment is, with respect to a participant, the date when the reduction occurs in the benefits that the participant would have accued after the effective date of the amendment under a benefit formula that is not a statutory hybrid benefit formula. The final regulations state that the date on which future benefit accruals are reduced cannot be earlier than the date of the adoption of the conversion amendment.

Market Rate Of Return

The interest crediting rate for determining benefits under a statutory hybrid benefit formula cannot exceed the market rate of return. Excluded from adjustments that may be made to the interest crediting rate are those made as a result of imputed service as well as certain ad hoc, one-time adjustments.

The final regulations clarify that an interest crediting rate is not in excess of a market rate of return if it can never be in excess of a particular rate that meets the market rate of return limitation. For example, “a rate that is a percentage (no greater than 100%) of a particular rate that meets the market rate of return limitation is not in excess of a market rate of return and a rate that is a fixed amount less than a particular rate that meets the market rate of return is also not in excess of a market rate of return.”

The right to interest credits in the future that are not conditioned on future service are considered to be protected benefits under IRC Sec. 411(d)(6), the regulations noted. Consequently, the protected benefit rules must be satisfied if the revised rate could result in interest credits that are smaller than the interest credits that would have been provided if the amendment had not been made.

The final regulations generally apply to plan years that begin on or after Jan. 1, 2011. However, the rules for interest crediting rates and combinations of interest crediting rates apply to plan years that begin on or after Jan. 1, 2012.

Proposed Regulations

Prop. Reg. Sec. 1.411(a)(13)-1 provides some relief from the requirement that benefit formulas be lump sum based. In addition to a single sum benefit formula, payments that are the actuarial equivalent of the single sum benefit are permissible, such as an immediate annuity.

The conversion protection requirements under IRC Sec. 411(b)(5) have been addressed in the proposed regulations so that an opening hypothetical account balance can be established without a subsequent comparison of benefits at the annuity starting date. “While testing at the annuity starting date would not be required under this method, a number of requirements…would need to be satisfied in order to ensure that the hypothetical account balance used to replicate the pre-conversion benefit…is reasonably expected in most, but not necessarily all, cases to provide a benefit at least as large as the preconversion benefit for all periods after the conversion amendment.”

The proposed regulations would permit the use of an interest credit that is determined in reference to a rate of return on a regulated investment company (RIC) as long as the RIC rate of return is not significantly more volatile than the broad U.S. equities market or a similarly broad international equities market. For example, a RIC that has most of its assets invested in an “industry sector or country other than the United States, that uses leverage, or that has significant investment in derivative financial products, for the purpose of achieving returns that amplify the returns of an unleveraged investment, generally would not meet this requirement.”

Prop. Reg. Sec. 1.411(b)(5)-1(d)(4)(iv) specifies that a 5% fixed annual interest crediting rate does not violate the rule that such a rate cannot exceed future market rates of interest. “Any higher fixed rate would result in an effective rate of return that is in excess of a market rate of return.”

Comments on the proposed regulations are due by Jan. 12, 2011. A public hearing is scheduled to be held on Jan. 26, 2011. Written comments can be sent to CC:PA:LPD:PR (REG-132554-08), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044, or via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-132554-08).

For more information, contact Neil S. Sandhu, Lauson C. Green, or Linda S. F. Marshal at (202) 622-6090.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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