Recently proposed IRS regulations provide a framework for cash balance plans to satisfy age discrimination laws prohibiting the reduction of the rate of an employee’s benefit accrual under a pension plan on account of the attainment of any age. These laws include Section 411(b)(1)(H) of the Internal Revenue Code of 1986 (the Code), Section 204(b)(1)(H) of the Employee Retirement Income Security Act of 1974 (ERISA) and Section 4(i)(1) of the Age Discrimination in Employment Act (ADEA), collectively referred to as the applicable provisions. The regulations, which are anticipated to become effective for plan years beginning on and after January 1, 2004, also address nondiscrimination testing and conversion issues for cash balance plans. If finalized as currently proposed, the proposed regulations will require businesses to amend most cash balance plans.
The General Rule
Under the general rule, which will apply unless a plan qualifies as an eligible cash balance plan, a participant’s rate of benefit accrual under a defined benefit plan for any plan year ending before normal retirement age is the excess of the participant’s accrued normal retirement benefit at the end of the plan year over the participant’s accrued normal retirement benefit at the end of the preceding plan year. Because cash balance plans are generally required to be front-loaded, i.e., the future stream of interest credits associated with each year’s pay credits is treated as accruing in the year of the pay credit rather than in each plan year as actually credited, the application of this general rule prevents most cash balance plans from complying with the fundamental rule. For example, assume two employees, ages 30 and 60, each earn $50,000 per year and are covered under a cash balance plan that provides a pay credit of 10 percent and specifies age 65 as the normal retirement age. In determining the 30-year-old participant’s benefit accrual for the plan year, the $5,000 pay credit will receive 35 years of interest credits while the 60-year-old participant’s identical pay credit will receive only five years of interest credits. Thus, the value of each year’s accrual as a percentage of pay will decrease as the participant approaches normal retirement age in violation of the fundamental rule regarding age discrimination in qualified plans.
Special Rule for Eligible Cash Balance Plans
Under a special rule, a participant’s rate of benefit accrual for a plan year under an eligible cash balance plan may be determined as the addition to the participant’s hypothetical account for the plan year without regard to interest credits. Using the example cited above, this special rule allows an eligible cash balance plan to calculate both participants’ benefit accrual rates for the year based on the same $5,000 pay credit that each received, regardless of age, and thereby satisfy the applicable provisions.
According to the proposed regulations, an eligible cash balance plan is a defined benefit plan that satisfies the following design requirements: the normal form of benefit is stated as an immediate payment of the balance in the hypothetical account (even if a single sum distribution is not an available form of payment), and the plan is front-loaded with respect to interest credits (that is, the right to future interest credits accrues in the year of the underlying pay credit). In addition, an eligible cash balance plan may not reduce the value of benefit accruals for any plan year by the actuarial equivalent of post-normal retirement age benefit distributions made during or prior to the plan year. This definition does not encompass pension equity plans and, therefore, such plans must be tested under the general rule. It is understood that most pension equity designs will not satisfy the general rule. Changes to the regulations will be required for this particular design to satisfy the applicable provisions.
Special Rule for Plans with Mixed Benefit Formulas
One of the most complicated and troubling aspects of the proposed regulations is a rule applicable to plans with mixed formulas. Mixed benefit formula plans may be separated into three types of plans where the benefit payable to a participant is based on the following:
- the sum of accruals under two different formulas, one of which is an eligible cash balance formula and the other of which is not; a formula which provides a benefit equal to the greater of the benefit determined under two or more formulas, one of which is an eligible cash balance formula and another of which is not
- a formula which provides accruals for some participants only under an eligible cash balance formula and covers the remaining participants under a traditional defined benefit formula
- a combination of a traditional benefit formula or eligible cash balance formula as described above.
In each of these cases, subject to certain significant restrictions, the plan may be bifurcated into two separate plans, one of which is an eligible cash balance plan and the other of which is not. The special rule applicable to eligible cash balance plans is applied in determining the rate of accrual under the cash balance formula, whereas the general benefit accrual rule is applied in determining the rate of accrual under the traditional formula. If the eligible cash balance formula and the traditional defined benefit formula interact in a manner other than as specified above, the plan is not treated as an eligible cash plan for any portion of the formula.
Significantly, the rule allowing bifurcation of the benefit formulas applies only if each "deemed" plan can satisfy the requirement of Code Section 410(a)(2) that no participant is excluded from participation on the basis of having attained a specified age. For example, a plan would not satisfy the requirements of Code Section 410(a)(2) with respect to the cash balance portion of a plan if it kept participants who were age 55 or older (or any other specific age) in the traditional defined benefit formula and limited participation in the cash balance formula to newly hired employees and participants who were younger than age 55 (or any other specific age) at the time of the cash balance conversion. This is because participants who attained age 55 would be excluded from participation under the cash balance formula.
Similar problems may arise where eligibility for a grandfathered or transition formula is dependent upon attainment of a specified age, for example, where participants who attained a specified age on the date of the cash balance conversion are covered under a formula equal to the greater of the new cash balance formula or the prior defined benefit formula. In such a case, it would be necessary to view all grandfathered participants as benefiting under the cash balance formula and receiving an additional benefit equal to the difference between the benefit provided under the prior defined benefit formula and the cash balance formula. By contrast, plans that offered all participants a choice of coverage under either the cash balance formula or the traditional defined benefit formula or excluded one or more groups of participants, determined on the basis of factors other than age, from coverage under the cash balance formula, would satisfy the requirements of Code Section 410(a)(2) for this purpose.
No Provision for Certain Actuarial Offsets
The proposed regulations establish certain key limitations on the ability to qualify as an eligible cash balance plan. For example, a plan will fail to qualify as an eligible cash balance plan if it provides for a reduction in the value of post-normal retirement age pay credits to reflect the actuarial equivalent of post-normal retirement age benefits distributions. This often happens in situations where plans allow employees to commence benefits in-service after normal retirement age, offsetting the value of ongoing accruals by the value of actual pension distributions. The proposed regulations, however, prohibit eligible cash balance plans from reducing ongoing cash balance pay credits by the actuarial value of in-service cash balance distributions. Similar limitations apply to plans that offset the value of actuarial increases (e.g., for post-age 70½ employment) against the value of ongoing cash balance accruals.
Testing for Compliance With Code Section 401(a)(4)
Eligible cash balance plans must also comply with a modified version of the Code’s nondiscrimination rules governing the testing of a defined contribution plan on a benefits basis, i.e., a cross-tested defined contribution plan, under Reg. §1.401(a)(4)-9(b)(2)(v)(D). It is expected that cash balance plans of most large employers will have no difficulty in complying with these rules.
The regulations provide that when converting from a traditional defined benefit plan to a cash balance plan, if a plan determines each participant’s benefit in a converted plan as an amount not less than the sum of the participant’s benefit accrued under the traditional defined benefit formula, then the cash balance account will automatically satisfy the conversion requirements. A plan that converts the existing accrued benefit at the time of the conversion to an opening cash balance account will satisfy the conversion requirements if the opening balance is not less than the actuarial present value of the participant’s accrued benefit payable in the normal form, determined using reasonable assumptions. The regulations offer little guidance concerning the reasonableness of assumptions used to determine the opening balance. However, it is clear that assumptions will not be reasonable if the interest rate increases based on the participant’s age. Periods of "wear-away" attributable to early retirement subsidies or decreasing interest rates used to calculate lump sum options under the protected accrued benefit at the time of the conversion presumably will not result in a violation of the applicable provisions.
If the opening balance exceeds the actuarial present value of the participant’s accrued benefit payable in the normal form, the excess portion is treated as an addition to the cash balance account for the year of the conversion and is taken into account in determining the rate of benefit accrual for such year. Thus, where the opening balance includes the value of early retirement subsidies or where the present value of the accrued benefit is calculated as of a date earlier than normal retirement age, a portion of the opening balance will be taken into account in determining the rate of benefit accrual for the year of the conversion. In these cases, plans will be required to demonstrate that differences in the rates of accrual are not age-based but rather are service-based. Alternatively, in certain cases increased rates of accrual under the cash balance formula during the conversion year for younger participants (e.g., those under age 55) will be offset by a continuation of the traditional defined benefit formula for older participants (e.g., those 55 and older) that will remain in effect for all future years. In these cases, it will be necessary to demonstrate that the value of the continued accruals under the traditional defined benefit formula for grandfathered participants exceeds the value of the one-time additional accrual for younger participants. The regulations provide no guidance as to the basis for making such a comparison.
The regulations also are silent with respect to conversions that occurred prior to the effective date of the regulations and did not comply with the requirements of the regulations. It is unclear whether the final regulations will address this issue.
Defined benefit plans with cash balance formulas must conform such formulas to the definition of eligible cash benefit plans as of the effective date of the regulations. Failure to qualify as an eligible cash balance plan will require that benefit accruals be determined in a manner which may result in a violation of the applicable provisions. At this point, all cash balance plan sponsors should assume that there are features of their plan design that may have to change in light of the new cash balance plan regulations.