The US Department of the Treasury (Treasury) and Internal Revenue Service (IRS) recently released long-awaited final regulations (the Final Regulations) with respect to market rates of return and related Pension Protection Act (PPA) requirements applicable to pension equity plans (PEPs) and cash balance plans (collectively, hybrid plans). The Final Regulations make certain key changes to final and proposed regulations issued by the IRS in 2010 (the Prior Regulations), as described below. In addition, Treasury and IRS issued proposed regulations providing Code Section 411(d)(6) relief for transitional amendments made to satisfy the market rate of return rules.
The Market Rate of Return Requirement
Code Section 411(b)(5)(B) provides that statutory hybrid plans satisfy the requirements of Code Section 411(b)(1)(H) prohibiting age discrimination only if the plan does not credit interest at a rate greater than a market rate of return. The Prior Regulations included a list of compliant interest rates and required hybrid plans to adopt one of these specified rates in order to comply with the market rate of return requirement. Several commenters objected to this approach and asked that the IRS provide a list of safe harbor interest crediting rates deemed to meet the market rate of return requirement while also allowing plans to adopt alternative interest rates that do not exceed a market rate of return. The Final Regulations do not adopt this approach and instead retain an exclusive list of permissible interest rates (including fixed rates, variable rates and combinations of rates) that meet the market rate of return requirement. A summary of the key changes to the market rate of return requirement follows:
Rate of Return on Plan Assets or a Subset of Plan Assets: Under the Prior Regulations, indexed benefits (such as those provided under a variable annuity benefit formula) may be adjusted using the actual rate of return on aggregate plan assets provided the plan assets are diversified to minimize the volatility of returns. The Final Regulations extend this rule to hybrid plans generally. In addition, the Final Regulations permit the rate of return on a subset of plan assets to be used, if certain requirements are satisfied.
Increase in Permissible Fixed Rate: The Final Regulations increase the permissible fixed interest rate that may be used as an interest crediting rate to 6 percent from the 5-percent maximum included in the Prior Regulations.
Increase in Permissible Floor Rate: Under the Prior Regulations, hybrid plans were permitted to use a fixed floor of up to 4 percent in connection with any of the permissible bond-based interest crediting rates. The Final Regulations increase this fixed floor to 5 percent when used in conjunction with any of the Notice 96-8 interest rates and retain the 4-percent fixed floor with respect to the three segment rates. However, the Final Regulations do not permit the use of an annual floor in conjunction with any of the permissible investment-based rates. Cumulative floors of up to 3 percent may be combined with any permissible interest rate, including investment-based rates. The following chart summarizes the maximum permitted floor that may be used in combination with a variable rate.
Notice 96-8 rate (for example, the yield on 30-year Treasury Constant Maturities)
5 percent annual
1st, 2nd or 3rd segment rate
4 percent annual
Investment-based rate (for example, the rate of return on aggregate plan)
3 percent cumulative
Change in Interest Crediting Rate: In general, a prospective amendment changing the interest crediting rate from one permitted rate to another permitted rate is subject to Code Section 411(d)(6). This means that the account balance can never be less than what it would have been if the old rate had continued but without taking into account any pay credits after the amendment date. The Final Regulations provide that the market rate of return rule is not violated merely because “active” participants are given the Code Section 411(d)(6) protection described above. This relief from the market rate of return rule does not extend to participants who are not active participants as of the date of the amendment. Thus, the interest crediting rate for deferred vested participants can never be changed, unless the new rate always will be greater than the old rate (e.g., a change from a 5 percent fixed rate to a 6 percent fixed rate or the addition of a permissible floor to the current rate) or the change is permitted under the regulations without regard to Code Section 411(d)(6) (e.g., a change from a Notice 96-8 rate to the third segment rate).
Participant Self-Direction: The Final Regulations do not permit participants to choose from a menu of permissible crediting rates.
Transitional Amendments to Satisfy the Market Rate of Return Rules
Along with the Final Regulations, Treasury and IRS issued proposed companion regulations (the Proposed Regulations) describing how a plan using an interest crediting rate that is not permitted under the Final Regulations must be amended to adopt a conforming rate. The Proposed Regulations resolve the conflict between the anti-cutback rule of Code Section 411(d)(6) and the market rate of return rules by permitting plans with noncompliant interest crediting rates to be amended with respect to future interest credits without violating the anti-cutback rule. To be eligible for this relief, the amendment must be adopted prior to, and effective no later than, the first day of the first plan year that begins on or after January 1, 2016.
The Proposed Regulations set forth specific correction procedures for each noncompliant feature of a noncompliant interest crediting rate. If the noncompliant interest crediting rate has more than one noncompliant feature, then each noncompliant feature must be separately addressed, as required under the Proposed Regulations. The Proposed Regulations only permit modification of the noncompliant features of the interest crediting rates, while requiring maintenance of any compliant features. Treasury and IRS did not adopt the approach suggested by some commenters that a plan using a noncompliant crediting rate be permitted to change to any of the maximum compliant interest crediting rates.
Comments on the Proposed Regulations must be submitted by December 18, 2014.
Subsidized Benefits Are Permitted
Under the Prior Regulations, a hybrid plan was eligible for the “whipsaw” relief provided under Code Section 411(a)(13)(A) only if the annuity benefits provided by the plan were actuarially equivalent, using reasonable actuarial assumptions, to the cash balance account or PEP accumulation. The inclusion of an early retirement subsidy or subsidized survivor annuity would result in the annuity form having a greater actuarial value than the cash balance account or PEP accumulation and disqualify the plan from the whipsaw relief. The Final Regulations change this to permit the plan to subsidize the annuity options. Thus, if an optional form of benefit is payable in an amount that is greater than the actuarial equivalent of the participant’s account balance or PEP accumulation, the plan is compliant. However, if an optional form of benefit is not at least the actuarial equivalent of the participant’s account balance or PEP accumulation, the whip saw relief is not applicable to that optional form of benefit.
Late Retirement Adjustments
The Final Regulations clarify that notwithstanding a hybrid plan’s ability to treat the account balance or PEP accumulation as the present value of the accrued benefit, the plan must either (1) provide actuarial increases to participants who commence their benefit after normal retirement age or (2) satisfy the suspension of benefits requirements that generally apply to defined benefit plans. In most cases, interest credits provided after normal retirement age will be less than the required actuarial increase, and an additional account adjustment will be required.
Preservation of Capital Requirement
The Final Regulations make clarifying changes to the preservation of capital requirement. Specifically, the Final Regulations provide that this requirement applies only at the time a participant’s entire vested benefit is distributed. In addition, in the case of a participant who (i) receives a distribution of his or her entire vested benefit under the plan, (ii) experiences five consecutive one-year breaks in service and (iii) then returns to employment with the plan sponsor, the plan may disregard the prior distribution in applying the preservation of capital requirement to benefits earned after returning to employment.
Like the Prior Regulations, the Final Regulations provide special rules for determining interest crediting rates and plan factors following the termination of a cash balance plan. Plan documents must reflect these rules. The Final Regulations provide detailed guidance for applying these rules in cases where the interest crediting rate and/or actuarial assumption used in converting lump sums to annuities are changed within five years of the plan termination date. In cases where the interest crediting rate is not based on interest rates (i.e., an investment-based rate is used), the Final Regulations change the Prior Regulations to require that the second segment rate (as opposed to the third segment rate) be substituted for an investment-based rate of return that applied during the relevant five-year period.
Pension Equity Plans
The Final Regulations contain special rules applicable to PEPs. Specifically, the Final Regulations expand the definition of PEP for years beginning on or after January 1, 2016, to include not only a benefit formula based on the participant’s final average compensation, but also a benefit formula based on the participant’s highest average compensation (with a permitted lookback period for determining highest average compensation).
A PEP accumulation may be reduced only for certain limited reasons. The Final Regulations clarify that a reduction in PEP accumulation is permitted to the extent that it results from a decrease in the participant’s final average compensation or, for a formula that is integrated with Social Security, from an increase in the integration level.
Commenters on the Prior Regulations suggested that a PEP formula should be treated as a statutory hybrid benefit formula, regardless of whether the formula provides interest credits. The Final Regulations reflect this recommendation.
Elimination of Proposed Conversion Amendment Alternative that was Included in the Prior Regulations
The Prior Regulations included a proposed rule pursuant to which certain plans could satisfy the conversion protection requirements by establishing an opening hypothetical account balance without a subsequent annuity starting date comparison of benefits to those earned under the pre-conversion formula. This proposed rule included a number of requirements intended to increase the likelihood that the hypothetical account balance used to replicate the pre-conversion benefit would provide a benefit at least as large as the pre-conversion benefit for all periods following the conversion. The proposed rule has been eliminated from the Final Regulations. Plans that relied on the proposed rule to satisfy the conversion protection requirements for plan years that begin on or after January 1, 2012, must be amended so that distributions with an annuity starting date in a plan year that begins on or after January 1, 2016, satisfy the rules in the Final Regulations, with respect to conversion amendments.
The Final Regulations are generally applicable for plan years that begin on or after January 1, 2016, (except provisions that merely clarify the Prior Regulations apply to plan years that begin on or after January 1, 2011, in accordance with the general effective date of the Prior Regulations). For plans that are not in compliance with the market rate of return requirements, remedial action must be taken prior to the first day of the 2016 plan year. The Preamble to the Final Regulations includes “no inference” language concerning the proper interpretation of Code Sections 411(a)(13) and 411(b)(5) prior to the effective date of the regulations.