Session 5 Cash Balance Plans in 2014

Transcription

1 Session 5 Cash Balance Plans in 2014 Kevin J. Donovan, CPA, MSPA Sara K. DeFilippo, EA, MSPA Actuarial Symposium, 8/15-8/16/2014 Cash Balance Plans in 2014 This session assumes a basic understanding of cash balance plans. Issues to be discussed will include interest crediting rates (the use of equity rates, rate of return on plan assets, etc.), recent guidance on pre-approved plans, applicable deduction rules, funding requirements and restrictions, and IRC 411 accrual rules. Additionally, any cash balance updates that may come our way by conference time will be covered. 1

2 Interest crediting rates IRC 411(b)(5)(B)(i)(I): An applicable defined benefit plan shall be treated as failing to meet the requirements of paragraph (1)(H) unless the terms of the plan provide that any interest credit (or an equivalent amount) for any plan year shall be at a rate which is not greater than a market rate of return. A plan shall not be treated as failing to meet the requirements of this subclause merely because the plan provides for a reasonable minimum guaranteed rate of return or for a rate of return that is equal to the greater of a fixed or variable rate of return. i.e. rate greater than market rate results in plan violating ADEA Did reg writers read last sentence? Interest Crediting Rates Must not exceed market rate of return Acceptable rates per Final Regs 1) Corporate yield: Any of 3 segment rates for a) Funding (24-month average), or b) 417(e) (one-month average) See next slide for MAP-21 issues 2) Treasury yields + margins (From Notice 96-8) 3) Cost-of-living indices + up to 300 bps Reg (b)(5)-1(d) 2

3 Interest Crediting Rates Notice If interest crediting rate = segment rate: Plan administrator can interpret as either pre-map-21 or post-map-21 Post-MAP-21 higher (right now) If interpreted to refer to MAP-21 rates, interpretation applies from EITHER: Plan year MAP-21 applies for 430, or 2012 (even if Minimum Funding deferred to 2013) Interest Crediting Rates Notice Whether MAP-21 segment rates meet hybrid requirements has not yet been determined MAP-21 rates possibly not acceptable If MAP-21 rates used now, may have to change when final hybrid regulations are issued Amendment to clarify that segment rate is unadjusted (pre-map-21) does not violate anti-cutback (411(d)(6)), and no need for 204(h) notice 3

4 Interest Crediting Rates Proposed Regs Fixed rate not to exceed 5% Actual Rate of Return (ROR) on Assets Includes positive and negative returns Plan assets must be diversified so as to minimize the volatility of returns Standard met if ERISA 404(a)(1)(C) met by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so. More later Interest Crediting Rates Proposed Regs Rate of return on RIC (Registered Investment Company - aka mutual fund) reasonably expected to be not significantly more volatile than the broad US equities market or a similarly broad international equities market 4

5 Interest Crediting Rates Proposed Regs Examples of Acceptable RIC Returns Vanguard S&P 500 Broad-based small-cap (Russell 2000) Broad-based international equities Examples of Unacceptable RIC Returns Industry sector (semiconductors) Single Country (except US) Leveraged to amplify return Significant derivatives to amplify return Interest Crediting Rates Proposed Regs Minimum Rates Yield rates (segment rates and 96-8 rates) Up to 4% annual minimum Actual ROR or RIC Up to 3% cumulative minimum NOT an annual minimum Applies ONLY at commencement; not part of annual account balance Similar to Preservation of Capital rule 5

6 Interest Crediting Rates Proposed Regs Participant-Directed interest credits? IRS requests comments in preamble Could menu of interest credits be offered? E.g., three options: 5% fixed rate S&P 500 return / 3% cumulative min 3 rd segment rate / 1% quarterly min Interest Crediting Rates Proposed Regs Based on conversations at 2013 CCA meeting it s obvious it s going on now Recall IRS position is that latest crediting rate used for projection So, each participant s accrued benefit based on different facts!? Plan document must provide for selections Removing selection 411(d)(6) cutback? What happens if fund discontinued? 6

7 Interest Crediting Rates Proposed Regs Again, must not exceed market rate Examples: Fixed rate of 4% What about fixed rate of 0%? Lesser of 30-year Treasury or 5% Lesser of 3 rd segment or 6% Lesser of S&P 500 or 6% Use of such caps common Interest Crediting Rates Proposed Regs Investment consultants want lower interest credits, so they don t miss their benchmark Frees investments from pressure to meet high target in adverse economic environment If investment return < crediting rate, additional funding Most of this goes to principals, though Small impact on nondiscrimination testing MVAR usually controls testing, not NAR Higher employee cost 401(a)(26) meaningful benefit more expensive 7

8 Interest Crediting Rates Proposed Regs Cost of 401(a)(26): Minimum benefit: 0.5% of pay as annuity at NRA NRA: 65 AE: 2013 applicable table and 5% (APR ) Employee age 40 Compensation: $40,000 Required minimum benefit: $40,000 *.5% 12 = $16.67 monthly benefit Interest Crediting Rates Proposed Regs Cost of 401(a)(26): $16.67 * = $2,421 single-sum value at 65 Discount 25 years at 5% = $715 pay credit Discount 25 years at 4% = $908 pay credit 27% greater cost at age 40! What does Plan sponsor want? Lower up-front cost (at 5%) with higher invest target? Higher up-front cost (at 4%) with lower invest target? Reality: Employee will leave in few years and take LS So higher crediting rate really the right answer? So what if investments don t achieve 5%? cost to fund shortage surely less than 27% 8

9 Interest Crediting rate Why? Why credit actual ROR? Assets and liabilities match each other If investment loss no make-up contributions Simply deposit pay credits (?) Investment risk shifted to employees (?) Why not credit actual ROR? 1) Potentially harder to pay top-25 lump sums 2) Determination of accrued benefit 3) Potentially lower 415 Limits 4) Potentially harder to pass 401(a)(4) 5) Potentially harder to meet 401(a)(26) 6) Potentially more difficult to support increasing pay credits (do we care in our market?) 7) Timing of contributions 8) Potential 411(a)(9) issue 9

10 Potentially harder to pay Top-25 LS Reg (a)(4)-5(b) restricts ability of certain HCEs to receive lump sums where plan less than 110% funded Regulations: 110% based on current liabilities, which are defined as reasonable and consistent Because of similarity of term, some plan documents define current liabilities based on IRC section 412(l), which doesn t exist after PPA Top 25 & MAP EA Gray Book Q&A 8 Both MAP-21 and pre-map-21 segment rates are currently reasonable approaches, with a reminder of the consistency issue Higher MAP-21 segment rates provide greater discount, so it s easier to achieve 110% Our clients now use MAP-21 basis for Top 25 Now back to crediting ROR 10

11 Plans using yield rates or fixed rate Project to assumed payment at 4% - 5% Discount at MAP-21 segment rates 5% - 6% Roundtrip often +/- 15% discount and therefore 110% funded even where plan only ~ 100% funded if assets compared to account balances (therefore pay LS) Example (yield rates or fixed rates) NRA: 62, AA: 52 Account Balance: $100,000, Plan Assets: $100,000 Actual Funded Status: 100% Interest Crediting Rate: 4% August 2013 MAP-21: 4.94%, S2: 6.15%, S3: 6.76% Projected account at 4% = $100,000 * (1.04) 10 = $148,024 PV at 6.15% = $148,024 / (1.0615) 10 = $81,495 Funded status for HCE restrictions: 123% No contribution needed to reach 110% level 11

12 Crediting Actual ROR Project at assumed investment return Reasonable assumption may erode discount May require real overfunding to pay top-25 Example (actual ROR) NRA: 62, AA: 52 Account Balance: $100,000, Plan Assets: $100,000 Actual Funded Status: 100% Interest Crediting Rate: Actual ROR current year 7.5% August 2013 MAP-21: 4.94%, S2: 6.15%, S3: 6.76% Projected account at 7.5% = $100,000 * (1.075) 10 = $206,103 PV at 6.15% = $206,103 / (1.0615) 10 = $113,471 Funded status for HCE restrictions: 88% Client must contribute $24,818 to reach 110% level 12

13 Uncertainty in Accrued Benefit (AB) IRC 411(a)(7) provides that the accrued benefit is a life annuity payable at NRA PPA added IRC 411(a)(13)(A) to allow the accrued benefit to be defined as the TAB in a CB plan, but only for purposes of allowing the TAB to be paid as a lump sum - i.e. ignoring 417(e), and age discrimination Uncertainty in Accrued Benefit (AB) AB = acct bal * (1 + int) ^ (nra aa) / apr (NRA) If crediting Actual ROR, what is int? IRS position-> project at current ROR» The IRS has taken the position that the hypothetical account balance must be projected to normal retirement date using the interest crediting rate in effect on the date the projection is made.» IRS hybrid training manual 13

14 » If the benefit accrued is subject to increase by reference to a variable index, the rate of increase in each future plan year is assumed to equal the rate in the current plan year... [So] [i]f an employee s benefit accrual is a fixed percentage of plan year compensation indexed through normal retirement age by reference to the average yield on 30-year Treasur[ies] and the yield for the current plan year is 8%, it is assumed that the yield will continue to be 8% in each future plan year.» 1.401(a)(4)-3(d)(5)(iii)(H) of old 1991 regs: What if current ROR e.g., 15%? If owners benefits disproportionately from CB accrued benefit explodes 415 issues Non-discrimination testing failure 14

15 Potentially lower benefits under IRC 415 Recall CB Plan s early retire reduction: Benefit at aa = a NRA / (1 + int) ^ (NRA - aa) / a aa where int = current crediting rate Suppose NRA = 62, aa = 55, ROR 2013 = 15% $ limit (age 55) = $17,500 * / 1.15 (7) / = $5, LS Limit (age 55) = $5, * = $974,937 If crediting rate were 5%, 415 LS Limit = $1,843,044 Potentially harder to pass IRC 401(a)(4) testing Combo plans often have: HCEs: mostly in CB Plan non-hces: mostly in PS Plan Testing depends on leverage, e.g. HCEs: 5.0% projection in CB Plan non-hces: 8.5% projection in PS Plan 15

16 If crediting ROR, projection = asset return Testing now volatile! If ROR high (e.g., 15%), testing likely fails HCEs at 15%, non-hces at 8.5% => leverage reversed! Usually testing governed by MVAR MVAR is 8.5% projection Possibly cap ROR at no more than 5% e.g. Model testing to design ROR cap that works Interest Crediting rate Why not? Potentially harder to pass IRC 401(a)(26) Need 40% / 50 participants at meaningful level Meaningful: 0.5% accrued benefit increase at NRA Low or negative returns can create problems Assume comp $45K at age 25, pay credit 2%, NRA 65, 2014 applicable table 5% At 5% projection rate = $45,000 *.02 * 1.05^40 / = > * 12 / $45,000 = 1.16% At 2% projection rate = $45,000 *.02 * 1.02^40 / = > * 12 / $45,000 =.36% Pass at 5% // Fail at 2% 16

17 Potentially harder to pass IRC 401(a)(26) - cont Need pay credit of 3% to attain 0.5% accrual rate To avoid amending pay credit each year, need minimum crediting rate, or not included in 40% / 50 count Already need cap for 415 & 401(a)(4) If ROR cap at 5%, and minimum at say 3%, why bother? Possibly Staff: use fixed interest rate (e.g., 5%) Principals: ROR with 5% cap? Higher investment risk on staff benefits to earn fixed rate, but they are small benefits Difficult to support increasing pay credits CB plans (almost always?) use 133 1/3 rule to pass accrual rules under 411(b) Increase in accrued benefit ( accrual ) in a year may not exceed that from any prior year by more than 1/3 Ignore prior formulas and grandfathers All other things being equal (compensation, etc.) With positive interest credits and flat pay credits, this is never an issue In fact, accruals decrease each year 17

18 Difficult to support increasing pay credits Where pay credits increase with age and/or service, accrual rules fail if aggregate increase in accrued benefit > 33 1/3% Yield-based/flat int credits allowed increasing pay credits Flat interest as high as 5% Minimum interest as high as 4% Crediting Actual ROR (or RIC) Low/negative returns can cause issues where increasing pay credits rely on interest credit to pass 133 1/3 Regs allow assumption of zero Difficult to support increasing pay credits Consider a plan that provides for increasing pay credits E.g., graded, where those at 5 years of service receive $1,000 and those at 25 years receive $3,000 Variable interest credit Will look at 5% and then at 2% Consider 25 year old getting $1,000 pay credit at age 45, will receive $3,000 pay credit 18

19 Difficult to support increasing pay credits AB increase with interest credit 5% $1,000 * 1.05 ^ 40 / = $48.47 $3,000 * 1.05 ^ 20 / = $54.81 $54.81 / $48.47 = 113% --> 133 1/3 passes AB increase with interest credit 2% $1,000 * 1.02 ^ 40 / = $15.20 $3,000 * 1.02 ^ 20 / = $30.69 $30.69 / $15.20 = 202% --> 133 1/3 fails! Fails accrual rules at 2%, and passes at 5% Put in minimum interest rate BUT recall that only cumulative minimum interest rates are allowed with ROR, not annual minimums Solution : cap interest credit at 3 rd segment rate not to exceed 6% with a minimum of greater of 4% or ROR Already have to cap it for 415 and 401(a)(4) = min (3 rd segment, 6%, max (ROR, 4%) ) With cap at 6% and min at 4%, AGAIN, WHY BOTHER!? 19

20 Timing of contributions Where contributions not made on last day of year, crediting ROR may cause interest credits higher than actual amounts earned E.g. assets earn 33.33% first ½ year and lose 10% for last ½ result is 20% return for the year i.e., P * *.9 = 1.2 P Prior year contribution made end of first ½ Contribution that lost 10% needs to credit 20%?? How is ROR on plan assets defined? Potential IRC 411(a)(9) issue IRC 411(a)(9) and Reg (a)-7(c) provide that periodic benefit (i.e., annuity) payable at any point cannot be less than previously available amount Assume acct balance $1.5 million at age 64 Age e/ 13 5% APR = ; Life annuity = $10,074 Loss results in age 65 balance of $1 million (even after pres of capital, cumulative minimum, etc.) Age e/ 13 5% APR = ; Life annuity = $6,885 Participant has right to $10,074 annuity at 65 20

21 Pre-approved CB Plans Announcement extended submission deadline for PPA restatement pre-approved DBPs To allow pre-approved DB plans to include cash balance provisions for the first time Announcement provided IRS intends to expand preapproved program to plans with certain cash balance features Which of course begs the question as to what features will and will not be allowed in pre-approved plans Announcement provides that current adopters of cash balance plans (which are currently individually designed by definition) complete Form 8905 (Certification of Intent to Adopt a Pre-approved Plan) before the end of their applicable individually designed on-cycle deadline. Pre-approved CB Plans Announcement provides that current adopters of cash balance plans (which are currently individually designed by definition) complete Form 8905 (Certification of Intent to Adopt a Pre-approved Plan) before the end of their applicable individually designed on-cycle deadline (to 1/31/15 for Cycle D). So what happens if upon restatement plan does not meet the specs required for pre-approval and therefore adopts an individually designed plan? Look at Rev Proc

22 Pre-approved CB Plans Temporary Eligibility for Six-Year Cycle An employer who adopts an individually designed plan is entitled to remain in the six-year remedial amendment cycle only for the current remedial amendment cycle. This temporary eligibility for the six-year cycle applies if: (1) the employer is an intended adopter (as described in section 17.04) and after timely executing the Form 8905, the employer decides to adopt an individually designed plan whose underlying plan document is not based on a pre-approved plan Pre-approved CB Plans An employer is an intended adopter if: (1) the employer currently maintains a qualified individually designed plan and (2) such employer and a sponsor or practitioner who maintains an existing pre-approved plan execute Form 8905 before the end of the employer s fiveyear remedial amendment cycle IRS Employee Plan News Issue March 19, 2014 added FAQs Withdrawing-Cycle-C-Applications 22

23 Pre-approved CB Plans 1. May a plan sponsor who signs a Form 8905 under Announcement intending to adopt a preapproved cash balance plan subsequently adopt an individually designed plan without losing reliance? Yes, a plan sponsor who originally intended to adopt a pre-approved cash balance plan may later adopt an individually designed cash balance plan as long as the plan sponsor adopts the individually designed plan within the two-year window for pre-approved defined benefit plans, which will be announced in future guidance (see Revenue Procedure , Section 19.03(1)). Pre-approved CB Plans ASPPA filed comment letter on what should be allowed in pre-approved CB Plans 0Letter/ASPPA%20ACOPA%20cash%20balance%20vol ume%20submitter%20june%2019% pdf 23

24 ASPPA Comment Letter Classes for Formula Definitions The flexibility available for defining classes for traditional defined benefit volume submitter plans should also be available for cash balance volume submitter documents. For each class defined, a corresponding pay and interest credit definition should be provided. In other words, both the pay credit and interest credit could vary for each class. ASPPA Comment Letter Pay Credits For each class, volume submitter documents should allow determination of pay credits based on a percentage of compensation, a flat dollar credit per year of service and the lesser of these or net selfemployment income. There should also be the option to base pay credits on the present value of an annual accrual times the APR of the annuity deferred to Normal Retirement Age. Alternatives for determining timing of the credit during the year should also be available, including beginning of the year, end of the year, or periodically throughout the year. 24

25 ASPPA Comment Letter Interest Credits A broad range of interest rate options should be available, including but not limited to a fixed rate or a variable rate based on an equity or bond index and the plan s actual rate of return. There should also be an option to subject the designated rate to a cap or floor. As with the pay credits, alternatives for determining timing of the credit during the year should be available, including beginning of the year, end of the year, or periodically throughout the year. Documents should also provide an option with regard to applying the interest credit to distributions occurring between interest crediting dates. ASPPA Comment Letter Top Heavy The document should permit any necessary Top Heavy accruals to be provided through a companion defined contribution plan and only as necessary to meet Top Heavy accruals in a nonfrozen cash balance formula defined benefit plan. Actuarial Equivalence In addition to traditional definitions of actuarial equivalence, an option should be available to match the pre-retirement interest rate to the formula definition for interest credits. 25

26 ASPPA Comment Letter Conversions allowing converted plans to be part of the volume submitter program could smooth the path for future conversions. If the volume submitter document is available to cash balance plans that were converted from traditional defined benefit plans, in addition to the A+B option, ASPPA and ACOPA recommend that an alternative be available to set the accrued benefit attributable to pre-conversion service equal to the greater of: the accrued benefit at the time of conversion and the benefit provided by the hypothetical account balance with the opening balance no less than the single sum value of the accrued benefit using 417(e) interest and mortality or plan actuarial equivalence, whichever provides the greater opening balance. Funding Reg (d)-1(f)(5)(i) In the case of an applicable defined benefit plan the amount of distribution is determined by projecting the future interest credits under the plan s interest crediting rules using actuarial assumptions that satisfy the requirements of paragraph (f)(3) of this section. Thus, if a plan provides for a single- sum distribution equal to the balance of a participant s hypothetical account under a cash balance plan, then the amount of that future distribution is equal to the projected account balance at the expected date of payment determined using actuarial assumptions that satisfy the requirements of paragraph (f)(3) of this section 26

27 Funding Reg (d)-1(f)(3) Other assumptions. In the case of actuarial assumptions other than those specified in sections 430(h)(2), 430(h)(3), and 430(i), each of those actuarial assumptions must be reasonable (taking into account the experience of the plan and reasonable expectations). In addition, the assumptions must, in combination, offer the plan s enrolled actuary s best estimate of anticipated experience under the plan based on information determined as of the valuation date So Funding First need to determine anticipated payment date (e.g. Normal Retirement Age) Then need assumption for future interest credit Fixed rate life is simple Variable rates not so simple, again - actuary s best estimate of anticipated experience as of the valuation date Impact of annual / cumulative minimums? 27

28 Funding TNC and FT determined by projecting forward to assumed separation (e.g. NRA) using interest crediting rate and discounting back using applicable segment rate August 2013 rates: MAP-21: S1: 4.94%, S2: 6.15%, S3: 6.76% 430(h): S1: 1.39%, S2: 4.05%, S3: 5.08% Funding Example 1 (interest crediting rate < segment rate) First year principal credit = $90,000 Assume lump sum payment at normal retirement age 8 years from retirement so use S2 for discounting S2 = 6.15% Interest crediting rate = 5% Projected account at 5% = $90,000 * (1.05) 8 = $132,971 Present value at 6.15% = $132,971 / (1.0615) 8 = $82,489 This represents TNC and in year 1 would = MRC i.e., required contribution not what s owed to employee ($90K) Ability to fund full amount discussed shortly 28

29 Funding Example 2 (interest crediting rate > segment rate) First year principal credit = $90,000 Assume lump sum payment at normal retirement age 4 years from retirement so use S1 for discounting S1 = 4.94% Interest crediting rate = 5% Projected account at 5% = $90,000 * (1.05) 4 = $109,396 PV at 4.94% = $109,396 / (1.0494) 4 = $90,206 Actual funding requirement i.e., could have MRC in excess of amount needed to fully fund TAB Funding What to do? Use lower crediting rates when designing plans where close to NRA If reasonable, assume later distribution to get into S2 for discount Use part of second year contribution to meet first year MRC i.e., goal normally to fund pay credits Live with the fact that you may need to pre-fund some pay credits Could be cumbersome but necessary if multiple owners 29

30 Funding Example 1 (continued) at-risk rules Assume full vesting end of year 3 (i.e., 2 years from EOY val date) earliest retirement date to determine at-risk TNC and FT Projected account at 5% = $90,000 * (1.05) 2 = $99,225 Present value at 1.39% = $99,225 / (1.0139) 2 = $96,523 At-risk TNC load = 4% * $90,206 = $3,608 At-risk FT load = $700 Maximum deduction = $ 96,523 + $ 3,608 + $0 + $700 - $0 = $100,831 At-risk TNC + At-risk FT assets Full $90K contribution credit therefore deductible Presumption: loads apply Significant reduction in S1 makes this less of an issue Funding Restrictions Impact on funding restrictions Top 25/AFTAP; EX.: Account balances total $500,000, assets same All participants 10 years from distribution except one with balance of $50,000 (an HCE who wants money now) Assume interest credit fixed 4%, S2 = 5% FT = $450,000 * (1.04) 10 / (1.05) 10 + $50,000 = $458,934 AFTAP = $500,000 / $458,934 = % After distribution assets / FT = $450,000 / $408,934 = % [> 110% so distribution may be made] Higher fixed rate would have prevented distribution 30

31 Funding Restrictions What if interest crediting rate is actual ROR? Or ROR on equity based RIC What is a reasonable projection of future interest credits? Remember the reg - actuary s best estimate of anticipated experience Projection of variable rate subject to ACTUARY S judgment affects FT & TNC Therefore affects %s and when people can get paid Funding Restrictions For years we used 30-year (or other) Treasury rate Common to assume current rate for projection But surely where actual (or RIC) ROR is 12% one year, negative 4% another year, etc. this is not reasonable. 31

32 Accrual Rules 411(b)(1)(A) 3-percent method A defined benefit plan satisfies the requirements of this paragraph if the accrued benefit to which each participant is entitled upon his separation from the service is not less than (i) 3 percent of the normal retirement benefit to which he would be entitled if he commenced participation at the earliest possible entry age under the plan and served continuously until the earlier of age 65 or the normal retirement age specified under the plan, multiplied by (ii) the number of years (not in excess of 33 1/3) of his participation in the plan. In the case of a plan providing retirement benefits based on compensation during any period, the normal retirement benefit to which a participant would be entitled shall be determined as if he continued to earn annually the average rate of compensation which he earned during consecutive years of service, not in excess of 10, for which his compensation was the highest. For purposes of this subparagraph, social security benefits and all other relevant factors used to compute benefits shall be treated as remaining constant as of the current year for all years after such current year. Accrual Rules 411(b)(1)(B) 133 1/3 percent rule A defined benefit plan satisfies the requirements of this paragraph for a particular plan year if under the plan the accrued benefit payable at the normal retirement age is equal to the normal retirement benefit and the annual rate at which any individual who is or could be a participant can accrue the retirement benefits payable at normal retirement age under the plan for any later plan year is not more than 133 1/3 percent of the annual rate at which he can accrue benefits for any plan year beginning on or after such particular plan year and before such later plan year. For purposes of this subparagraph (i) any amendment to the plan which is in effect for the current year shall be treated as in effect for all other plan years; (ii) any change in an accrual rate which does not apply to any individual who is or could be a participant in the current year shall be disregarded; (iii) the fact that benefits under the plan may be payable to certain employees before normal retirement age shall be disregarded; and (iv) social security benefits and all other relevant factors used to compute benefits shall be treated as remaining constant as of the current year for all years after the current year. 32

33 Accrual Rules 411(b)(1)(C) Fractional rule A defined benefit plan satisfies the requirements of this paragraph if the accrued benefit to which any participant is entitled upon his separation from the service is not less than a fraction of the annual benefit commencing at normal retirement age to which he would be entitled under the plan as in effect on the date of his separation if he continued to earn annually until normal retirement age the same rate of compensation upon which his normal retirement benefit would be computed under the plan, determined as if he had attained normal retirement age on the date on which any such determination is made (but taking into account no more than the 10 years of service immediately preceding his separation from service). Such fraction shall be a fraction, not exceeding 1, the numerator of which is the total number of his years of participation in the plan (as of the date of his separation from the service) and the denominator of which is the total number of years he would have participated in the plan if he separated from the service at the normal retirement age. For purposes of this subparagraph, social security benefits and all other relevant factors used to compute benefits shall be treated as remaining constant as of the current year for all years after such current year. Accrual Rules Recent requests received by the IRS Please provide a detail calculation to demonstrate that the plan s benefit formula for the staff employees complies with 411(b). Benefit formula for the staff is a flat $15 multiplied by Years of Participation Service See chart on next slide; clearly satisfies the 133 1/3 rule 33

34 Accrual Rules Check of Ratio Annual One-Year of Current Benefit Annual to Prior Age Svc. at NRD Accrual Accruals 42 1 $ 180 $ % % % % , % , % , % , % , % , % , % , % , % , % , % , % , % , % , % , % Accrual Rules Recent requests received by the IRS Does the plan s benefit formula for owners satisfy the 133 1/3 accrual rule without factoring in interest credits OR does it satisfy the 133 1/3 accrual rule with factoring in interest credits (including any minimum plan interest rate)? 411(b) Owner s benefit formula is cash balance allocation with pay credits equal to 20% of compensation; crediting interest rate is a fixed 5% See chart on next 2 slides; clearly satisfies the 133 1/3 rule with and without factoring in interest credits 34

35 Accrual Rules Check of Accumulated One-Year Ratio Annual Interest Pay One-Year Annual of Current Pay Credit to Credit at Annual as a % to Prior Age Svc. Pay Credit Accrual of Pay Accruals 42 1 $ 260,000 $ 52,000 $ 85,971 $ 137,971 $ 10, % ,000 52,000 79, ,401 10, % 95.24% ,000 52,000 73, ,144 9, % 95.24% ,000 52,000 67, ,185 9, % 95.24% ,000 52,000 61, ,509 8, % 95.24% ,000 52,000 56, ,104 8, % 95.24% ,000 52,000 50, ,956 7, % 95.24% ,000 52,000 46,054 98,054 7, % 95.24% ,000 52,000 41,385 93,385 7, % 95.24% ,000 52,000 36,938 88,938 6, % 95.24% ,000 52,000 32,703 84,703 6, % 95.24% ,000 52,000 28,669 80,669 6, % 95.24% ,000 52,000 24,828 76,828 5, % 95.24% ,000 52,000 21,169 73,169 5, % 95.24% ,000 52,000 17,685 69,685 5, % 95.24% ,000 52,000 14,367 66,367 5, % 95.24% ,000 52,000 11,206 63,206 4, % 95.24% ,000 52,000 8,197 60,197 4, % 95.24% ,000 52,000 5,330 57,330 4, % 95.24% ,000 52,000 2,600 54,600 4, % 95.24% ,000 52,000-52,000 3, % 95.24% Accrual Rules Check of Accumulated One-Year Ratio Annual Interest Pay One-Year Annual of Current Pay Credit to Credit at Annual as a % to Prior Age Svc. Pay Credit Accrual of Pay Accruals 42 1 $ 260,000 $ 52,000 $ - $ 52,000 $ 3, % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % ,000 52,000-52,000 3, % % 35

36 Accrual Rules It is commonly accepted that cash balance plans must pass 411(b) using the 133 1/3 rule. This is primarily because the fractional rule and the 3% method both require no more than 10 years of average compensation be used in determining the benefit and most cash balance plans are accumulation plans using compensation for all years. What about a cash balance plan that has flat pay credits? E.g. many cash balance plans provide pay credits of some dollar amount not tied to current compensation. Does anything prevent such plans from using the 3% method for example? Accrual Rules Consider a plan effective 1/1/14 that provides for pay credits of $100,000 annually beginning 1/1/12, for no more than 20 years. Assume also that due to 415 there would be no accrual in 2014 such that the accrual in 2015 would cause a violation of the 133 1/3% rule. Since the plan does not use compensation in its benefit formula thereby not violating the 10-year average compensation requirement couldn t such plan pass 411(b) using the 3% method? The obvious point here is to attempt to create a funding target and therefore a cushion in year 1. 36

37 Accrual Rules The 3% method is checked by calculating the total benefit at retirement (for someone with a maximum 20 years of service). NRA = 62, aa = 42 Pay Credit = $100,000 (credited end of year) Interest crediting rate = 5% Projected Account Balance at NRA = $3,306,595 Life Annuity at NRA = $3,306,595 / = $21,153 Since annual accrued benefit to date each year is less than 3% x years of participation x projected benefit, the 3% method is satisfied. See chart on next slide. Accrual Rules Annual EOY Interest Account Pay Account Credit to Balance at Annual 3% x Svc x Age Svc Credit Balance Benefit Proj NRB 42 1 $ 100,000 $ 100,000 $ 152,695 $ 252,695 $ 1,617 $ , , , ,357 3,156 1, , , , ,559 4,622 1, , , , ,847 6,019 2, , , ,176 1,148,739 7,349 3, , , ,541 1,346,732 8,615 3, , , ,096 1,535,297 9,821 4, , , ,972 1,714,883 10,970 5, ,000 1,102, ,260 1,885,916 12,064 5, ,000 1,257, ,017 2,048,806 13,106 6, ,000 1,420, ,260 2,203,939 14,099 6, ,000 1,591, ,972 2,351,685 15,044 7, ,000 1,771, ,096 2,492,394 15,944 8, ,000 1,959, ,541 2,626,404 16,801 8, ,000 2,157, ,176 2,754,032 17,618 9, ,000 2,365, ,834 2,875,583 18,395 10, ,000 2,584, ,309 2,991,346 19,136 10, ,000 2,813, ,357 3,101,595 19,841 11, ,000 3,053, ,695 3,206,595 20,513 12, ,000 3,306,595-3,306,595 21,153 12,692 37