Cash Balance Interest Credits

Cash Balance Interest Credits Kevin J. Donovan, CPA, EA, MSPA, FCA Managing Member, Pinnacle Plan Design, LLC Kevin J. Donovan, CPA, EA, MSPA, FCA Managing Member, Pinnacle Plan Design, LLC Kevin is a shareholder in the accounting firm BeachFleischman PC, where he heads up the firm s pension subsidiary Pinnacle Plan Design, LLC. Kevin is a CPA and an Enrolled Actuary. He is a founding member of the ASPPA College of Pension Actuaries (ACOPA) and recently served as ACOPA's Vice President. In addition to being a member of NIPA, Kevin is a member of the American Society of Pension Professionals and Actuaries (ASPPA), as well as the American Institute of Certified Public Accountants (AICPA). Kevin is a frequent author and lecturer on qualified retirement plans. He has spoken at numerous conferences sponsored by ASPPA, NIPA, the AICPA, ACOPA, the Conference of Consulting Actuaries. In 2015 Kevin was the recipient of the ASPPA Educator s award. 2 1

Cash Balance Plans What is a Cash Balance Plan? DB plan where benefit defined as theoretical account balance As opposed to periodic benefit payment Paper account only AKA, Accumulated benefit (regs), hypothetical account, etc. DB plan since not DC plan [IRC 414(j) v. IRC 414(i)] Account credited with Pay credits, normally % of compensation, flat dollar amount, or combination thereof E.g. lesser of $$125,000 or 50% of compensation AKA, Principal credits (regs) Hypothetical allocations, Contribution credits, Theoretical allocations, etc Interest credits (aka earnings credits) our emphasis 3 Interest Credits - PPA Age Discrimination started with interest credits IBM District court Cash balance plans are age discriminatory Younger participants have more interest credits at retirement Appeals Courts & Congress: not the case But what if interest credits really high? (15%?) At some point, higher interest credits become discriminatory against older participants 4 2

Interest Credits - PPA 27 Year Old 55 Year Old Compensation $50,000 $50,000 Interest Crediting Rate 5% 5% Pay Credit $600 $600 Value of Pay Credit at Age 62 (5% Growth) Annuity Conversion at Age 62 Annuity at Age 62 $254.59 (3,309.61 / 13) Annuity as % of Compensation $3,309.61 $844.26 0.51% (254.59 / 50,000) Congress is OK with this. $13 $13 $64.94 (844.26 / 13) 0.13% (64.94 / 50,000) 5 Interest Credits - PPA 27 Year Old 55 Year Old Compensation $50,000 $50,000 Interest Crediting Rate 15% 15% Pay Credit $25 $25 Value of Pay Credit at Age 62 (15% Growth) Annuity Conversion at Age 62 Annuity at Age 62 $256.11 (3,329.39 / 13) Annuity as % of Compensation $3,329.39 $66.50 0.51% (256.11 / 50,000) $13 $13 $5.12 (66.50 / 13) 0.01% (5.12 / 50,000) Congress is not OK with this. Result: Congress limited interest credits with PPA 2006 6 3

Interest Credits - PPA 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 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. See also Reg. 1.411(b)(5)-1(d)(1)(i) 7 Interest Credits - PPA So: shall be treated as failing to meet (1)(H) A rate in excess of a market rate results in plan DQ shall not be treated as failing to meet this subclause merely because the plan provides for a reasonable minimum guaranteed rate of return Statute provides for reasonable minimum Regs appear a bit more restrictive, at least if equity based 8 4

Interest Credits - Regs Final regulations provide exclusive list of rates that qualify as market rates i.e., cannot argue something else (e.g. LIBOR rate) is market rate Reg. 1.411(b)(5)-1(d)(1)(iii) 9 Interest Credits - Regs Acceptable interest rates under final regs Fixed rate up to 6% Reg. 1.411(b)(5)-1(d)(4)(v) First, second or third segment for funding or 417(e) Reg. 1.411(b)(5)-1(d)(3); 1.411(b)(5)- 1(d)(4)(iv) Treas. rates and COLI, with margins, from Notice 96-8 Reg. 1.411(b)(5)-1(d)(4)(ii) / (iii) 10 5

Interest Credits - Regs Acceptable interest rates under final regs (cont) Investment return on plan assets If assets diversified to minimize volatility of returns Reg references ERISA 404(a)(1)(C): 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. Reg. 1.411(b)(5)-1(d)(5)(ii)(A) 11 Interest Credits - Regs Acceptable interest rates under final regs (cont) Investment return on subset of plan assets Subset diversified to minimize volatility of returns 10% limit in subset on employer securities / R.E. Market value of assets in subset must approximate liabilities for benefits to which subset relates Reg. 1.411(b)(5)-1(d)(5)(ii)(B) 12 6

Interest Credits - Regs Acceptable interest rates under final regs (cont) Investment return on mutual funds (RICs) Must be the rate of return on an actual mutual fund As opposed to an index Not significantly more volatile than US markets No industry sector; No single country other than U.S. OK to track indices such as S&P 500 or Russell 2000 through a mutual fund Reg. 1.411(b)(5)-1(d)(5)(iv) 13 Interest Credits - Regs Greater of rates In general a plan may not provide an interest credit equal to greater of two otherwise compliant rates Reg. 1.411(b)(5)-1(d)(6)(i) Exceptions (discussed herein) exist for Certain minimum rates Changing from one compliant rate to another Post retirement increases 14 7

Interest Credits - Regs Acceptable minimum rates 4% annual for segment rates Reg. 1.411(b)(5)-1(d)(6)(ii)(A) 5% annual for 96-8 rates Reg. 1.411(b)(5)-1(d)(6)(ii)(B) 3% cumulative (not annual) for any rates Reg. 1.411(b)(5)-1(d)(6)(iii) 15 Interest Credits - Regs Reality Most new plans are using either Fixed rate, or ROR on assets, possibly with cap (and/or floor) Or some combination of the two 16 8

Interest Credits - Regs What is an interest credit? an interest credit for purposes of this paragraph means the adjustments to a participant s accumulated benefit under a statutory hybrid benefit formula, to the extent not conditioned on current service Reg. 1.411(b)(5)-1(d)(1)(ii) 17 Interest Credits - Regs What is an interest credit? Some plans have an interest credit rate that is greater for active employees E.g., the rate is 6% while employed but 4% after separation from service Under regs piece dependent on service (i.e. the extra 2%) not an interest credit And is therefore a pay credit and treated as such 18 9

Changing interest rate Can interest rate be changed? Why would you want to? May be having testing issues with current (otherwise compliant) rate Current rate non-compliant 19 Changing interest rate Relief for Interest Crediting changes Interest crediting is a right to which participant is entitled once the pay credit has accrued i.e., once pay credit for a year has been earned, the right to interest at current rate through distribution is guaranteed Cannot cut future interest credits, even before they re credited Except in narrow relief provided in 2014 regs Reg. 1.411(b)(5)-1(e)(3)(i) 20 10

Changing interest rate OK to change from one compliant rate to another Wear-away approach on old balance i.e. payout greater of balance at date of change, plus interest at old rate, or such balance, plus pay credits, plus interest at new rate But not for those not active (or no longer benefiting) at amendment date. Otherwise would be receiving greater of two compliant rates Reg. 1.411(b)(5)-1(e)(3)(iii) 21 Changing interest rate Consider plan using 30-year Treasury rate Recall IRS requires.5% accrual to be receiving meaningful benefit for IRC 401(a)(26) 30-year rate for December 2014 is 2.83% Consider employee age 37, NRA 62 Compensation = $50,000; pay credit 2% of comp. APR 2015 applicable table = 156.595 (13.05 annual) 22 11

Changing interest rate Pay credit = $50,000 *.02 = $1,000 To NRA = $1,000 * (1.0283 ^ 25) = $2,009.07 Benefit = $2,009.07 / 13.05 / 50,000 =.31% Not meaningful What if change interest crediting rate to 5% fixed? To NRA = $1,000 * (1.05 ^ 25) = $3,386.36 Benefit = $3,386.36 / 13.05 / 50,000 =.51% Meaningful 23 Changing interest rate Re change from 30-year rate to fixed rate Must keep track of pre-amendment balance and continue to credit interest at 30-year rate At date of distribution such balance would be compared to actual balance Must track through distribution date since if interest rates rise substantially the old rate could re-appear 10 years later. Particularly for those receiving no pay credits Of course if 30-year rates stay where they are will be non-issue 24 12

Changing interest rate Non-compliant rates General rule: correct in most straightforward way Reg. 1.411(b)(5)-1(e)(3)(vi) Examples: Fixed at 7%: reduce to 6% 30-year Treasury yield, with floor of 6%: reduce floor to 5% Special rules apply for more complicated situations In general switch to 3 rd segment OK Effective January 1, 2017 Need to amend prior to first day of first plan year beginning on or after January 1, 2017 25 Using ROR Why use rate of return (ROR) for interest crediting? Goal is to invest assets to mirror crediting rate And shift investment risk to employees Losses do not create a funding shortfall Goal is to simply deposit pay credits Especially for multi owner situations Ala a money purchase plan! 26 13

Using ROR Issues with using ROR Potentially lower 415 Limits Potentially harder to pass 401(a)(4) / 401(a)(26) Interim interest credits Potential 411(a)(9) issue 27 Using ROR It is important to recall that a cash balance plan is a DB plan and 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 account balance in a CB plan, but only for purposes of allowing the account balance to be paid as a lump sum - i.e. ignoring 417(e), and age discrimination 28 14

Using ROR To determine the accrued benefit in a cash balance plan the account balance is projected to NRA with interest credits and converted to an annuity using plan factors AB = acct bal * (1 + int) ^ (nra aa) / apr (NRA) If crediting Actual ROR, what is int? 29 Using ROR 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 Consistent with recent cash balance LRMs And 1.401(a)(4)-3(d)(5)(iii)(H) of old 1991 regs 30 15

Using ROR - 415 CB Plan s early retirement reduction performed at greater of 5% or interest credit rate Recall max benefit = $210,000 per year at age 62, reduced for years of participation less than 10 Let s look at a case where ROR is being used and most recent ROR is 15% Partner in law firm 31 Using ROR - 415 Consider 59-year old partner in law firm 2 years in plan (2014 and 2015) Leaving and wants money (it happens) Annuity based on 5% / 2015 applicable table Pay credit $200,000 Look at interest credits of 5% and 15% 32 16

Using ROR - 415 Account balance at 5% and 15% TAB Balance 1/1/14 $ - $ - 2014 contribution credit 200,000 200,000 Balance 12/31/14 (1/1/15) 200,000 200,000 2015 interest credit 10,000 30,000 2015 contribution credit 200,000 200,000 TAB Balance 12/31/15 $410,000 $430,000 33 Using ROR - 415 What is 415 lump sum limit? If interest credit rate 5% $210,000 / 12 * 156.5947 / 170.0164 / (1.05^3) = $14,193.02 Two years of part = $14,193.02 / 10 * 2 = $2,838.60 Max LS = $2,838.60 * 158.7841 = $450,725 Account balance $410,000 so can pay 34 17

Using ROR - 415 What is 415 lump sum limit? If interest credit rate 15% $210,000 / 12 * 156.5947 / 170.0164 / (1.15^3) = $10,803.12 Two years in plan = $10,803.12 / 10 * 2 = $2,160.62 Max LS = $2,160.62 * 158.7841 = $343,073 Account balance $430,000 OOPS!! Mitigate by capping crediting rate at 5% 35 Using ROR 401(a)(4) Normal accrual rate (NAR) for testing generally = increase in accrued benefit / Comp. Assume same factors as previous slides pay credit $100K; Comp. $250K At 5% NAR = $100K * 1.05 ^ 7 / 13.05 / 250K = 4.31% At 15% NAR = $100K * 1.15 ^ 7 / 13.05 / 250K = 8.15% Leverage obtained by testing PS at 8.5% lost! Again mitigated by capping crediting rate at 5% 36 18

Using ROR 401(a)(26) Recall math from earlier slide re change in crediting rate Pay credit = $50,000 *.02 = $1,000 To NRA = $1,000 * (1.0283 ^ 25) = $2,009.07 Benefit = $2,009.07 / 13.05 / 50,000 =.31% Not meaningful What if interest crediting rate 5% fixed? To NRA = $1,000 * (1.05 ^ 25) = $3,386.36 Benefit = $3,386.36 / 13.05 / 50,000 =.51% Meaningful Lower rate can cause a26 failure mitigate with 5% fixed for NHCs 37 ROR Interim Interest Credits 2015 Grey Book Q28 Under the final hybrid regulations, a plan is not required to provide interest credits to participants whose benefits commence during an interest crediting period before the interest crediting date, but may provide such interest credits. Can a cash balance plan provide an interest credit for the current partial year based on a different acceptable interest credit basis than is used for the full period? 38 19

ROR Interim Interest Credits 2015 Grey Book Q28 (cont.) RESPONSE No. Regulation 1.411(b)(5)-1(d)(1)(iv)(D) provides that.. a plan is not treated as failing to meet the requirements of this paragraph (d) merely because the plan calculates increases or decreases to the participant's accumulated benefit by applying a rate of interest or rate of return (including a rate of increase or decrease under an index) to the participant's adjusted accumulated benefit (or portion thereof) for the period. The reference under this regulation to a rate of interest or rate of return means the plan s rate of interest or rate of return. SO When crediting annual ROR will want to NOT credit interim interest and get folks paid ASAP 39 Using ROR 411(a)(9) IRC 411(a)(9) and Reg. 1.411(a)-7(c)(1) provide that periodic benefit (i.e., annuity) payable at any point cannot be less than previously available amount Most cash balance plans provide for immediately payable lump sums upon termination of employment Reg 1.401(a)-20 Q&A 17 provides that if a non deminimis (over $5K) lump sum is available at any point (referred to as earliest retirement age in the reg) then qualified annuity forms must be available at same time 40 20

Using ROR 411(a)(9) Assume acct balance $1.5 million at age 64 Age 64 417e/2015 5% APR = 149.47; Life annuity = $10,035 Loss results in age 65 balance of $1 million Even after preservation of capital rule, as there were substantial previous gains Age 65 417e/2015 5% APR = 145.819; Life annuity = $6,858 Participant has right to $10,035 life annuity at 65 VERY EXPENSIVE 41 ROR - Sub pools of assets New option in 2014 regs: Credit return on sub-pool of plan assets Sub-pool option intended to accommodate cash balance conversions: Pool 1: Assets invested to pay traditional DB benefits Pool 2: Assets invested to pay interest credit = ROR on CB accounts 42 21

ROR - Sub pools of assets But Preamble to regs also states: a plan sponsor may wish to credit interest based on a rate of return that differs for different groups of participants (such as using a more conservative, or less volatile, subset of plan assets for long service employees) 43 ROR - Sub pools of assets Lead to lifestyle/target date CB plans? Each sub-pool is a separate investment policy Participants assigned to particular sub-pool Segment participants by age? Age discrimination a risk? See inter-sector notes on following slide 44 22

ROR - Sub pools of assets October 15, 2014 inter-sector notes: The IRS/Treasury representatives explained that any sort of age-based criteria would take you out of the age discrimination safe harbor for lump sumbased plan formulas, which means that the plan would have to satisfy the general age discrimination requirements of IRC section 411(b)(1)(H)(i). They commented that they were careful that the example they provided in the preamble depended on service, not age. 45 ROR - Sub pools of assets Does the ability to use sub-pools equate to individual direction as some have implied? In the words of the great philosopher Eric Theodore Cartman Uh, no 46 23

Late Retirement With respect to a participant with an annuity starting date after NRA, a cash balance plan must either provide an actuarial increase after NRA, or satisfy the requirements for suspension of benefits under 411(a)(3)(B). Accordingly, a cash balance plan that does not properly suspend benefits violates the requirements of 411(a) if the balance of the hypothetical account is not increased sufficiently for post NRA distributions Reg. 1.411(a)(13)-1(b)(2)(i) 47 Late Retirement Consider a plan crediting interest based on the ROR of plan assets (or other equity based rate) Absent a minimum rate such a plan could violate the rules for post NRA increases in years with low or negative returns But a minimum rate would violate the market rate requirement (absent relief) 48 24

Late Retirement Reg. 1.411(b)(5)-1(e)(4) provides such relief A statutory hybrid plan is not treated as providing an effective interest crediting rate that is in excess of a market rate merely because the plan provides that the participant s benefit, as of each annuity starting date after normal retirement age, is equal to the greater of-- (i) The benefit based on the accumulated benefit determined using an interest crediting rate... not in excess of a market rate ; and (ii) The benefit that satisfies the requirements of section 411(a)(2). 49 Late Retirement Of course this is not an issue if significant pay credits are still being received i.e. post retirement actuarial increase is only required if adjusted NRA accrual would result in a benefit greater than that received under the terms of the plan including continued accruals 50 25

Late Retirement Consider balance at NRA (65) of $500,000 Interest credit based on ROR plan assets APRs based on 2015 417(e) table and 5% Age 65 = 145.819 age 66 = 142.109 Assume reasonable rate for post retirement increase is 5% - note there is no guidance here 51 Late Retirement Accrued benefit at 65 = $3,428.91 $500,000 / 145.819 = $3,428.91 Age 66 AB would need to be $3,694.35 $3,428.91 * 145.819 * 1.05 / 142.109 = $3,694.35 Balance would need to be at least $525,000 $3,694.35 * 142.109 = $525,000 If ROR under 5% and no (or low) pay credit would need to adjust interest credit upward 52 26

Late Retirement Note that this is algebraically the same as insuring interest credit is enough for reasonable adjustment So what is reasonable? Certainly not a negative rate based on ROR or RIC 30-year Treasury? Currently ~ 3% 3-year Treasury + 50 bps? Currently ~ 1.5% Again, zero guidance 53 27