Pension Update: The Hybrid Plan Regulations ABA Tax Section 2011 Midyear Meeting January 22, 2011 Boca Raton, Florida Background on Hybrid Plans Hybrid plans represented more than 40% of defined benefit plans in 2007 compared with about 10% in 1997* Hybrid plans are often described as defined benefit plans that look like defined contribution plans Like DC plans, hybrid plans commonly express the participant s benefit as a current account balance Unlike DC plans, hybrid plan accounts are hypothetical bookkeeping accounts and generally do not reflect actual contributions or earnings Cash balance plans, the most common form of hybrid plan, define the benefit by reference to a participant s hypothetical account balance, which is credited with hypothetical contributions (pay credits) and hypothetical earnings (interest credits) Other types of hybrid plans (e.g., Pension Equity Plans) Prior to the Pension Protection Act of 2006 (PPA), there were no legislative rules specific to hybrid plans guidance attempted to apply existing DB rules to hybrid plans *Source: Hewitt Associates SpecBook survey of nearly 1,000 major US employers 2
Hybrid Plans under Prior Law Controversial issues under prior rules age discrimination and whipsaw Age discrimination argument that interest crediting disproportionately benefits younger workers who have a longer time to benefit from such crediting and, therefore, for a given hypothetical contribution younger workers receive a larger benefit at retirement Whipsaw where the interest crediting rate of the plan is higher than the discount rate, the payout of a single sum equal to the account balance prior to normal retirement age can result in a forfeiture Notice 96-8: Provided that balance generally must be projected to normal retirement age and then discounted to present value to determine single sum payout. However, 96-8 provided that, if the interest crediting rate was no greater than the yield on 30-year Treasury bonds (generally), then the plan could limit the single sum distribution to the account balance. In 2002, IRS and Treasury issued proposed regulations relating to cash balance and other hybrid plans that would have provided guidance on the age discrimination issue. These regs were withdrawn in 2004 after Congress enacted a rider to a bill that prohibited Treasury from spending funds to finalize the regulations. 3 Prior Law - Cash Balance Conversions Most cash balance plans are a result of conversion from traditional final average pay defined benefit formula In many cases the plan conversion resulted in a period of wearaway, where the accrued benefit did not increase until the benefit under the cash balance formula exceeded the 411(d)(6) protected benefit under the prior plan formula In 1999, the IRS Employee Plans Division issued a moratorium on determination letters involving cash balance plans that were a result of a conversion 4
Hybrid Plan PPA Guidance to Date Code 411(a)(13) and 411(b)(5), added by PPA Notice 2007-6, issued in December 2006, provided initial guidance Proposed regulations published in December 2007 Final and proposed regulations published October 19, 2010 5 2010 Regulations and Future Guidance 2010 final and proposed regulations The regulations proposed in December 2007 are finalized Proposed regulations address issues not addressed under the final regulations Future guidance The proposed regs will be finalized Possible that another set of proposed regulations will be issued these proposed regulations request comments on a number of issues 6
Key Terminology Applicable Defined Benefit Plan Statutory Hybrid Plan Statutory Hybrid Benefit Formula Lump Sum-Based Benefit Formula Similar Effect Formula 7 Applicable Defined Benefit Plan Under the Code: Applicable Defined Benefit Plan DB plan under which the accrued benefit (or portion thereof) is calculated as The balance of a hypothetical account, or Accumulated percentage of final average pay Secretary of Treasury to issue regulations to include defined benefit plan which has a similar effect as an applicable DB plan 8
Statutory Hybrid Plans/Formulas Under the Regulations: Statutory hybrid plan a DB plan that includes a statutory hybrid benefit formula Statutory hybrid benefit formula a benefit formula that is either a lump sumbased benefit formula or a similar effect benefit formula 9 Lump Sum-based Benefit Formula A lump-sum based benefit formula is one where the terms of the plan express the participant s accumulated benefit as a current balance (cash balance) or as a current accumulated percentage of final average pay (pension equity) Does not depend on plan s definition of accrued benefit Does not depend on whether single-sum distribution is available Exception for employee contribution-based benefit 10
Similar Effect Formula A formula has a similar effect to a lump sum-based benefit formula if Includes right to future adjustments, and Total dollar amount of adjustments is expected to be smaller for an older participant than a similarly-situated younger participant Includes Indexed career average pay plans Variable annuities, unless the assumed interest rate is 5% or higher Excludes Employee contribution-based benefit Postretirement benefit adjustments Variable annuities with assumed interest rate of 5% or higher 11 Whipsaw Relief Under 411(a)(13)(A) -- Plans won t violate the anti-forfeiture, participant consent, and minimum valuation rules solely because present value of a participant s benefit is equal to the current account balance (in the case of a cash balance plan) Applies to most hybrid plans -- Plans with lump sum-based benefit formulas (i.e., cash balance plans and PEPs) -- but not to similar effect hybrid plans (such as indexed plans) Proposed regulations -- Proposed regs provide additional guidance 12
3-year Vesting Requirement 3-year cliff vesting Participant-by-participant application Applies to the participant s entire benefit under the plan (not just hybrid formula benefit) Applies where plan provides the greater of two benefits and the non-statutory hybrid benefit is the controlling benefit Does not apply to separate offset plan 13 Age Discrimination Safe Harbor Code 411(b)(1)(H) -- Rate of employee s benefit accrual cannot reduce because of age. PPA introduced safe harbor 411(b)(5)(A) As of any date -- Accumulated benefit of any participant must not be less than corresponding amount for any similarly situated younger participant Accumulated benefit can be expressed under any of the three safe-harbor formula measures as normal retirement annuity, hypothetical account, or PEP balance Similarly situated -- Identical in every respect relevant for determining benefits (e.g., period of service, compensation, position, date of hire, work history, etc.) except for age. Any characteristic based directly or indirectly on age is disregarded. 14
Final Regs Conversion Protection A+B required -- Must provide A+B benefit with no permitted interaction between A and B benefits (i.e., cannot offset benefits) Conversion amendment if both -- (1) Amendment reduces nonhybrid benefits that participant would have accrued but for amendment, and (2) post-amendment, a portion of participant s benefit is determined under a hybrid formula Set and test -- Plans can satisfy conversion protection requirements by using an opening account balance, provided that the participant s benefit at benefit commencement is not less than it would be under A+B (i.e., separate tracking of A+B necessary) Other conversion situations Acquisitions/employee transfers 3-year presumption Can t avoid rule through gradual conversion 15 Proposed Regs Additional Conversion Protection Rule Set and forget -- Opening account balance can be established upon conversion without subsequent comparison at annuity starting date, provided certain requirements are met Requirements intended to ensure very unlikely that benefit provided by opening balance will be less than benefit provided under the plan before conversion - i.e., benefit provided by opening balance likely to be at least as large as A benefit Must use a permissible bond-based interest crediting rate and this rate must be greater than the discount rate used to determine opening account balance Applies only to single-sum distribution (A+B still applies to annuity forms) 16
Market Rate of Return Interest credits cannot exceed a market rate of return Interest credit Increase or decrease for a period to a participant s accumulated benefit Calculated by applying a rate of interest or other rate of return Credit not conditioned on current service nor made due to imputed service Preservation of capital At annuity starting date, benefit cannot be less than the sum of the principal credits i.e., while interest credits in a period can be negative, they cannot cumulatively result in reduction of benefit to less than principal credits 17 Market Rates Final Regulations Permissible rates under final regulations -- 1 st, 2 nd, or 3 rd segment rate Notice 96-8 rates Annuity contract rates Plan asset rate of return (for indexed plans) Plan can use lesser of rates rate equals lesser of two rates where at least one is a permissible rate Plan can use capped rates rate is always less than a permissible rate 18
Proposed Market Rate of Return Regs For plan years beginning on or after 1/1/12, there would be a closed list of acceptable rates Additional permissible rates under proposed regs -- Two equity-based rates Rate of return on plan assets, provided assets are diversified Plans that comply with ERISA Title I diversification requirement meet volatility standard Rate of return on a RIC that is reasonably expected to be not significantly more volatile than broad U.S. equities market or similarly broad international equities market Certain limited greater-of rates permissible Annual 4% floor in conjunction with permissible bond-based rate Cumulative 3% floor (applied at annuity starting date) in conjunction with any permissible rate Fixed 5% rate 19 Timing of Amendments and 411(d)(6) PPA section 1107 For amendments pursuant to statute and regulations, remedial amendment period, generally including 411(d)(6) relief, extended through end of 2009 plan year Notice 2009-97 Extended hybrid plan amendment deadline through end of 2010 plan year Applies to all interim and discretionary amendments Relief from 411(d)(6), provided amendments are to the extent necessary to comply with statutory requirements Does not apply to account balance (whipsaw) amendments Notice 2010-77 -- Extends 2009-97 for another year Cumulative list and determination letter filings 20
Additional Amendment-Related Issues To the extent necessary the standard for 411(d)(6) relief 204(h) notice if significant reduction in rate of future benefit accrual Plan operation prior to effective date of regulations Reasonable, good faith interpretation of statute? Reliance on final/proposed regulations? 21 Common Amendment Questions What if we need a fixed rate above 5% to satisfy backloading? Does the amendment delay in Notice 2010-77 apply to all amendments or just market rate amendments? Can we change from our above-market fixed rate to the rate on plan assets or to a permissible RIC rate? Can we change from one permissible rate to another permissible rate, where neither is above-market? What if our rate is a permissible bond-based rate but the lookback or stability period doesn t comply with the final regs? 22
Effective Dates Statutory effective dates PPA age discrimination safe harbors generally apply to periods beginning on or after June 29, 2005 PPA conversion protections apply to a conversion amendment adopted and effective after June 29, 2005 PPA whipsaw relief effective for distributions made after August 17, 2006 For plans in existence on June 29, 2005, 3 year vesting and market rate of return rules are effective for years beginning after December 31, 2007 For plans not in existence on June 29, 2005, 3 year vesting rule effective for plan years ending on or after June 29, 2005 and market rate of return limitation effective for periods beginning on or after June 29, 2005 Regulatory effective dates Final regs generally apply to plan years that begin on or after Jan. 1, 2011 and proposed regs generally are proposed to apply (once finalized) to plan years that begin on or after Jan. 1, 2012 23