A BNA, INC. PENSION & BENEFITS! DAILY Reproduced with permission from Pension & Benefits Daily, 107 PBD, 06/03/2011, 06/03/2011. Copyright 2011 by The Bureau of National Affairs, Inc. (800-372- 1033) http://www.bna.com Hybrid Plans at the Crossroads: Will Treasury and IRS Allow Them to Be Defined Benefit Plans? BY RICHARD C. SHEA, ROBERT S. NEWMAN, AND KATHERINE MINEKA T reasury and IRS face a fundamental choice: Do they force hybrid plans to operate like defined contribution plans or do they allow them to remain what they legally are, namely, defined benefit plans? Richard C. Shea (rshea@cov.com) is a partner at Covington & Burling LLP, Washington, D.C. He served in the Office of Tax Policy at the United States Department of the Treasury during the early 1990s. Robert S. Newman (rnewman@cov.com) and Katherine Mineka (kmineka@cov.com) are, respectively, a partner and a senior associate at the firm. Recent proposed and final regulations 1 issued by the agencies take the first approach and limit hybrid plans to operating like defined contribution plans. Going down this path simply provides another way to shift the risks of retirement savings to employees, something the nation s retirement system does not need. The agencies could instead take the second (in our view, legally mandated) approach and allow hybrid plans to operate as defined benefit plans. If they did, hybrid plans could offer an entirely new retirement plan 1 75 Fed. Reg. 64,123 (Oct. 19, 2010) (final regulations); 75 Fed. Reg. 64,197 (Oct. 19, 2010) (proposed regulations)(200 PBD, 10/19/10; 37 BPR 2306, 10/26/10). Corrections to the regulations were published in the Federal Register on Dec. 28, 2010. See 75 Fed. Reg. 81,456 (final regulations); 75 Fed. Reg. 81,543 (proposed regulations). COPYRIGHT 2011 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN
2 option. Rather than shift all the risks to employees, as defined contribution plans do, or retain all the risks for employers to bear, as do more conventional defined benefit plans, the regulations could foster the growth of a retirement plan that shares the risks of retirement savings between employers and employees. 2 In the Pension Protection Act of 2006 (PPA), Congress recognized the important role that cash balance and pension equity plans can play in the retirement security of American workers. The PPA settled the longstanding question of whether a defined benefit plan can express benefits in terms of an account, as hybrid plans do. Clearly encouraging hybrid plans, the PPA explained how an account-based defined benefit plan can comply with rules such as the statutory prohibitions against forfeitures and age discrimination. But the PPA did more. While permitting hybrid plans to credit a market rate of return (like defined contribution plans), the PPA also added new features to hybrid plans to protect employees from the full rigors of the market (unlike defined contribution plans). Under the PPA, negative market returns can never push an employee s benefit below the sum of the pay credits to his or her account. In addition, the PPA expressly permits plans to offer higher guaranteed minimum rates of return. In crafting the current proposed and final regulations, Treasury and IRS sought to curtail the effect of these new protections for employees and at the same time eliminated the ability of hybrid plans to subsidize employees retirement distributions. Taking this approach means that the benefits provided by a hybrid plan, like the benefits provided by a defined contribution plan, cannot exceed the value of the participant s account. Yet these constraints are unnecessary, and, indeed, unwarranted. The purposes of the PPA, as well as sound retirement policy, dictate that hybrid plans be able to operate as what they legally are, namely, defined benefit plans. Defined Contribution Versus Defined Benefit Defined contribution plans have two salient characteristics. First, a participant s benefit is limited to his or her account balance and whatever can be purchased with that balance. If a defined contribution plan participant elects to receive a benefit in the form of a lump sum, the lump sum must equal the account balance. If the participant wishes to receive a benefit in the form of an annuity, the plan must purchase an annuity using the assets in the account; the plan cannot offer an annuity in excess of what can be purchased with the account balance. The bottom line is that the value of the benefit provided by a defined contribution plan cannot exceed the value of the assets in the participant s account at the time of distribution. There is no way for a defined contribution plan to subsidize the benefits available to participants under the plan. The second salient characteristic of defined contribution plans is that the account balance itself is limited to 2 If, on the other hand, hybrid plans are limited to operating like defined contribution plans, they would merely serve to increase the contribution and deduction limits for defined contribution-type retirement vehicles, which is likely to benefit high-income individuals, but hardly anyone else. the dollar value of the contributions made to the account and the gains (or losses) that the contributions generate when actually invested in the market. A defined contribution plan cannot offer a guaranteed rate of return or protection against loss unless it purchases the guarantee or protection with the assets in the account. Financial products that offer a guaranteed return or protection against loss can be purchased in the market but come at the cost of a reduction in the rate of return investors can earn from the assets they invest in the product. By contrast, defined benefit plans are not subject to either of these limitations. First, a defined benefit plan can pay out benefits that exceed the value of the accrued benefit. 3 For example, a defined benefit plan might offer an early retirement subsidy by paying the same monthly annuity amount available at normal retirement age to a participant who retires early (i.e., with no reduction for early commencement). A defined benefit plan also could offer a subsidy with respect to the form of distribution, for example, by offering a 100 percent joint and survivor annuity under which the monthly annuity amount is the same as the participant would receive under a single life annuity (i.e., with no reduction for the survivor portion of the benefit). In addition, subsidies can be included in other benefits available under the plan, such as pre-retirement death benefits, disability benefits, or benefits in the case of layoff or plant closing. In each case, the subsidized benefit can exceed the value of the benefit the participant has accrued and vested in at the time payment begins. Second, defined benefit plans can offer guaranteed returns and protections against loss that are not available in the market. The accrued benefit in a defined benefit plan does not need to reflect the value of any actual assets and therefore is not limited to the benefit that any actual assets could purchase in the market. 4 Regulations Treat Hybrid Plans Like DC Plans Under the regulations, hybrid plans are limited to providing distributions that are exactly equal in value to the balance in the participant s account at the time of distribution. In addition, the regulations limit the rates of return hybrid plans may credit in order to ensure that the market protections Congress provided in the PPA have no meaningful economic value. In short, the regulations force hybrid plans to act like defined contribution plans. Hybrid Distributions Limited to Account Balance. With respect to the distribution options under hybrid plans, the PPA did just one thing: It eliminated any requirement to perform a so-called whipsaw calculation in determining the amount of any distribution from a hy- 3 See Treas. Reg. 1.411(d)-3(g)(6)(iv) (early retirement and QJSA subsidies); Treas. Reg. 1.401(a)-20, Q&A-37 & 38 (fully subsidized QJSAs). 4 The funding rules, as amended by the PPA, could in some cases limit the benefits that may be paid from a defined benefit plan when the plan is significantly underfunded. See tax code 436. However, these rules do not require a one-to-one correlation between the assets in the trust and the benefits that are paid. Indeed, in an underfunded plan, benefit distributions necessarily will exceed the assets available to pay them. 6-3-11 COPYRIGHT 2011 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN
3 brid plan. 5 The regulations, however, impose a series of conditions on distributions from hybrid plans that appear nowhere in the statute. Under the regulations, for example, a lump sum must equal the participant s account balance at the time of distribution, and all other forms of distribution must be actuarially equivalent to that account balance, in order to satisfy tax code Section 411(a)(13)(A). 6 In essence, the regulations would constrain hybrid plans to providing only the benefits that could be purchased with the account balance, just like defined contribution plans. By limiting the annuities payable under a hybrid plan to the actuarial equivalent of the hypothetical account balance, the regulations prevent hybrid plans from providing subsidies to participants. Subsidies, by definition, provide value in excess of the participant s accrued benefit. Under the hybrid regulations, no value may be provided that is not reflected in the account. The regulations would therefore prevent hybrid plans from offering subsidized benefits, such as those based on time of commencement (e.g., early retirement) or form of payment (e.g., qualified joint and survivor annuity). Yet most broad-based hybrid plans offer early retirement subsidies 7 and subsidize at least some forms of distribution, typically the qualified joint and survivor annuity. Indeed, the PPA specifically recognized that a hybrid plan may offer an early retirement subsidy or retirement-type subsidy. 8 Removing these subsidies will result in less favorable treatment for many plan participants and a massive cutback in participants protected accrued benefits. It is unclear what policy objective Treasury and IRS hope to achieve at such a significant cost to participants. 9 Hybrid Rate of Return Limited to DC Plan Rate. Under the PPA, a hybrid plan cannot credit participants hypothetical accounts with a rate of return in excess of a market rate of return. 10 The PPA also added two rules to protect participants from the full rigors of the market. First, the participant s account balance at the time distributions begin can never be less than the sum of the contribution credits made to the account through that date; in effect, this rule places a zero cumulative floor under the account, permitting hypothetical investment losses to offset gains but never principal. 11 This differs from a defined contribution plan, where losses may reduce not only gains but also any contributions made to the participant s account. Second, the PPA permits plans to provide a reasonable, minimum guaranteed rate of return that is higher than the zero cumulative floor. 12 This also differs from a defined contribution plan, which may only offer a guaranteed rate of return to the extent that the account assets are invested in a commercially-available financial instrument with a guaranteed rate of return (such as a guaranteed investment contract). The proposed and final regulations adopt an artificial definition of market rate of return that bears little resemblance to its commonly understood meaning. 13 Rather than offering a wide range of investment rates of return available in the market, the regulations limit the permissible rates to relatively low fixed interest rates and variable rates with relatively low volatility. As a result, the zero cumulative floor and minimum guaranteed rates of return add little value to the participant s benefit. 14 Indeed, the preamble acknowledges as much. 15 5 Under the whipsaw approach, a cash balance plan was required to calculate the amount of a lump sum payment by projecting the participant s account balance to normal retirement age using the plan s interest crediting rate, and then converting the resulting benefit to a present value using certain statutory actuarial assumptions. This calculation often resulted in lump sum payments that exceeded the account balance (and the younger the participant, the greater the lump sum). Under the PPA, however, the account balance is considered to be the present value of the accrued benefit in a hybrid plan, and no whipsaw calculation is required. Tax code 411(a)(13)(A). 6 Prop. Treas. Reg. 1.411(a)(13)-1(b)(2)(iv)(A), (b)(3). 7 Early retirement subsidies on hybrid benefits typically are offered to protect the benefit expectations of older, longerservice employees following a conversion from a traditional defined benefit plan with early retirement subsidies. 8 For the purpose of determining whether a participant s accrued benefit under the plan as of any date would be equal to or greater than that of any similarly situated younger individual, the accrued benefit is determined by disregarding the subsidized portion of any early retirement benefit or retirement-type subsidy. Tax code 411(b)(5)(A)(iii). 9 Whatever the objective, there is no need to restrict subsidies on participants hybrid benefits because current law already regulates the maximum amount of subsidy permitted under a defined benefit plan. See tax code 411(a)(9); Treas. Reg. 1.411(a)-7(c) (periodic amount of single life annuity payable at early retirement age cannot exceed periodic amount of single life annuity payable at normal retirement age); tax code 417(a)(5)(B) & (b); Treas. Reg. 1.401(a)-20, Q&A- 38(a)(2) Ex. 2 (periodic amount of joint portion of QJSA cannot exceed periodic amount of single life annuity commencing at same age); tax code 401(a)(9), 417(b)(1); Treas. Reg. 1.401(a)(9)-6, Q&A-2(b)&(c) (periodic amount of survivor portion of QJSA cannot exceed periodic amount of joint portion of QJSA); Treas. Reg. 1.401(a)-20 Q&A-16 (no form of benefit may be more valuable than the QJSA payable commencing at the same age). 10 Tax code 411(b)(5)(B)(i)(I) (a plan will be deemed to violate tax code 411(b)(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 ). 11 Tax code 411(b)(5)(B)(i)(II) ( An applicable defined benefit plan shall be treated as failing to meet the requirements of [tax code 411(b)(1)(H)] unless the plan provides that an interest credit (or equivalent amount) of less than zero shall in no event result in the account balance or similar amount being less than the aggregate amount of contributions credited to the account. ). 12 Tax code 411(b)(5)(B)(i)(I) (a plan shall not fail to have a market rate of return merely because the plan provides for a reasonable minimum guaranteed rate of return. ). 13 Treas. Reg. 1.411(b)(5)-1(d); Prop. Treas. Reg. 1.411(b)(5)-1(d). 14 According to the drafters, the regulations restrictions on market rate of return stem from concern that a more volatile rate, coupled with the zero cumulative floor, could result in age discrimination. However, this concern is unfounded. In particular, the zero cumulative floor does not result in age discrimination because its value primarily accrues to investors with short investment horizons, i.e., older workers. Data show that the zero cumulative floor has most value when investments are held for a short period; rarely would it have value for investments held for more than 10 years. See ERISA Industry Committee, Comments on Proposed & Final Regulations on Hybrid Retirement Plans, First Comment: Market Rate of Return, pp. 9-10 (Jan. 12, 2011), available at http://op.bna.com/ pen.nsf/r?open=ddoe-8h9swb. This suggests that a younger participant with more than 10 years before retirement would almost never benefit from the zero cumulative floor. 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4 In a defined contribution plan, a participant wishing to invest in a option with protection against loss would be required to pay for the protection with a lower rate of return. Similarly, if a participant wanted a guaranteed rate of return, the rate would be lower than the expected return if the plan assets were invested in a variable rate product with no guaranteed floor. By limiting permissible market rates of return to low fixed interest rates and variable rates with relatively low chance of significant gains, the regulations effectively force hybrid plan participants to pay for the additional protections of the zero cumulative floor and the minimum guaranteed rate of return. This is directly analogous to how such protections would be implemented in a defined contribution plan and results in a less favorable benefit formula than the plan could otherwise offer. It is difficult to imagine that Congress added the zero cumulative floor and minimum guaranteed rate of return protections to the PPA intending that Treasury would then deprive them of any meaningful economic value by limiting the market rates of return available to hybrid plan participants. But that is precisely what has happened in the current proposed and final regulations. Let Hybrid Plans Be Defined Benefit Plans Nothing in the text of the PPA would constrain hybrid plans to act just like defined contribution plans. Instead, Treasury and IRS should consider an alternate approach, one that recognizes that hybrid plans are defined benefit plans and regulates them accordingly. Under this alternate approach, hybrid plans could provide an account-based benefit while maximizing the enhancements and protections that are available under a defined benefit plan. Despite certain similarities with defined contribution plans, hybrid plans are defined benefit plans. As defined benefit plans, hybrid plans have greater flexibility to structure their benefits. A hybrid formula could be designed to give participants the benefits of an individual account with the potential to appreciate over time based on actual market investment returns, while still providing the security and benefit enhancements of a defined benefit plan. To give participants the benefits of an individual account, a hypothetical account established under a hybrid plan should be permitted to function similarly to a real defined contribution plan account. Under this approach, the plan would credit the hypothetical account with an actual market rate of return. Ideally, the return should be on a diversified portfolio of investment assets that shifts over time in response to each participant s other hand, an otherwise similarly-situated older participant with less than 10 years before retirement would be much more likely to experience a negative cumulative rate of return in the absence of the zero cumulative floor. Furthermore, Congress specifically added the zero cumulative floor as a condition of relief from the age discrimination rules. In doing so, Congress expressed the view that the failure of a plan to include the zero cumulative floor would be age discriminatory. It is hard to imagine how a provision that was added to protect older participants could simultaneously create a discriminatory rate of return. 15 75 Fed. Reg. at 64205. changing circumstances. 16 This result could be achieved automatically through the use of target date funds or managed accounts approved as qualified default investment alternatives under Section 404(c)(5) of the Employee Retirement Income Security Act. 17 It could also be achieved by permitting participants to direct the allocation of their hybrid plan account among some or all of the investment options available under the employer s tax code Section 401(k) plan, ideally with the assistance of appropriate investment advice. 18 Under this approach, there would be no need for artificial constraints on the volatility of investment returns since qualified default investment alternatives are by their nature highly diversified and the investment options under a Section 401(k) plan are selected by fiduciaries whose choices are regulated under Title I of ERISA. Constructing hybrid accounts in this fashion would afford participants most of the advantages of an individual account in a defined contribution plan. In addition, because of its legal status as a defined benefit plan, a hybrid plan could offer participants benefit enhancements that are not available under a defined contribution plan. The plan could provide participants with a reasonable, minimum guaranteed rate of return, either at the mandated minimum level required by the zero cumulative floor or voluntarily at a higher rate permitted under the PPA. The plan could also segregate part of a participant s account (either automatically or at the participant s direction) and credit it with one of the non-investment rates of return permitted under the regulations, such as a fixed rate of interest or a variable bond yield. The plan could offer favorable annuity conversion rates and (subject to the limits applicable to all defined benefit plans) even provide subsidies on distributions to some or all participants and their beneficiaries, including subsidies on early retirement benefits, joint and survivor annuities, pre-retirement death benefits, disability benefits, and layoff and plant closing benefits. By combining the best features of defined contribution and defined benefit plans, hybrid plans would represent a meaningful improvement for both plan participants and plan sponsors. Under a hybrid plan, participants would be able to enjoy an account-based benefit earning a market-based rate of return with meaningfully lower investment risk than a traditional defined contribution plan. In addition, a hybrid plan could provide subsidies and other valuable benefits that are not available through a defined contribution plan. Plan sponsors would also benefit because an account-based structure makes it easier for the sponsor to reduce funding volatility and to match plan investments to future benefit obligations. Sponsors would also benefit from the flexibility to offer early retirement 16 One of the major shortcomings of the regulations in their current form is that they fail to offer investment rates of return that are properly diversified and capable of adjusting over time in response to participants changing circumstances. Indeed, the investment rates offered under the regulations are guaranteed to be inappropriate for virtually all participants virtually all of the time (e.g., the rate of return on an S&P 500 mutual fund). 17 29 C.F.R 2550.404c-5(e)(4)(i) & (iii). 18 Employer stock might be excluded from the available options and, for technical reasons, an intermediate bond fund or a variable bond yield rate of return might be substituted for the Section 401(k) plan s stable value fund. 6-3-11 COPYRIGHT 2011 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN
5 benefits and other enhancements that cannot be offered through a defined contribution plan. Such an arrangement offers the ability to share the risks of retirement saving between employers and employees in a way that is not available in either defined contribution plans or more conventional defined benefit plans. An Opportunity for Significant Improvement The past two decades have seen a significant shift toward account-based plans as the primary source of retirement benefits for employees. As a result, investment risk has shifted from the plan sponsor to the participant. In drafting the hybrid plan regulations, Treasury and IRS have an opportunity to embrace and encourage an account-based plan that has the benefits of a defined contribution plan but reduces investment risk for participants and offers other benefit enhancements such as subsidies. By contrast, if the regulations go into effect as written and hybrid plans are forced to operate like defined contribution plans, the PPA will have made hybrid plans irrelevant. Congress, however, did not write the PPA to make hybrid plans look just like defined contribution plans. The PPA seeks to foster hybrid plans operating like defined benefit plans to provide plan participants and sponsors with the advantages of both worlds. Treasury and IRS should reconsider their current approach of creating yet another defined contribution vehicle that adds nothing of material value to the nation s retirement system. ISSN BNA 6-3-11