False alarm! IRS withdraws controversial proposed cross-testing regulation provisions

A couple of months ago, the IRS proposed some changes to the §1.401(a)(4) nondiscrimination testing regulations.  On Thursday, they withdrew the part of those proposed regulations that was bad news for plan sponsors, as noted in our prior post.

We are pleased the IRS has reconsidered the unintended consequences benefit formula restrictions and “facts and circumstances” based determinations could have on employers’ willingness to sponsor qualified retirement plans.

Surprises in the proposed cross-testing regulations

surprised face

On January 29th, the IRS proposed revisions to the nondiscrimination testing regulations of §1.401(a)(4).  The title of proposed regulations (and most of the attention generated by them) is focused on the relief for closed defined benefit (DB) plans.  This post summarizes the proposed changes that would affect more than just closed DB plans.  Most of them are beneficial to plan sponsors, but one is not.

The bad news – benefit formula restrictions

The biggest surprise is a proposed restriction in setting different benefit levels for different participant groups.

Currently, plans can generally separate the participant population into groups with different benefit levels/formulas as desired, so long the plan is doesn’t disproportionately favor Highly Compensation Employees (HCEs) relative to non-HCES.  Plans can even go so far as to separate each plan participant into his or her own “group”.

The proposed regulations would require HCEs’ benefit formulas to apply to a “Reasonable Classification” of employees*.  This is a “facts and circumstances” determination.  §1.410(b)-4(b) states that “reasonable classifications generally include specified job categories, nature of compensation (i.e. salaried or hourly), geographic location, and similar business criteria”.  Picking participants by name (or in a way that effectively does that) is not considered a reasonable classification.

This is an important issue for plans that allow each participant to have a separate benefit level and rely of the Average Benefit Test to satisfy §1.401(a)(4).  Other plans may need to consider if their benefit groups are a reasonable classification.

*Unless the rate group satisfies the Ratio Percentage Test.

The good news – cross-testing gateways for aggregated DB/DC plans

The favorable part of the proposed regulations is more flexibility in combining DB and DC plans for nondiscrimination testing.  These proposed changes were suggested by the IRS in Notice 2014-5, so they aren’t a surprise to those that have kept up with the IRS’s previous relief efforts for closed DB plans.  However, those suggestions haven’t got much attention so they are good news for many.

Plans must pass through a “gateway” before aggregating DC and DB plans in a cross-test.  A cross-test is generally much more favorable than testing each plan separately.  The currently available gateways are:

  1. The DB/DC plan is “primarily defined benefit in character”
  2. The DB/DC plans consist of broadly available separate plans
  3. The DB/DC plan provides a minimum allocation to all benefitting non-HCEs

The proposed regulations would expand the DB/DC gateway options in three ways:

1.  New gateway: The proposed regulations would add another gateway – passing the cross-test test with a 6% interest rate (rather than the standard 7½% to 8½%). While the DB/DC would technically still need to pass the cross-test with a standard interest rate, this option could practically eliminate the gateway requirement for DB/DC plans that can pass with 6% interest.

2.  Matching contributions use: The proposed regulations would allow the average matching contribution for non-HCEs (up to 3% of pay) to count toward the DB/DC minimum allocation gateway. Matching contributions would still not be included in the cross-test.

3.  Option to average DC allocation rates: Current rules allow DB allocation rates for non-HCEs to be averaged for satisfying the minimum allocation gateway. The proposed regulations would allow the same treatment for DC allocation rates.  The purpose of this change is to allow plans to provide lower allocation rates for those with less service by providing higher rates to those with more service.

The IRS notes that they’re considering if restrictions on this option are needed to ensure it is used as intended, and not as another technique for minimizing non-HCE benefits.  The proposed regulations would also limit averaging of DB and DC rates to reduce the impact of outliers.

Many plans that satisfy the §1.401(a)(4) requirements with a general test will need or want to revisit their benefit formula design if these proposed regulations become final.  There is sure to be a lot of resistance to the benefit formula restrictions, so the regulations may not be finalized as proposed.  If you would like to send comments on the proposed regulations you can do so until April 28, 2016.

Plan sponsors may apply the proposed regulations specific to closed DB plans right away, but may not use the flexibility of the other proposed cross-testing rules until they are finalized.  We encourage you to contact your actuary if you have questions about how these proposed rules would affect your plan.

MAP-21: Good News & Bad News for Pension Plans

The “Moving Ahead for Progress in the 21st Century” (MAP-21) legislation signed into law last week included significant pension law changes.  These included good news and bad news for sponsors of defined benefit pension plans.

The good news is that MAP-21 provided some relief from the historical low interest rate environment.  The funding segment interest rates (which are based on 24 month average rates) will now be restricted to a range around the 25 year average rates.  That range is 10% for 2012, ramping up to 30% for 2016 and beyond.  This effectively increases the funding interest rates for 2012, which can significantly lower the liability and minimum contribution requirements from what they otherwise would be.

The bad news of MAP-21 is sharp increases in PBGC premium rates.  The fixed and variable rate premiums will increase as shown in the table below.  Rates will also be indexed for inflation.

Certain plans will also need to disclose the effect of the stabilized interest rates to participants on the Annual Funding Notice.  This applies to plans with 50 our more participants, a funding shortfall of $500,000 or more (based on rates without stabilization), and stabilized Funding Target less than 95% of the Funding Target without stabilization.

It’s important to note that the interest rate changes are optional for 2012.  Some plans, like professional firm cash balance plans, will not benefit from the interest rate changes and can avoid the expense of restating their 2012 valuation results.

Many plans will want to take advantage of the option to calculate the minimum contributions with the stabilized rates.  Those that do will have the option to measure funded status for benefit restriction purposes with or without stabilization.  MAP-21 does not allow the stabilized rates to be used for 2012 benefit restrictions without also using them for the minimum contribution calculation.

The interest rate stabilization of MAP-21 will not apply to the minimum lump sums under §417, maximum deductible contributions, PBGC variable rate premiums or PBGC §4010 reporting.  Pension accounting under FASB ASC 715 is also not affected.

Additional guidance from the IRS is needed to determine the exact impact of this law change and how to implement it for 2012.  Please contact Van Iwaarden Associates if you would like an estimate of the impact on your plan or to discuss the application of these rules in more detail.

Steering Clear of Pension Benefit Restrictions

Negative asset performance and declining valuation interest rates during 2011 will cause some pension plans to face benefit restriction issues for the first time in 2012.   Potential repercussions include limits on accelerated distributions (lump sums), restrictions on plan amendments increasing the value of benefits, mandatory benefit accrual freezes and restrictions on unpredictable contingent event benefits (UCEBs).

Many sponsors want to do all that they can to avoid these benefit restrictions.   Regulations allow four options to do so:

  1. Waiving credit balance – If there is any credit balance (carryover balance or prefunding balance) on the valuation date, the easiest way to improve the funding status is to waive the balance.  In fact, this action is required in certain cases.  The trouble is, for most underfunded plans, the credit balance is not big enough to be of much help.  It can also reduce future funding flexibility.
  2. Posting security – Sponsors can also post funds in escrow outside of the plan and count it as an asset for purposes of determining if benefit restrictions apply.  This option comes with plenty of strings attached, and would not truly improve the funding status of the plan.
  3. Additional current year contribution – A third option is to make an additional contribution for the current year (a “436 contribution”).  A 436 contribution needs to be made before the date the restriction would otherwise start.  This option can avoid restrictions on UCEBs, amendments and accruals, but not limits on lump sums.
  4. Additional prior year contribution – The fourth and perhaps most attractive option is to make an additional contribution for the prior year.  Here are a few things plan sponsors considering this solution should know:
    • The contribution does not need to be made before the valuation date.  For example, a plan sponsor that is concerned their January 1, 2012 funded status may trigger benefit restrictions would not need to make an additional contribution by December 31, 2011.  This is important because it allows time for the plan’s actuary to measure the preliminary funded status, determine if a contribution is needed to avoid restrictions, and to calculate the amount of such a contribution.
    • The January 1, 2012 funded status generally needs to be certified by March 31, 2012.  Ideally, additional contributions would be made by this date because the actuary can not certify the status based on contributions that haven’t already been made.  However, an actuary can issue a “range certification”.  For example, the actuary can certify that once the contribution is made, the funded status will be between 80% and 100%.  This prevents restrictions and allows the sponsor to have until the normal contribution due date (the earlier of September 15, 2012 and the date the 2011 tax return is filed) to fund any additional contribution for 2011.
    • The contribution increase may be more affordable than it first appears.  That’s because any additional contribution for the prior plan year is included in the assets for determining the minimum contribution on the next valuation date.   Making an additional 2011 contribution of $1,000,000 may reduce the 2012 minimum contribution by about $160,000.
    • WARNING:  If, for any reason, the additional contribution isn’t made so the final funded status is outside of the previously certified range, there are serious consequences.  Potential consequences include retroactive benefit restrictions and plan disqualification.  Therefore, the sponsor needs to be absolutely sure that they will be able to make the contribution prior to requesting a range certification.

Since benefit restrictions can be complicated and costly to implement, it makes sense to avoid them – especially if they can be avoided by paying down unfunded liability that needs to be funded sooner or later.

Employers Must Act Quickly to Elect Pension Relief for 2009 or 2010

On December 17, the IRS issued Notice 2011-3.  This Notice provides guidance on single-employer defined benefit plan elections under the Pension Relief Act of 2010.  The Notice provides that the deadline for electing to extend the amortization period is the latest of: (1) the last day of the plan year, (2) 30 days after the valuation date and (3) January 31, 2011.

So the election deadline for plan years ending December 31, 2010 and earlier is only about a month away.  The biggest impact of the Pension Relief Act is probably for those years, since they include the first valuations after the 2008 stock market decreases.

Cash Balance Interest Credits: Rates Near Record Lows

The Federal Reserve has posted the November Treasury interest rates.  The 10 year constant maturity yield is 2.76%, which is near a record low.  This rate is the basis for many cash balance plan interest crediting rates.  Perhaps this low growth rate will inspire plan sponsors to change the interest credit index.  This is allowed under the recently issued hybrid plan regulations as discussed in a previous post.

Threat to Cross-Tested Plans

A Congressional proposal has been introduced that would “severely reduce the attractiveness of cross-tested plans” according to the American Society of Pension Professionals & Actuaries.

Cross-tested plans can be used to provide different defined contribution allocations to different groups of employees.  Often cash balance plans are aggregated with a defined contribution plan and cross-tested for nondiscrimination.  Changes to the cross-testing rules could threaten these arrangements, requiring plans to be redesigned or terminated.

Anyone who’d like to to share their opinion of this proposal with their Congress member can email them using a tool ASPPA has provided, or you can find contract information at www.house.gov.

Multiemployer Defined Benefit Plan Summary Report

One little noticed PPA requirement is the multiemployer summary plan report.  It’s due to participating unions and contributing employers within 30 days after 5500 due date (starting with the 2008 5500), so one should have been filed already for most multiemployer pension plans.

The Department of Labor was required to publish a model form for by August 17, 2007, but has not yet done so.  Until (or unless?) some guidance is released, plans will need to make a good faith effort to comply with this disclosure requirement.