IRS issues final regulations on Market rates of return for hybrid plans

On September 19, 2014, IRS published long-awaited final regulations on a number of issues affecting hybrid plans (generally, cash balance, pension equity, and variable annuity plans). The most significant piece of the final regulations is final rules with respect to interest crediting rates permitted under the ‘market rate of return’ standard. Those rules are generally effective in 2016. Together with the final hybrid regulations, IRS also published a proposed regulation to deal with the transition to the new permitted interest crediting rate rules.

In this article we review (1) the final permitted interest crediting rate rules and (2) the proposed transition rules.

Background

We assume a general familiarity with how cash balance plans work. Summarizing: in the typical cash balance plan, the participant has a ‘hypothetical account.’ Each year, a percent of the participant’s pay for that year is credited to that account – the ‘pay credit.’ Those pay credits earn ‘interest credits,’ at a rate stated in the plan.

The issue addressed in the final hybrid regulations is: what sort of interest crediting rates are allowed in a cash balance plan? This issue has a history going back at least to 1996, when IRS issued Notice 96-8, identifying certain fixed income rates that could be used as interest crediting rates by a cash balance plan.

In 2006, the Pension Protection Act (PPA) generally authorized the use of any interest crediting rate that is not in excess of a ‘market rate of return’ – clearly contemplating the possibility that a plan might base interest credits on a non-fixed income rate, such as the rate of return on an equity fund. PPA also added a ‘preservation of capital’ rule, generally requiring that the participant’s benefit be no less than the sum of all pay credits, thus assuring that the cumulative return cannot be below 0%. IRS proposed regulations in 2010 began the process of specifying what rates were permitted under the PPA market rate of return standard. The regulations published on September 19 finalize that proposal in most respects.

Permitted interest crediting rates

The final regulations adopt an exclusive list of permitted cash balance plan interest crediting rates. The following chart summarizes the rates permitted:

Maximum fixed rate: The 2010 proposed regulations allowed a maximum fixed rate of 5%. The final regulations increased this amount to 6%.

Government bond rates plus permitted margin: The 2010 proposed regulations allowed a 4% annual floor on interest credits based on permitted fixed income rates. The final regulations increased this amount to 5% for government bond-based rates.

Segment rates: The final regulations generally allow the use of minimum funding rules segment rates, with or without adjustment for the interest rate stabilization rules under the Highway and Transportation Funding Act (HATFA) and Moving Ahead for Progress in the 21st Century Act (MAP-21). (See our article Pension Funding Relief Extended for a discussion of those rates.) Those segment rates generally reflect the rates on investment grade corporate bonds. The final regulations retain the 4% annual floor on interest credits based on these rates.

Investment-based rates: The proposed regulations included a provision for rates based on the actual rate of return on aggregate plan assets and the rate of return on a regulated investment company. The final regulations added a provision for interest credits based on the rate of return on a subset of plan assets. As the IRS noted in its preamble to the final regulations, this rule will permit a sponsor “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).” The rule in effect allows a target date fund-like arrangement in a cash balance plan. With respect to investment based returns, the following rules apply:

The plan’s (or subset’s) assets must be diversified so as to minimize the volatility of returns.

Qualifying employer securities and real property in a subset may not exceed 10% of the fair market value of assets in the subset.

The fair market value of assets in a subset must approximate the benefits related to that subset, determined using reasonable actuarial assumptions.

Rate of return on a regulated investment company: The return on the investment company (e.g., a mutual fund) must be reasonably expected to be not significantly more volatile than the broad United States equities market or a similarly broad international equities market. Examples of permitted types: regulated investment companies with investments that track the rate of return on the S&P 500, a broad-based ‘small-cap’ index (such as the Russell 2000 index), or a broad-based international equities index.

The preamble to the final regulations confirms that it is acceptable to determine an investment-crediting rate based on a specified blend of multiple rates. Thus, it is apparently acceptable to determine interest crediting rate based on one-quarter of the rate of return on one specified mutual fund and three-quarters of the rate of return on another specified mutual fund, provided that each of the funds separately satisfies the asset diversification requirement.

As noted, the list of permitted interest crediting rates in the final regulations is exclusive. IRS rejected requests that it allow plans to adopt other bases (e.g., 80% of trust return with a 0% annual floor), indicating that such an approach would be impractical because the IRS would have to review any number of potential interest-crediting bases to determine whether or not they are acceptable. However, the IRS did leave the door open to providing additional crediting bases in future published guidance.

No participant choice of interest crediting rates – at least for now

The final regulations do not permit a cash balance plan to allow participants to choose among different interest crediting rates. In the preamble, IRS stated:

Because of the significant concerns relating to the use of statutory hybrid plan designs that would permit participants to choose among a menu of investment options specified in the plan document, the Treasury Department and the IRS continue to study these issues [related to a participant choice cash balance plan]. It is possible that the Treasury Department and the IRS will conclude that such plan designs are not permitted.

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Overall, the final regulations bring clarity and certainty to the use of investment-based interest crediting rates. They also – with the increases in the permissible fixed rate (from 5% to 6%) and the annual floor on government bond rates (from 4% to 5%) – add some flexibility.

Effective date and pre-effective date crediting rates

The final regulations are generally effective in 2016. As the IRS stated in the preamble to the related proposed regulations, “[p]rior to the first day of the first plan year that begins on or after January 1, 2016, a plan that uses an interest crediting rate that is not permitted under the final hybrid plan regulations must be amended to change to an interest crediting rate that is permitted under those regulations.”

Critically, while (as noted) beginning in 2016 the list of permitted interest crediting rates in the final regulations is exclusive, prior to that date sponsors may rely on the broader language of the statute. Quoting the preamble:

[I]f prior to the effective date of these final regulations a plan provided an interest crediting rate that is not provided for under the final regulations, the plan’s interest crediting rate for that period could nonetheless satisfy the statutory requirement that an applicable defined benefit plan not provide for interest credits (or equivalent amounts) for any plan year at an effective rate that is greater than a market rate of return.

The 411(d)(6) problem

Tax Code section 411(d)(6) generally “prohibits a plan amendment that decreases a participant’s accrued benefits … with respect to benefits attributable to service before the amendment.” One (very technical and counter-intuitive) feature of most cash balance plans is that, to avoid problems under Tax Code and ERISA anti-backloading rules, generally all future interest credits ‘accrue’ with respect to any given year’s pay credit. The final regulations describe the effect of this rule as follows:

The right to future interest credits determined in the manner specified under the plan and not conditioned on future service is a factor that is used to determine the participant’s accrued benefit, for purposes of section 411(d)(6).

With respect to a plan that uses an interest crediting rate that is not based on the (exclusive) list of permitted rates in the final regulations, a problem is presented: as to future interest credits on past pay credits, may the rate be changed (to a permitted rate) without violating 411(d)(6)?

Special rule with respect to a change to third segment rate

Under the final regulations (which amend a rule first adopted in 2010), a plan doesn’t violate 411(d)(6) if it changes from one of the fixed income rates allowed in Notice 96-8, or the first or second segment rates, to the third segment rate, if:

The change applies to interest credits granted only after the effective date of the amendment,

The effective date of the amendment is at least 30 days after adoption,

On the effective date of the amendment, the new interest crediting rate is not lower than the interest crediting rate that would have applied on that date in the absence of the amendment, and

Any fixed annual floor that was used in connection with the pre-amendment rate is retained to the maximum extent permissible. IRS provides this example: if prior to the amendment a plan was using a 30-year Treasury rate with an annual floor of 4.5%, if the plan is amended to change the rate to the third segment rate it must provide a 4% annual floor.

Proposed regulation – transition to rules under the final regulation

In connection with the final regulations and the possible 411(d)(6) issues they present, IRS proposed a set of rules that allow sponsors to amend plans to transition from an interest crediting rate that is not permitted under the final regulations to one that is permitted. The rules address situations that may exist with respect to different sorts of impermissible rates, as follows:

Timing rules not satisfied: If a plan does not satisfy applicable timing rules (the regulation gives the example of a plan that determines interest credits using the yield on 30-year Treasuries for the last week of the preceding plan year), then it must “correct the aspect of the plan’s interest crediting rate that fails to comply,” by adopting a permitted timing rule.

Fixed rate in excess of 6 percent: If a plan credits interest using a fixed rate in excess of 6%, then it must reduce the rate to 6%.

Margin exceeding the maximum: If a plan credits interest using a bond-based interest rate that would otherwise be permitted except that it applies a margin that exceeds the maximum, then it must be amended to reduce the margin to the maximum permitted for the underlying rate.

Minimum rate exceeding maximum: If a plan credits interest using a bond-based interest rate in combination with a minimum rate in excess of the highest permitted minimum rate, then it must be amended either —

To reduce the minimum rate to the highest minimum permitted with the plan’s rate, or

To credit interest using a fixed interest crediting rate of 6%.

Greatest of two or more variable bond-based rates: If a plan credits interest using a composite rate that is the greatest of two or more bond-based rates, then it must be amended to credit interest using the lesser of the composite rate and the third segment rate. In effect, this allows a plan to comply by capping an impermissible rate at the third segment rate.

Impermissible bond-based rate: If a plan credits interest using an impermissible bond-based rate (the regulation gives the example of a plan that credits interest using a broad-based long-term investment grade corporate bond index), then —

If a permitted bond-based rate has similar duration and quality characteristics as the plan’s rate, then the plan must be amended to use that rate.

If not, then the plan must be amended to use the lesser of the plan’s rate and the third segment rate.

Impermissible investment-based rate: If a plan credits interest using an impermissible investment-based rate (the regulation gives the example of a plan that credits interest using the rate of return for the S&P 500 index), then –

If a permitted investment-based rate has similar risk and return characteristics, then the plan must be amended to use such a rate.

If not, then the plan must be amended to use a permitted rate “that is otherwise similar to the plan’s impermissible investment-based rate….” The regulation explains that this rule generally requires “the use of a rate that is less volatile than the plan’s impermissible investment-based rate but is otherwise similar to that rate….”

Correction only applies to future interest credits: Any correction under the foregoing rules may be applied “only with respect to interest credits that are credited for interest crediting periods that begin after the applicable amendment date.”

Reconciling 411(d)(6) and the market rate of return rule

Finally, there may be situations in which compliance with the Tax Code 411(d)(6) anti-cutback rules may present an issue under the market rate of return rule. With respect to this issue, the final regulations provide the following relief:

Because section 411(d)(6) requires that a plan amendment not result in a reduction to the accrued benefit, changes in interest crediting rates would be difficult to implement without special market rate of return rules. Thus, like the 2010 proposed regulations, the [final] regulations contain a [rule providing] that the market rate of return rule is not violated merely because the plan provides that the benefit of active participants after the interest crediting rate change can never be less than the benefit under the old rate (without future principal credits), subject to an anti-abuse rule.

Conclusion

It is a relief to finally – after 8 years – get certainty on the market rate of return issue. The final regulations provide a workable framework for cash balance plan design, particularly with respect to investment-based interest crediting rates. The transition rules also seem to provide practical solutions to at least some of the problems sponsors using ‘unpermitted’ interest crediting rates will face. And sponsors and practitioners will have a chance to request changes to the proposed regulation to accommodate issues not adequately addressed in it.

Cash balance, pension equity and variable annuity plan sponsors will want to review the final and proposed regulations carefully with counsel. While our focus has been the new market rate of return rules, the regulations cover a number of issues that may be relevant to certain plans, plan designs and fact situations.

We will continue to follow this issue.