Questions and Answers

What are the interest crediting requirements for a hybrid defined benefit plan not to be age discriminatory?

A hybrid plan will be age discriminatory unless it provides, as of the effective date applicable to the plan, that any interest credit or equivalent amount for any plan year does not exceed a market rate of return, as may be defined by the Treasury regulations or other guidance. The plan can provide for a reasonable minimum guaranteed rate of return or for a rate of return equal to the greater of a fixed or variable rate of return. [I.R.C. § 411(b)(5)(B)(i); ERISA § 204(b)(5)(B)(i); ADEA § 4(i)(10)(B)(i)]

A plan's interest crediting rate is the rate by which a participant's benefit is increased under the terms of the plan to the extent that the increase is not conditioned on current service. Regardless of what the increase is called or how it is calculated, the amount of the increase is an interest credit. So, it is irrelevant for this purpose whether the amount is calculated by reference to a rate of interest, a rate of return, an index, or anything else. [Prop. Treas. Reg. § 1.411(b)(5)-1(d)(1)(ii)] Thus, for instance, an ad hoc credit applied to all participants, including terminated employees, would be treated as an interest credit and needs to be taken into consideration for purposes of determining whether a plan's interest crediting rate exceeds a market rate of return.

Where a single rate is used, the interest crediting rate is not in excess of a market rate of return if the plan provides an interest credit for the year at a rate that is equal to one of the following three rates specified in the terms of the plan. [Prop. Treas. Reg. § 1.411(b)(5)-1(d)(1)(iii)]:

The interest rate on long-term investment grade corporate bonds, which for plan years beginning after 2007 is the third segment rate under Internal Revenue Code Section 430(h)(2)(C)(iii), with or without regard to the three-year transition rule under Internal Revenue Code Section 430(h)(2)(G), provided that the rate floats at least annually; [Prop. Treas. Reg. § 1.411(b)(5)-1(d)(4)]
A safe harbor interest rate that is deemed to be not in excess of the following [Prop. Treas. Reg. § 1.411(b)(5)-1(d)(5)]

The sum of one of the Treasury bond interest rates plus its associated margin from the table below (as previously permitted under IRS Notice 2007-6 and specified under IRS Notice 96-8) that is adjusted at least annually;

Treasury Bond Interest Rates	Associated Margin
The discount rate on 3-month Treasury Bills	175 basis points
The discount rate on 12-month or shorter Treasury Bills	150 basis points
The yield on 1-year Treasury Constant Maturities	100 basis points
The yield on 3-year or shorter Treasury bonds	50 basis points
The yield on 7-year or shorter Treasury bonds	25 basis points
The yield on 30-year or shorter Treasury bonds	0 basis points

An eligible cost-of-living index under Treasury Regulations section 1.401(a)(9)-6, A-14(b), but with the eligible cost-of-living index of Treasury Regulations Section 1.401(a)(9)-6, A-14(b)(2) increased by 300 basis points, that is adjusted at least annually;
Additional safe harbors that the IRS may specify in guidance of general applicability; or

A reasonable minimum guaranteed rate of return or equity-based rate to be permitted under regulations that will be issued at a later date. [Prop. Treas. Reg. § 1.411(b)(5)-1(d)(6)]

Over the long-term, the third segment rate for purposes of determining lump sum values [I.R.C. § 417(e)(3)(C)] would be expected to provide interest credits similar to those under the third funding segment rate [I.R.C. § 430(h)(2)(C)(iii)] listed in item 1 above, so the definition of the rate of interest on long-term investment grade corporate bonds arguably should be expanded to include the third segment rate for purposes of determining lump-sum values, ignoring the five-year transition from the 30-year Treasury rate. [I.R.C. § 417(e)(3)(D)(iii)] Particularly in a plan that historically had used the same interest rate both to provide interest credits and determine lump-sum values (and the value of any other optional form requiring the use of Internal Revenue Code Section 417(e)(3) interest rate assumptions, plan participants may not understand why the interest credits provided under the plan do not match the interest rate used to determine the value of payment forms requiring the use of the interest rate assumptions of Internal Revenue Code Section 417(e)(3). Using the third segment rate for purposes of determining lump-sum values, if permitted as an alternative, would help minimize confusion among those plan participants who may not understand why the third segment rates under Internal Revenue Code Section 430(h)(2)(C) differ from those under Internal Revenue Code Section 417(e)(3). Of course, if the only optional form payment under the plan (besides the required QJSA and QOSA ) is a lump sum, such confusion would be avoided if the plan provides that the hypothetical account balance (or accumulated percentage of final average compensation, in the case of a pension equity plan) is paid as the lump sum in accordance with Internal Revenue Code Section 411(a)(13)(A), because then no interest (discount) rate is required to determine the lump-sum amount as a present value.

Go to Questions and Answers Page

What are the requirements for defining interest crediting rates under the plan?

Prior to the PPA, there were no specific rules governing what interest crediting rate to use under a cash balance pension plan. Instead, choice of interest rate was generally influenced by other factors. For instance, a high interest crediting rate was more likely to cause the plan to be subject to whipsaw (when the minimum lump-sum benefit turns out to be higher than the notional account balance, essentially because the interest crediting rate is higher than the lump-sum discounting rate) as defined in chapter 1. However, a low interest crediting rate can make the plan less appealing to employees because their perceived return of their notional accounts seems unusually low compared to other market indices. Thus, many cash balance plans tended to incorporate interest crediting rates that were tied to standard measures representing a stable, low-risk investment.

The PPA created safe harbor rules to meet the age discrimination requirements for a plan to be tax qualified. For cash balance plans, this safe harbor requirement includes provisions about how interest crediting rates are determined. In particular, the interest credit rate cannot exceed a market rate of return to be defined by the Treasury Department. And, since the interest crediting rate is tied to a market rate of return, there is general recognition that it could be negative, but a requirement is added such that any negative interest credit cannot cause the notional account balance to fall below the aggregate amount of service credits made to the plan.

Go to Questions and Answers Page

When is an interest credit compounded?

Interest credits generally continue as long as a participant has a notional account in the plan. Interest credits may accrue annually, quarterly, monthly, or daily. If a person receives a distribution during an accrual period, the plan may provide for a partial interest credit to the point of distribution. For instance, if the interest credit is compounded annually, but the distribution is made 6 months into the year, an interest credit may be provided to reflect interest for one-half of the year. In the case of a terminated participant, the participant is entitled to interest credits on only the vested portion of the participant's account.

Go to Questions and Answers Page

Do any pay limits apply to cash balance pension plans?

Yes. Just like other qualified plans, any pay recognized in a cash balance formula is capped by IRC Section 401(a)(17). For 2009, the pay limit is $245,000. This limit is adjusted annually based on inflation in increments of $5,000. The adjusted amounts are generally available in October for the following year.

Go to Questions and Answers Page

How does the pay cap work if the plan year does not equal a calendar year?

Compensation used by a plan to determine accruals or allocations must be limited by the pay cap. Plan year compensation, or compensation during whatever other 12-month period ending within the plan year is used to determine accruals or allocations for the plan year, must be limited by the pay cap in effect for the calendar year in which the plan year, or other 12-month period ending within the plan year, begins. If a period shorter than 12 months is used to determine accruals or allocations for the plan year, the pay cap must be prorated for the shorter period. This could happen because of a short plan year (due to a new plan or change in plan year) or because the plan provides allocations or benefit accruals for a period less than 12 months, such as monthly or quarterly. If a period of less than 12 months is used to determine an employee's accrual or allocation because the employee is hired or terminated during the 12-month period or otherwise not covered for the entire 12-month period, no proration is required if the plan provides that the accrual or allocation is based on compensation for the portion of the plan year the employee is a participant, provided the plan doesn't otherwise prorate the pay cap over the 12-month period. [Treas. Reg. § 1.401(a)(17)-1(b)(3)]

Go to Questions and Answers Page

How are groups of employees eligible for a cash balance pension plan defined?

Plan sponsors have the ability to define which segments of employees are eligible for a cash balance plan. For instance, plans may provide that participation is restricted to employees who are not covered by a collective bargaining agreement. Or, the plan could be available to employees at a certain location or part of a specific business unit.

Some plans also become closed to new participants. When this is the case, the eligible employee group may be defined as employees who are hired prior to a specific date and those hired after that date are no longer eligible. Plans may have this provision if they are transitioning from a defined benefit approach (including cash balance formulas) to a defined contribution approach for future hires.

When a plan limits coverage to a segment of all employees in the controlled group, the coverage must be shown to be nondiscriminatory. Under coverage rules, the employees eligible to participate in the plan must not be overly skewed toward highly compensated employees (as defined by IRC Section 414(q)(1)) relative to the number of highly compensated employees in the entire controlled group.

Go to Questions and Answers Page