Questions and Answers
Dollar Limit
The dollar limit is increased annually for inflation and is $195,000 for 2009. [I.R.C. § 415(d)] The increase is applied only to participants who terminated previously to the extent that this is specifically allowed within the plan document. [Treas. Reg. § 1.415(a)-1(d)(3)(v)(C)] The adjustment is made by indexing the dollar limit in a manner consistent with the adjustment to Social Security benefit amounts, and rounding down to a multiple of $5,000. [I.R.C. § 415(d); Treas. Reg. § 1.415(d)-1(a)(1)] The adjustment applies only to payments on and after January 1 of the calendar year for which the increase is effective and applies to the limitation year ending with or within that calendar year. [Treas. Reg. § 1.415(d)-1(a)(3)]
The dollar limit is also subject to adjustments based on:
- Age at commencement. If a participant commences his or her benefit before age 62 or after age 65, the dollar limit must generally be actuarially adjusted to reflect early or late retirement. [I.R.C. § 415(b)(2)(C), (D)] If a plan does not charge for QPSA coverage, as is true for most cash balance plans, no mortality adjustment is required, but only if the plan applies this treatment both for adjustments before age 62 and adjustments after age 65. [Treas. Reg. §§ 1.415(b)-1(d)(2)(ii), (e)(3)(ii)]
- Participation. If a participant has been a participant in the plan for less than ten years, then the dollar limit is reduced pro rata by multiplying the dollar limit by the participant's number of years of participation (but not less than 1) divided by 10. Years of participation for this purpose are essentially the participant's years of benefit service (computed to fractional parts of a year, if applicable). [Treas. Reg. § 1.415(b)-1(g)(1)]
Example. If Carolyn has been a participant in the plan for six years and terminates in 2009, her benefit, payable as a single life annuity, would be limited to $117,000 (60 percent of $195,000). [I.R.C. § 415(b)(5)] - Form of benefit. A retirement benefit payable in a form other than a single life annuity must be converted to an actuarially equivalent single life annuity to demonstrate compliance with the dollar limit. The basis for the adjustment depends on whether the form of benefit is a nondecreasing annuity benefit (i.e., a form of benefit not subject to IRC Section 417(e)(3), such as a life annuity, contingent annuitant, or term certain and life options) or a decreasing annuity (i.e., a form of benefit subject to IRC Section 417(e)(3), such as lump sums or term certain annuities). [I.R.C. § 415(b)(2)(B)] A Social Security level income option also appears to be a decreasing annuity form of benefit. [Preambles to the proposed and final relative value regulations, Fed. Reg. 4058, 4060 and Fed. Reg. 14798, 14800, respectively]
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Compensation Limit
The compensation limit is 100 percent of the average compensation for not more than three consecutive calendar years, or other three consecutive 12-month periods as specified in the plan, during which the participant had the greatest aggregate compensation from the employer, as limited by IRC Section 401(a)(17). [Treas. Reg. § 1.415(b)-1(a)(5)(i)] If a participant is employed for less than three years (consecutive 12-month periods), the participant's actual number of years is used, including fractions, but not less than one year. [Treas. Reg. § 1.415(b)-1(a)(5)(ii)] If a participant's employment terminates and the participant is later rehired by the employer, any intervening year during which the participant performs no services for the employer is disregarded for purposes of determining the participant's three consecutive years with the greatest aggregate compensation from the employer. [Treas. Reg. § 1.415(b)-1(a)(5)(iii)] The definition of compensation used for determining the compensation limit is not necessarily the same as the plan's definition of compensation used for determining benefits. [Treas. Reg. § 1.415(c)-2]
To be included in an employee's compensation for a given limitation year, compensation must generally have been paid (or made available) to the employee in that limitation year and prior to the employee's severance from employment. [Treas. Reg. § 1.415(c)-2(e)(1)] However, a plan may provide that amounts earned during a limitation year, but not paid during that year due solely to the timing of pay periods and pay dates, can be included if the amounts are paid during the first few weeks of the immediately following limitation year, the amounts are included on a uniform and consistent basis with respect to all similarly situated employees, and no compensation is included in more than one limitation year. [Treas. Reg. § 1.415(c)-2(e)(2)]
A plan may provide that certain compensation, paid by the later of 21/2 months after the employee's severance from employment or the end of the limitation year in which such severance from employment with the employer occurs, is included in Internal Revenue Code Section 415 compensation. The types of compensation to which this rule applies include regular pay, overtime or shift differential pay, commissions, bonuses, and other similar payments. Further, a plan may provide that certain other compensation, paid by the later of 21/2 months after the employee's severance from employment or the end of the limitation year in which such severance from employment with the employer occurs, is included in Internal Revenue Code Section 415 compensation to the extent such compensation would have been included in the definition of compensation if paid prior the participant's severance from employment. The types of compensation to which this latter rule applies include payment for unused accrued bona fide sick, vacation, or other leave, but only if the employee could have used the leave had employment continued and amounts received pursuant to a nonqualified unfunded deferred compensation plan, but only if the amounts would have been paid at the same time had the employee continued employment and only to the extent the payment is includible in the employee's gross income. Any other types of compensation (such as parachute payments under Internal Revenue Code § 280G(b)(2) or severance pay) are not eligible for the special rules of this paragraph. [Treas. Reg. § 1.415(c)-2(e)(3)]
A plan may also provide that the requirement for amounts to be paid, or treated as paid, to an employee prior to severance from employment in order to be compensation within the meaning of Internal Revenue Code Section 415(c)(3) does not apply to certain compensation continuation payments to (1) an individual who does not currently perform service for the employer due to qualified military service (under Internal Revenue Code § 414(u)(1) to the extent the payments do not exceed amounts the individual would have received but for the qualified military service, or (2) a participant who is permanently and totally disabled, if specified conditions are satisfied. [Treas. Reg. § 1.415(c)-2(e)(4)]
A plan may provide that the compensation limit applicable to a terminated participant is adjusted to take into account increases in the cost of living. [Treas. Reg. § 1.415(d)-1(a)(2)(i)] The adjustment applies only to payments on and after January 1 of the calendar year for which the increase is effective and applies to the limitation year ending with or within that calendar year. [Treas. Reg. § 1.415(d)-1(a)(3)] If a terminated participant is rehired, the compensation limit is the greater of the prior limit applicable to the participant, which can be adjusted for increases in the cost of living if the plan permits, or the compensation limit as recalculated including the participant's service after rehire. [Treas. Reg. § 1.415(d)-1(a)(2)(iii)]
The compensation limit is adjusted for:
- Years of service. The compensation limit is reduced pro rata if the participant has less than ten years of service. [I.R.C. § 415(b)(5)] The compensation limit is reduced pro rata by multiplying the compensation limit by the participant's number of years of service (but not less than one) divided by ten. Years of service for this purpose must be determined on a reasonable and consistent basis. Use of what is essentially the participant's years of benefit service (computed to fractional parts of a year, if applicable) is considered to be on a reasonable and consistent basis. It would seem that years of vesting service could be used for this purpose as well. [Treas. Reg. § 1.415(b)-1(g)(2)]
- Form of benefit. The compensation limit may be adjusted for forms of benefit other than a single life annuity or qualified joint and survivor annuity in the same manner as the dollar limit. [I.R.C. § 415(b)(2)(B)]
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$10,000 Limit Exception
An exception to the benefit limits occurs if the benefit payable under the plan is less than $10,000 in any plan year. This exception creates a floor to the maximum benefit amount. The $10,000 limit is not reduced for early commencement nor adjusted for payment form. [I.R.C. § 415(b)(4)] However, the $10,000 limit is reduced pro rata if the participant has less than ten years of total service. [I.R.C. § 415(b)(5)(B)] The $10,000 limit is reduced pro rata by multiplying the $10,000 limit by the participant's number of years of service (but not less than one) divided by ten. Years of service for this purpose must be determined on a reasonable and consistent basis. Use of what is essentially the participant's years of benefit service (computed to fractional parts of a year, if applicable) is considered to be on a reasonable and consistent basis. It would seem that years of vesting service could be used for this purpose as well. [Treas. Reg. § 1.415(b)-1(g)(2)]
Cash balance plans typically provide benefits in the form of a lump sum. The $10,000 floor to the benefit limits is not adjusted for forms of payment, which means that the floor would only preserve a $10,000 lump-sum payment made in a plan year, thereby mitigating the impact of the floor when benefits are paid as a lump sum. In other words, even payment as a single life annuity would be less than the $10,000 exception per year; an actuarially equivalent lump sum in excess of $10,000 would exceed the floor and not be subject to the $10,000 exception. [I.R.C. § 415(b)(4)]
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What are the rules prohibiting age discrimination for cash balance, pension equity, and other hybrid defined benefit plans?
A defined benefit pension plan is not allowed to discriminate on the basis of age. This is true for hybrid plans as well as traditional pension plans. Whether or not a defined benefit pension plan (hybrid or otherwise) discriminates on the basis of age is governed by a set of legal rules that were most recently changed by the PPA. The PPA changed the age discrimination rules for defined benefit plans and created some special rules for plans established as, or converted to, hybrid defined benefit plans. These new rules generally apply to periods beginning on and after June 29, 2005. Because the PPA has no retroactive effect, the rules in effect prior to the effective date of the PPA apply to hybrid plans in existence prior to June 29, 2005 for periods before June 29, 2005. [PPA § 701(d)]
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How has the PPA changed the age discrimination rules for defined benefit plans?
The PPA creates an important change to the age discrimination rules in effect prior to its effective date by creating a uniform, safe harbor age discrimination standard for defined benefit plan accruals under the Code, ADEA, and ERISA. [I.R.C. § 411(b)(5)(A); ADEA § 4(i)(10)(A); ERISA § 204(b)(5)(A)] This safe harbor standard applies to all defined benefit plans, including hybrid plans, for periods beginning on or after June 29, 2005. If a defined benefit plan, even if other than a hybrid plan, meets the requirements of the safe harbor age discrimination standard, the plan will not be treated as failing the benefit accrual rules prohibiting age discrimination.
Besides satisfying the safe harbor age discrimination standard applicable to all defined benefit plans, a cash balance or other hybrid defined benefit plan must satisfy additional requirements or the plan will be considered age discriminatory. [I.R.C. § 411(b)(5)(B); ERISA § 204(b)(5)(B); ADEA § 4(i)(10)(B)]
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What is the safe harbor age discrimination test created by the PPA?
The PPA created the following safe harbor age discrimination standard to apply for periods beginning on or after June 29, 2005: A defined benefit plan will not be treated as failing the benefit accrual rules prohibiting age discrimination if a participant's accrued benefit, as determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated younger individual who is or could be a participant. [I.R.C. § 411(b)(5)(A)(i); ERISA § 204(b)(5)(A)(i); ADEA § 4(i)(10)(A)(i)] However, a hybrid plan will be deemed age discriminatory if the plan's interest crediting rate exceeds a market rate of return, even if the safe harbor age discrimination test is satisfied. The safe harbor test for age discrimination is whether a participant's accrued benefit could possibly be less than that of any younger individual who, except for age, is otherwise identical to the participant. If this is possible, then the plan is age discriminatory. This safe harbor applies to all defined benefit plans, not just hybrid plans. However, the PPA provides that no inference is to be drawn with respect to this age discrimination safe harbor prior to its PPA effective date.
The proposed hybrid plan regulations provide that a plan meets the safe harbor age discrimination requirements if the accumulated benefit of an individual who is or could be a participant, as of any date, cannot be less than the accumulated benefit under the same formula of any similarly situated younger individual who is or could be a participant. For purposes of this comparison, any subsidized portion of an early retirement benefit included in a participant's accumulated benefit is disregarded. The subsidized portion of an early retirement benefit is a retirement-type subsidy (within the meaning of Treasury Regulations Section 1.411(d)-3(g)(6)) that is contingent upon a participant's severance from employment and commencement of benefits before normal retirement age. [Prop. Treas. Reg. § 1.411(b)(5)-1(b)(1)(iii)] If a plan cannot meet the safe harbor standard, the plan must meet the general age discrimination requirements under Internal Revenue Code Section 411(b) (1)(H)(i). [Prop. Treas. Reg. § 1.411(b)(5)-1(b)(1)(i)] Prior to the PPA, disputes arose as to whether hybrid plans satisfied the general age discrimination rules, based on the uncertainty of whether the accrued benefit is defined only as an annuity at normal retirement age and benefit accrual is only the change in that annuity.
For purposes of making the safe harbor comparison, the accumulated benefit must be expressed as one of the following three types: an annuity at normal retirement, a hypothetical account balance, or the current value of the accumulated percentage of the participant's final average pay. [Prop. Treas. Reg. § 1.411(b)(5)-1(b)(1)(ii)(A)] If the accumulated benefit is expressed under the terms of the plan as an annuity payable at normal retirement (such as under a traditional defined benefit plan), the comparison is made using the annuity. If the accumulated benefit is expressed under the terms of the plan as the balance of a hypothetical account (such as under a typical cash balance plan), the comparison is made using the hypothetical account balance. If the accumulated benefit is expressed under the terms of the plan as the current value of the accumulated percentage of the participant's final average pay (such as under a typical pension equity plan), the comparison is made using the current value of the accumulated percentage of final average pay. [Prop. Treas. Reg. § 1.411 (b)(5)-1(b)(1)]
Generally, application of the safe harbor requires that the comparison of the accumulated benefits be made using the same expressed benefit (i.e., using the same type of accumulated benefit formula). [Prop. Treas. Reg. § 1.411(b)(5)-1(b)(1)(ii)(A)]
However, a plan that provides a participant's accumulated benefit as the sum of amounts determined under different types of accumulated benefit formulas will satisfy the safe harbor, if the plan separately satisfies the safe harbor requirements for each different type of accumulated benefit. Implicitly, different benefit formulas of the same type of accumulated benefit (i.e., annuity at normal retirement, hypothetical account balance, or current value of accumulated percentage of final average pay) would be aggregated for purposes of the comparison requirements under the safe harbor. Similarly, a plan that provides the greater of accumulated benefits under different types of accumulated benefit formulas will satisfy the safe harbor, if the plan separately satisfies the safe harbor for each different type of accumulated benefit. For the purposes described in this paragraph, a similarly situated younger participant is treated as having an accumulated benefit of zero with respect to a benefit formula that does not apply to the participant. In making benefit comparisons, the subsidized portion of any early retirement benefit is disregarded. [Prop. Treas. Reg. § 1.411(b)(5)-1(b)(1)(ii)(B)]
A similar age discrimination safe harbor applies to a defined benefit plan that indexes benefits under a formula other than a lump-sum-based formula, if specified requirements are met, but does not apply to cash balance or pension equity plans, because cash balance or pension equity plans provide for a lump-sum-based formula. Prop. Treas. Reg. § 1.411(b)(5)-1(b)(2)]
