Questions and Answers

What are the general requirements to provide benefit statements to employees?

A plan administrator needs to make written statements of total and vested accrued benefits available to plan participants and beneficiaries. [ERISA § 105] These statements need to be provided within 30 days, if the participant or beneficiary requests the statement and the request is made in writing. [ERISA § 105(a)] However, only one statement needs to be provided in any 12-month period and the statement can be based on the latest available information. [ERISA § 105(b)] The Summary Plan Description is required to include notice to plan participants that the pension statement information is available upon request. [Treas. Reg. § 2520.102-3(t)(2)]

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How did the Pension Protection Act of 2006 modify the requirement for benefit statements?

The PPA modified the rules for providing pension benefit statements to employees. The PPA also modified the rules for defined contribution plans, with different requirements that depend on whether a participant has the ability to direct investments under the plan. [PPA § 508]

In addition to the general rules outlined in the previous question, employers with defined benefit plans (including cash balance plans) must provide active, vested participants with either: (a) a benefit statement once every three years, [ERISA § 105(a)(1)(B)(i)] or (b) an annual notice that benefit statements are available and an explanation of how an employee can receive a benefit statement. [ERISA § 105(a)(3)(A)] The communication to participants must be provided in manner easily understood by the average plan participant.

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Must a cash balance plan offer a lump-sum form of payment?

A cash balance plan is not required to provide a lump-sum form of payment, although most cash balance plans do. Typically, a participant, or a survivor beneficiary of a participant, can elect to receive the benefit from a cash balance plan in a lump sum that is rollover eligible. By offering a lump sum, the plan more closely mimics a defined contribution plan. The lump-sum payment option in a cash balance plan is said to be portable, because the lump-sum payment can be rolled over to another employer's eligible retirement plan or an IRA and typically can be taken at termination of employment rather than waiting until normal or early retirement age (generally, age 65 or 55, respectively). Some defined benefit plans other than cash balance plans offer a lump-sum payment option and the proportion offering lump sums increased as cash balance plans became more popular.

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What forms of payment must a cash balance plan offer?

As a tax-qualified defined benefit plan, a cash balance plan must offer a qualified joint and survivor annuity (QJSA) form of payment to each married participant who has a vested benefit payable from the plan. [I.R.C. § 401(a)(11)]

As a tax-qualified defined benefit plan, a cash balance plan must offer an unmarried participant who has a vested benefit payable from the plan an annuity for the life of the participant only, which is often referred to as a single life annuity. The annuity payments cease when the participant dies, and no survivor benefits are payable to any beneficiary. [Treas. Reg. § 1.401(a)-20, Q&A-25(a)] Other than the QJSA for married participants, the single life annuity for unmarried participants, and a qualified optional survivor annuity --required by the Pension Protection Act of 2006 (PPA), a cash balance plan need not offer any other form of payment to the participant, although most do.

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What are the accrual rules for defined benefit plans?

The accrual rules were designed to ensure that the benefit accrual in later years cannot be excessive relative to the accrual in earlier years. In other words, the benefit accruals may not be excessively backloaded. There are three general rules to determine whether a benefit is too backloaded: [ERISA §§ 204(b)(1)(A), (B), & (C); I.R.C. §§ 411(b)(1)(A), (B), (C)]

3% rule. A participant's accrued benefit upon separation from service must not be less than 3 percent of the normal retirement benefit the participant would receive, if the participant began participating at the earliest entry date possible under the plan and worked continuously until the earlier of age 65 or normal retirement age, multiplied by the number of years the participant would have participated in the plan at that point (but not more than 331/3 years). [I.R.C. § 411(b)(1)(A)]
1331/3 % rule. The annual rate at which a participant can accrue a normal retirement benefit (typically measured as the change in the normal retirement benefit as a percentage of participant compensation, but possibly measured as the change in the dollar amount of the normal retirement benefit, as permitted by IRS Revenue Ruling 2008-7) for any year must not be more than 1331/3 % of the annual rate at which the participant can accrue a normal retirement benefit in any preceding year. [I.R.C. § 411(b)(1)(B)]
Fractional rule. The accrued benefit at separation from service must not be less than a fraction of the accrued benefit at normal retirement age, determined as if the participant had earned compensation until normal retirement age and treating the participant as having attained normal retirement age on the date the fractional rule is being tested, but taking into account no more than 10 years of service immediately prior to separation from service. The fraction for the test has the number of years of participation until separation from service as the numerator and the number of years of participation as if the participant continued in active service until normal retirement age as the denominator. [I.R.C. § 411(b)(1)(C)]

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What special considerations apply to cash balance plans for accrual rule purposes?

A plan sponsor of a cash balance plan needs to determine the process for converting the current account balance within the plan into an annuity payable at normal retirement age. This process will determine the accrued benefit for purposes of the backloading rules.

IRS Notice 96-8 defined two types of cash balance plans:

Frontloaded. Interest credits are not conditioned on current (or future) service and therefore are considered part of the accrued benefit; and
Backloaded. Interest credits are conditioned on current service and are therefore not part of the accrued benefit.

Proposed Treasury Regulations define an interest credit under a hybrid plan as the increase in a participant's benefit that is not conditioned on current service [Prop. Treas. Reg. § 1.411(b)(5)-1(d)(1)(ii)] and define a hypothetical contribution (i.e., a pay credit) as any amount credited under a hybrid plan other than an interest credit. [Prop. Treas. Reg. § 1.411(b)(5)-1(d)(2)(ii)(B)] Thus, under the proposed regulations, interest credits are frontloaded by definition.

The accrued benefit calculation for a frontloaded cash balance plan is significantly different than for a backloaded cash balance plan:

Frontloaded Cash Balance Plans
Frontloaded interest crediting plans include future interest credits as part of the accrued benefit and, therefore, should include future interest credits to convert a current cash balance account to a normal retirement age accrued benefit.

Example. 1. Morgan is a 45-year old participant in a cash balance plan with an annual pay credit of 5 percent of pay and an interest crediting rate of 4 percent. Assume also that account balances at age 65 are converted to annuities by using a fixed factor of 10. For the 1331/3 % test, consider the accrual at age 45 compared to the accrual a participant might have at age 55:

Morgan's annual accrual at age 45	=	5% of pay x (1.04)(65-45) / 10
	=	1.1% of pay
Morgan's annual accrual at age 55	=	5% of pay x (1.04)(65-55) / 10
	=	0.7% of pay

This decreasing pattern of accrual values will continue at all ages, allowing this simple frontloaded plan design to pass the 1331/3 % rule test.

Backloaded Cash Balance Plans
Backloaded interest crediting plans do not include future interest credits as part of the accrued benefit and, therefore, need to reflect interest credits as part of the annual accrual.

Example. 2. Continuing the example above for frontloaded cash balance plans, but further assuming that Morgan has a $50,000 cash balance and currently earns $75,000. If the interest credits are not part of Morgan's accrued benefit, which essentially makes them another form of pay credit (per the definitions of interest credit and hypothetical contribution under the proposed regulations), her annual accrual is based on this formula:

Annual accrual = (pay credit + interest credit) / annuity factor / pay Therefore, Morgan's annual accrual at age 45 is calculated as follows:

Pay credit	5% of $75,000	$3,750
Interest credit	$50,000c4%	$2,000
Increase in notional account		$5,750
Payable as an annuity at normal retirement age	$5,750/10	$575
As a percent of pay	$575/$75,000	0.8%

By age 55, Morgan's cash balance account would have grown to $120,000. Her annual accrual at 55 would be:

Pay credit	5% of $75,000	$3,750
Interest credit	$120,000x4%	$4,800
Increase in notional account		$8,550
Payable as an annuity at normal retirement age	$8,550/10	$855
As a percent of pay	$575/$75,000	1.1%

The 1.1 percent accrual is 138 percent of the 0.8 percent accrual, so in this example the plan would fail the 1331/3 % accrual rule test.

For this reason, the vast majority of cash balance plans are frontloaded by design, and it would take a specific design created with these accrual rules in mind to have a backloaded cash balance plan that passes the accrual rules. While it may be possible to structure a backloaded plan to pass, the tests will become difficult as the ratio of the cash balance (and hence the interest credits) to the pay credits becomes larger. To be classified as a frontloaded cash balance plan, the plan will need to provide interest credits until commencement, even for periods after the participant's termination. IRS Revenue Ruling 2008-7 states that, "in order for a plan's interest credits to satisfy the accrual rules of 411(b)(1), the interest must be frontloaded."

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Which tests do cash balance plans use to pass the accrual rule requirements?

Cash balance plans rarely (if ever) apply a service cap to pay credits. Therefore, the 3% rule would be failed automatically, as it would be possible for a participant to have more than 331/3 years of accruals.

The 1331/3 % rule is the most often used for cash balance plans, although some plans have used the fractional rule. In almost all cases, the plan will more likely pass by applying the 1331/3 % rule to the cash balance formula, unless the design is specifically structured to pass one of the other tests.

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Who is a highly compensated employee for purposes of testing?

The nonexcludable employees of the employer must be divided between highly compensated employees (HCEs) and nonhighly compensated employees (NHCEs) to determine whether a plan significantly discriminates in favor of highly compensated employees. A highly compensated employee is an employee of the employer who, for the plan year currently being tested:

had compensation from the employer during the 12-month period prior to the plan year being tested that was greater than $80,000, as adjusted ($110,000 in 2009); or
was a 5-percent owner at any time during the current plan year being tested or the 12-month period prior to the current plan year. [I.R.C. § 414(q)(1)]

The determination of highly compensated employees can be limited to the highest paid 20 percent of employees of the employer for the 12-month period prior to the current plan year. [I.R.C. § 414(q)(3)] Electing to use this top 20 percent rule may help pass nondiscrimination testing in some circumstances. The election must be made for all tax-qualified plans of the employer (the controlled or affiliated service group) or none of them, and, if made, then each plan document must provide for the election.

Determining the top 20 percent highly compensated employees is a two-step process. Step 1 is to determine the number of employees it takes to have the top 20 percent of the employees of the employer. Step 2 is to identify the highest paid employees of the employer by ranking the employees from highest paid to lowest paid, but no more than the number of employees determined in the step 1.

Example. If it is determined in step 1 that there are 600 employees of the employer, then the top 20 percent group is limited to the highest paid 120 employees identified in step 2, regardless of whether the compensation received from the employer by any of those 120 employees exceeds $80,000, as adjusted ($110,000 in 2009). The remaining 480 employees are considered nonhighly compensated employees.

Certain employees are excluded only to determine how many employees are in the top 20 percent of the employees of the employer in step 1. Other employees are excluded for purposes of both steps 1 and 2. The following categories of employees are disregarded solely for purposes of step 1:

Employees who have not completed six months of service by the end of the 12-month period prior to the plan year being tested
Employees who normally work less than 171/2 hours per week --An employee who works less than 171/2 hours per week at least half of the weeks worked by the
Employees who normally do not work more than six months in a year --An employee who works on one day during a month is deemed to have worked that month
Employees who have not attained age 21 by the end of the 12-month period prior to the plan year being tested [I.R.C. § 414(q)(5)]

The above categorizations of employees may be made separately with respect to each employee or based on employees within reasonable job categories established by the employer. The employer may use a shorter period of time or lower age (including a zero age or service) when applying the four categories, if applied on a consistent and uniform basis. Excluding these categories of employees during the first step reduces the number of employees that will need to be included for the second step. However, many employers set one or more of the age and service requirements to zero to reduce the administrative complexity of tracking the requirements, if they can pass the coverage and nondiscrimination tests with a larger number of employees in the top 20 percent group.

Employees who performed no services for the employer during the 12-month period prior to the plan year being tested are excluded from both steps 1 and 2.

Collective bargaining employees are included when determining the top 20 percent for purposes of both steps 1 and 2, unless at least 90 percent of the employees of the employer are covered by collective bargaining agreements and the plan being tested does not cover collective bargaining employees; in that case, the employer can elect to disregard the collective bargaining employees in both steps 1 and 2 when determining the top 20 percent.

The acquisition and divesture transition rules of IRC Section 410(b)(6)(C) do not apply to the determination of HCEs, because the rules for determining HCEs do not reference or rely on IRC Section 410(b). Because the transition relief does not apply, presumably steps 1 and 2 include employees from an acquisition or merger in the plan year of the acquisition or merger and do not exclude employees lost due to a divestiture in the plan year of the divestiture.

An employer can elect to use the calendar year beginning with or within the 12-month period prior to the plan year being tested to determine who highly compensated employees are. [IRS Notice 97-45] The calendar year election must be made for all tax-qualified plans of the employer (the controlled or affiliated service group) or none of them, and, if made, then each plan document must provide for the election. This calendar year election may be particularly useful if an employer has more than one plan and the plans have different plan years. For example, an employer has two plans. Plan A has a calendar plan year and plan B has a plan year ending August 31. By using the calendar year election for the plan years ending within 2007, compensation during the 12-month period ending December 31, 2006 would be used to determine HCEs for both plans A and B. Without a calendar year election, compensation during the 12-month period ending December 31, 2006 would be used for plan A and compensation during the 12-month period ending August 31, 2006 would be used for plan B to determine who highly compensated employees are. Because different 12-month periods are used to measure compensation for each plan, the same employee could be an HCE for plan A, but not plan B, or vice versa. If plans A and B are combined for testing purposes, for the average benefit percentage test or permissive aggregation, each employee who is an HCE for either plan A or B is a HCE for the combined testing purposes.

Compensation used in determining highly compensated employees is the same as the definition of compensation used for the limit on annual additions in a defined contribution plan under IRC Section 415(c)(3). [I.R.C. § 414(q)(4)]