Editor’s Note: Self-audits for retirement plan sponsors have become even more important now that the Inflation Reduction Act has earmarked an extra $80 billion in IRS funding dollars—much of which is expected to be earmarked for enforcement.  Many failures can be corrected under the EPCRS before the IRS gets involved in a more extensive audit.  Qualified plan sponsors should ensure that they have adopted all amendments required under recent legislation, including the SECURE Act and 2020 CARES Act.  Sponsors should also ensure that their plans are being properly operated in accordance with these new amendments and rules (so, if the plan adopted expanded loan provisions, the plan should check to ensure that it’s being operated in accordance with those amendments–noting that the deadlines for some amendments has been delayed).  Plans should also ensure that all elective deferrals are being deposited on time and that all documents are filed on time (including Forms 5500).  They should also check to ensure their plans are being operated in accordance with the RMD rules.

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Planning Point: Beginning January 1, 2023, employers will only be required to count plan participants with account balances when determining whether they cross the 100-participant threshold for Form 5500 filing requirements.  This new rule will allow many plans to avoid the expense of preparing and filing audited financial statements with their Forms 5500.  Prior to 2023, plans were required to file audited financial statements with their Forms 5500 if at least 100 people were eligible to participate in the plan, regardless of whether those participants actually contributed to the plan.

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Although qualification requirements (Q 3838 to Q 3935) and deduction limits (Q 3937 to Q 3943) generally affect all qualified plans, there are additional qualificationg requirements and deduction limits that are specific to certain types of plans.

As a general rule, qualification requirements can be divided between: (1) defined benefit plans (Q 3715 to Q 3724) and defined contribution plans (Q 3725 to Q 3731), and (2) pension (Q 3733 to Q 3748) and profit sharing plans (Q 3749 to Q 3751).

To some degree, these categories overlap. For example, all defined benefit plans are pensions, but not all pensions are defined benefit plans (Q 3733). Similarly, all profit sharing plans are defined contribution plans, but not all defined contribution plans are profit sharing plans; some are pensions.

Furthermore, special qualification, design, and nondiscrimination requirements apply to 401(k) plans (Q 3752 to Q 3808). Section 412(i)¹ insurance contract plans, although subject to the general requirements for defined benefit plans, must meet special requirements (Q 3812 and Q 3813) to be exempt from certain funding standards (Q 3742 to Q 3748). Stock bonus plans and ESOPs are subject to their own special requirements (Q 3816 to Q 3825). There also are special rules for Keogh and S corporations plans (Q 3826 to Q 3829).

Limitations on an employer’s deduction for plan contributions generally are based on whether the plan is a pension (Q 3735) or a profit sharing plan (Q 3750).

Plans that offer insurance benefits are subject to the special rules explained in Q 3830 (for plans that offer life or health insurance to participants) and Q 3836 (for plans that transfer pension assets to Section 401(h) accounts).

The IRC permits two types of qualified plans: defined benefit plans and defined contribution plans (Q 3725). All defined benefit pension plans are structured as pension plans (Q 3733), while defined contribution plans may be structured as pension or profit sharing plans. A defined benefit plan is a qualified retirement plan that expresses the participant’s benefit as a certain amount, either as an exact dollar amount or a formula that determines the amount that will be paid at retirement. The benefit is defined by the formula, but the contribution is determined by an actuary. The IRC states that the term “defined benefit plan” means any plan that is not a defined contribution plan.¹

Variations on the traditional defined benefit plan include Section 412(i)² insurance contract plans (Q 3812) and cash balance plans (Q 3720). See Q 3728 for the application of the Section 415 requirements to defined benefit plans, and Q 3716 for special qualification requirements. The IRS has even approved a rather unique adjustable pension plan (APP) or variable defined benefit plan (VDB) that seems to be gaining popularity in union situations.³

Limitation on Benefits

A defined benefit plan must contain a limit on the projected “annual benefit” under the plan or under all such plans aggregated if the employer has more than one defined benefit plan (Q 3868, Q 3719).

Accrued Benefit Requirements

A defined benefit pension plan may not exclude from participation employees who are beyond a specified age, but the benefit of an employee who is within five years of normal retirement age when employment begins is computed using a retirement age that is the fifth anniversary of the time that plan participation begins for that employee.¹ A defined benefit plan must benefit a minimum number or percentage of employees (i.e., the 50/40 test) as explained in Q 3717.

Accrued Benefit Requirements for Not Fully Insured Plans

A defined benefit plan, other than a fully insured plan, must satisfy one of the following three accrued benefit tests:

The 3 percent test. The accrued benefit to which a participant is entitled upon separation from service must be not less than 3 percent of the normal retirement benefit to which the participant would have been entitled if the participant commenced participation at the earliest entry age under the plan and served continuously until the earlier of age 65 or the normal retirement age specified under the plan, multiplied by the number of years (not in excess of 33⅓) of participation in the plan.²

The 133⅓ percent test. In any particular plan year when qualification of the plan is tested, the plan must not allow for the annual rate of accrual of a participant’s normal retirement benefit in any later plan year to exceed 133⅓ percent of the annual rate of accrual in any previous year.³

The fractional (or pro rata) test. The accrued benefit to which a participant is entitled upon his or her separation from service must be not less than a fraction of the participant’s assumed retirement benefit, the numerator of which is the participant’s total number of years of participation in the plan and the denominator of which is the total number of years the participant would have participated in the plan had the participant separated from service at normal retirement age.⁴ The participant’s assumed retirement benefit is computed as though the participant had continued to earn the same rate of compensation annually that he or she had earned during the years that would have been taken into account under the plan (but not in excess of 10 years of service immediately preceding separation) had the participant reached normal retirement age at the date of his or her separation. For the calculation method (and examples) that will produce the lowest accrued benefit satisfying the fractional test where benefits are accrued following a break in service, see Revenue Ruling 81-11.⁵

A defined benefit plan that provides a stated benefit offset by the benefits of a profit sharing plan will satisfy the benefit accrual requirements if the benefit determined without the offset satisfies the requirements and if the offset is equal to the amount deemed provided by the vested portion of the account balance in the profit sharing plan on the date the amount of the offset is determined.⁶

A defined benefit plan must require separate accounting for the portion of each employee’s accrued benefit derived from any voluntary employee contributions permitted under the plan.⁷ Revenue Ruling 78-202⁸ discusses the rules relating to calculation of accrued benefits derived from mandatory employee contributions.⁹ A plan generally may not be amended to reduce a participant’s accrued benefit.¹⁰ Procedures for obtaining approval of a retroactive plan amendment reducing a participant’s accrued benefit are specified in Revenue Procedure 94-42.¹¹

In addition, if a defined benefit plan subject to the minimum funding rules adopts an amendment that would increase current liability under the plan, and the funded current liability percentage under the plan (the ratio of the value of the plan’s assets to its current liability) is less than 60 percent, the plan must require that the amendment will not become effective until the employer (or a member of the employer’s controlled group) provides adequate security in favor of the plan.¹² See also Q 3838 to Q 3936 and Q 3736 for other qualification requirements.

In plan years beginning after December 31, 2007, defined benefit plans that are “at risk” (Q 3744) became subject to a qualification requirement that suspends many benefit increases, plan amendments, and accruals in single-employer plans when funding falls below specified levels ranging from 60 percent to 80 percent.¹³ Notice must be provided to participants and beneficiaries when funding falls below 60 percent.¹⁴ If a single employer plan in bankruptcy is funded at or above 80 percent, the plan may adopt an amendment, after November 8, 2012, to eliminate an option or form of benefit that includes a prohibited payment under IRC Section 436(d)(5), if certain conditions are met.¹⁵ See Q 3743 for the funding requirements applicable in plan years beginning after 2007 through date of publication including MAP-21 and HATFA 2014. There was a special relief provision in the WRERA 2008 just for plan years beginning after September 2008 and before October 2009.¹⁶ Final regulations on minimum required contributions, effective January 1, 2016, are specified in Treasury Regulation Section 1.430(a)-1.¹⁷

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Planning Point: There are also prohibitions for transferring company general reserve assets in connection with a Section 409A-covered “nonqualified deferred compensation plan” during the period a defined benefit plan is “at risk” (see Q 3564 and Q 3568).

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Accrued Benefit Requirements for Fully Insured Plans

An insurance contract plan (formerly a Section 412(i) plan, but now governed by IRC section 412(e)(3)) automatically satisfies any of the foregoing accrued benefit tests if (1) the plan is funded exclusively by insurance contracts calling for level annual premiums from the date the insured becomes a participant in the plan to not later than retirement age, (2) benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age and are guaranteed by the insurer, and (3) an employee’s accrued benefit at any time is not less than the cash surrender value his or her insurance contracts would have assuming that all premiums currently due are paid and there is no indebtedness against the contracts.¹⁸ See Q 3812 and Q 3813 for details on fully insured plans.

A plan is considered a fully insured 412(i) plan when funded exclusively by group insurance or group annuity contracts if the group contract has the requisite characteristics of individual contracts.¹⁹ The IRS has taken the position that, for example, amounts received by an insurer under a group contract must be allocated to purchase individual benefits for participants: “A plan which maintains unallocated funds in an auxiliary trust fund or which provides that an insurance company will maintain unallocated funds in a separate account, such as a group deposit administration contract, does not satisfy the requirements of … [a fully insured insurance contract plan].”²⁰

If at the time an employee separates from service the value of his or her employee contributions exceeds the cash surrender value of the insurance contract(s) funding the employee’s retirement benefit, the plan could supplement the cash surrender value or values to satisfy the minimum vesting standard and the plan would not fail to be a fully insured plan.²¹

A defined benefit plan also must benefit the lesser of (a) 50 employees or (b) the greater of (i) 40 percent of all employees or (ii) two employees (or if there is only one employee, that employee).¹ Governmental plans are not subject to this 50/40 test.²

Defined benefit plans must meet the minimum participation test on each day of the plan year. Under a simplified testing method, a plan is treated as satisfying this test if it satisfies it on any single day during the plan year so long as that day is reasonably representative of the employer’s workforce and the plan’s coverage. A plan does not have to be tested on the same day each plan year.³ Final regulations provide that a plan that does not satisfy the test for a plan year may be amended by the 15th day of the 10th month after the close of the plan year to satisfy the test retroactively.⁴ Comparable plans may not be aggregated for purposes of meeting this test.⁵

The 50/40 test may be applied separately with respect to each separate line of business if an employer makes an election to which the Secretary of the Treasury consents.⁶ Furthermore, the requirement that a separate line of business have at least 50 employees generally does not apply in determining whether a plan satisfies the 50/40 test on a separate line of business basis.⁷

A defined benefit plan’s prior benefit structure also must satisfy the minimum participation rule.⁸ The prior benefit structure under a defined benefit plan for a plan year includes all benefits accrued to date under the plan, and each defined benefit plan has only one prior benefit structure. A prior benefit structure satisfies the minimum participation rule if the plan provides meaningful benefits to a group of employees that includes the lesser of 50 employees or 40 percent of the employer’s employees. Whether a plan is providing meaningful benefits, or whether the employees have meaningful accrued benefits under a plan, is determined on the basis of all the facts and circumstances.⁹

The same employees who are excludable under the coverage tests (Q 3842) generally may be excluded from consideration in meeting the 50/40 participation test.¹⁰ If employees who do not meet a plan’s minimum age and service requirements are covered under a plan that meets the 50/40 test separately with respect to such employees, those employees may be excluded from consideration in determining whether other plans of the employer meet the 50/40 test, but only if (1) the benefits for excluded employees are provided under the same plan as benefits for other employees, (2) the benefits provided to excluded employees are not greater than comparable benefits provided to other employees under the plan, and (3) no highly compensated employee is included in the group of excluded employees for more than one year.¹¹

An employee generally is treated as benefiting under a plan for a plan year if the employee actually accrues a benefit for the plan year. An employee who fails to accrue a benefit merely because of the IRC Section 415 limits (Q 3868, Q 3719) or a uniformly applicable benefit limit under the plan’s structure is treated as benefiting under a plan for the plan year.¹²

As to which individuals must be treated as “employees” and which organizations make up an employer, see Q 3928, Q 3929, Q 3933, and Q 3935.

The SECURE Act made changes that would make it easier for certain sponsors of closed defined benefit plans to satisfy their nondiscrimination testing requirements.

Many employers who have closed defined benefit plans to new participants have continued to allow groups of “grandfathered” employees to earn benefits under the closed defined benefit plans. Because of this, many of these plans have had difficulties meeting the applicable nondiscrimination requirements as more of these grandfathered employees become “highly compensated” over time. For a number of years, the IRS has provided relief from the nondiscrimination rules for closed defined benefit plans. The SECURE Act essentially codifies a number of these relief provisions.

Generally, a defined benefit plan cannot discriminate in favor of highly compensated employees with respect to any plan benefit, right or feature. Under the SECURE Act, defined benefit plans will be treated as passing nondiscrimination testing with respect to benefits, rights and features if:

(1) the plan passes nondiscrimination testing in the plan year during which the plan closure takes place, and the two subsequent plan years,

(2) the plan was not amended after closure to discriminate in favor of highly compensated employees, either by modifying the closed class or the benefits, rights and features provided to that class and

(3) the plan was closed before April 5, 2017 or there was no substantial increase in value of either coverage or value of the benefits, rights and features for the five-year period before the plan was closed.

A plan is treated as having had a “substantial increase” in coverage or value of the benefits, rights, or features during the applicable five-year period only if, during that period:

“(i) the number of participants covered by such benefits, rights, or features on the date the five-year period ends is more than 50 percent greater than the number of such participants on the first day of the plan year in which the period began, or

(ii) the benefits, rights, and features have been modified by plan amendments in such a way that, as of the date the class is closed, the value of the benefits, rights, and features to the closed class as a whole is substantially greater than the value as of the first day of such five-year period, solely as a result of the amendments.”

Additionally, closed defined benefit plans can be aggregated with the employer’s defined contribution plans for purposes of compliance testing if:

(1) the defined benefit plan provides benefits to a closed group of participants,

(2) the defined benefit plan passes nondiscrimination and coverage testing in the plan year during which the plan closure takes place, and the two subsequent plan years,

(3) no amendments that discriminate in favor of highly compensated employees were made after the plan closed, and

(4) the plan was closed before April 5, 2017 or there was no “substantial increase” in value of either coverage or value of the benefits, rights and features for the five-year period before the plan was closed (see above).

If the defined benefit plan is aggregated with a plan that provides matching contributions, the defined benefit plan must also be aggregated with the portion of the DC plan that provides elective deferrals and the matching contributions must be treated in the same way as nonelective contributions for purposes of nondiscrimination and coverage testing.

The nondiscrimination relief is effective immediately, but plans have the option of applying this relief retroactively to plan years beginning after December 31, 2013.

In a defined benefit plan, the highest annual benefit payable under the plan must not exceed the lesser of (a) 100 percent of the participant’s average compensation in the high three years of service or (b) $275,000 in 2024 ($265,000 in 2023, $245,000 in 2022, $230,000 in 2020-2021, as indexed).¹ Regulations specify that this limit also applies to the annual benefit payable to a participant.² The regulations referenced throughout this question were issued April 5, 2007, and generally are effective for limitation years beginning after June 30, 2007.³ For general rules affecting the application of the Section 415 limits, see Q 3868; for the defined contribution plan limits, see Q 3728.

In plan years beginning after 2005, a participant’s high three years of service is the period of three consecutive calendar years during which the participant had the greatest aggregate compensation from the employer.⁴ Regulations state that a plan may not base accruals on compensation in excess of the Section 401(a)(17) limit ($345,000 in 2024, $330,000 in 2023, $305,000 in 2022, $290,000 in 2021, $285,000 in 2020, as indexed).⁵ For plan years beginning prior to January 1, 2006, a participant’s high three years of service had to be three consecutive years in which he or she was both an active participant in the plan and had the greatest aggregate compensation from the employer.

For purposes of defined benefit limits, “annual benefit” means a benefit that is payable annually in the form of a straight life annuity. If the benefit is payable in a form other than a straight life annuity, the annual benefit is determined as the straight life annuity that is actuarially equivalent to the form in which the benefit is paid.⁶ The application of the Section 415(b) limit to a benefit that is not payable in the form of an annual straight life annuity is explained in Treasury Regulation Section 1.415(b)-1(c). Earlier guidance appeared in Revenue Ruling 2001-51.⁷ The “annual benefit” does not include employee contributions and rollover contributions.⁸

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Planning Point: In Revenue Ruling 2012-4,⁹ the IRS ruled that a qualified defined benefit plan that accepts a direct rollover of an employee’s or former employee’s benefit from a qualified defined contribution plan maintained by the same employer does not violate Sections 411 or 415 if the defined benefit plan provides an annuity resulting from the direct rollover that is determined by converting the amount directly rolled over into an actuarially equivalent immediate annuity using the applicable interest rate and applicable mortality table under Section 417(e). If the plan were to provide an annuity using a more favorable actuarial basis than required under Section 411(c), the portion of the benefit resulting from this more favorable treatment would be included in the annual benefit. This interpretation applies to rollovers made on or after January 1, 2013.

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The annual benefit does not include employer contributions to an individual medical account under IRC Section 401(h) (Q 3836) of any individual under a defined benefit pension plan. Such amounts are treated as annual additions to a separate defined contribution plan (Q 3728).¹⁰

There are special rules requiring an adjustment of the annual benefit where a participant has more than one annuity starting date (for example, where benefits under one plan are aggregated with benefits under another plan from which distributions have already commenced, or where benefits are increased under a cost of living adjustment).¹¹

The $265,000 limit (as indexed for 2023) is adjusted downward if the annuity starting date occurs before the participant reaches age 62.¹² If the annuity starting date occurs after the participant reaches age 65, the limit is adjusted upward.¹³ The calculation of the adjustments is explained at IRC Section 415(b)(2)(E) and Treasury Regulation Section 1.415(b)-1(d) and (e). Earlier guidance on implementing these adjustments was provided in Revenue Ruling 2001-51.¹⁴

An adjustment also is required for certain other forms of benefit, as well as for employee contributions and rollover contributions (Q 3996 to Q 4019), so that such benefits are converted to the actuarial equivalent of a straight life annuity.¹⁵ Under earlier guidance this adjustment was more complex, generally following the manner in which Social Security benefits are reduced for Social Security purposes. The interest rate assumption used for making this adjustment must be no less than the greater of 5.5 percent or the rate specified in the plan.¹⁶ In the case of benefits subject to IRC Section 417(e)(3), the interest rate must be the rate set forth in IRC Section 417(e)(3).¹⁷ Guidance and detailed rules for making this calculation appear in Notice 2004-78¹⁸ and in Treasury Regulation Section 1.415(b)-1(c)(3). Simplification for amounts not subject to minimum present value rules of IRC Section 417(e)(3) is set forth in Treasury Regulation Section 1.415(b)-1(c)(2).

Adjustments to the ceiling do not need to be made for ancillary benefits not directly related to retirement benefits (such as preretirement death and disability benefits and postretirement medical benefits).¹⁹ If the benefit is paid in the form of a joint and survivor annuity for the benefit of the participant and the participant’s spouse, the value of the feature will not be taken into consideration in reducing the ceiling unless the survivor benefit is greater than the joint benefit.²⁰

The 100 percent of compensation limit generally does not apply to governmental plans, multiemployer plans, or certain collectively bargained plans.²¹

The dollar limit and 100 percent compensation limit are subject to a 10 year phase-in rule. The $265,000 limit (as indexed for 2023)²² is reduced by multiplying it by the following fraction: the numerator is the participant’s years of participation in the defined benefit plan, and the denominator is 10.²³ The 100 percent of compensation limit is reduced in the same manner, but based on years of service, rather than years of participation.²⁴ “Years of service,” for this purpose, includes employment with a predecessor employer, including affiliated employers.²⁵ Neither reduction will reduce the limitation to less than 10 percent of the otherwise applicable limitation amount.²⁶

A benefit of up to $10,000 in any limitation year may be provided to a participant without violating the IRC Section 415 limits, notwithstanding the 100 percent limit or required adjustments for ancillary benefits. This benefit, however, is subject to the 10 year phase-in rule described above, based on years of service. The participant must not at any time also have participated in a defined contribution plan maintained by the employer.²⁷

A plan may incorporate by reference the automatic adjustments of plan benefits to the extent of the annual cost-of-living increases provided under the IRC. The scheduled benefit increases may not take effect earlier than the year in which the dollar limit adjustment becomes effective.²⁸ Regulations state that the annual increase does not apply in limitation years beginning after the annuity starting date to a participant who previously has commenced receiving benefits unless the plan so specifies.²⁹ Earlier regulations stated that a plan could provide for automatic freezing or reduction of the rate of benefit accrual to prevent the limitations from being exceeded.³⁰

A defined benefit plan may maintain a qualified cost-of-living arrangement under which employer and employee contributions may be applied to provide cost-of-living increases to the primary benefit under the plan. This kind of arrangement is qualified if the adjustment is based on increases in the cost-of-living after the annuity starting date, determined by reference to one or more indexes prescribed by the IRS (or a minimum of 3 percent). The arrangement must:

(1) be elective;

(2) be available to all participants under the same terms;

(3) provide for such election at least in the year the participant attains the earliest retirement age under the plan (determined without regard to any requirement of separation from service) or separates from service; and

(4) exclude key employees.³¹

Toward the end of 2016, the IRS released two significant sets of proposed regulations on issues important to defined benefit plans. In November, 2016, the IRS proposed a regulation³² that would update minimum present value requirements applicable to certain distributions and also to take account of final IRS regulations³³ released earlier in the fall addressing the minimum present value requirements for pension benefits payable partly as an annuity and partly in an accelerated amount.

The second set of proposed regulations³⁴ updates the mortality tables to be used for single employer defined benefit plans.³⁵ Those regulations were effective for plan years beginning on or after January 1, 2018. In 2022, the IRS released proposed regulations updating the mortality tables to be used to calculate required minimum distributions for single-employer defined benefit pension plans. The new tables are effective beginning in 2023.³⁶

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Planning Point: The change in required mortality tables is expected to increase plan funding liabilities;³⁷ hence PBGC variable rate premiums and also lump sum distributions. Plan sponsors had only until the end of 2017 to offer lump sum distributions utilizing the old mortality assumptions, and also avoid future PBGC premium increases based upon increased plan liabilities.

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A cash balance plan is a defined benefit plan that calculates benefits and contributions in a manner similar to the way that defined contribution plans make those calculations. The similarity ends in that a cash balance plan’s calculations require an actuary. A cash balance plan resembles a defined contribution plan in that each employee has a hypothetical account, or “cash balance,” to which contributions and interest payments are credited. In a typical cash balance plan, the employee’s benefit accrues evenly over the years of service, with annual pay credits to the hypothetical account. There is no separate account. These pay credits usually are a fixed percentage of pay that is stated in the plan document, such as 4 percent.

With no separate account, there is no directed investing available. As with other defined benefit plans, the employer bears both the risk and the benefits of investment performance. That is, losses in the plan’s investments generally require additional employer funding. The actual amount that must be contributed is determined actuarially. This ensures that the plan has sufficient funds to provide the promised benefits.

For plan years beginning in 2012, the interest credit (or the equivalent amount) for any plan year must be at a rate that is not greater than a “market rate” of return. The term “market rate” of return is defined in regulations issued in 2010.¹ A plan will not fail this requirement merely because it provides for a reasonable minimum guaranteed rate of return or for a rate of return equal to the greater of a fixed or variable rate.² An interest credit of less than zero may not result in the account balance being less than the aggregate amount of contributions credited to the account.³ This legislative change eliminates the possibility of “whipsaw,” in which disparate interest rates used for crediting and discounting purposes resulted in the discounted present value of employees’ accounts being higher than the theoretical account’s value.

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Planning Point: IRS Revenue Procedure 2018-21 allows certain preapproved defined benefit plans containing a cash benefit formula to use the actual rate of return on plan assets to determine interest crediting. Many expect that this move will encourage more plans to move to the preapproved plan structure, as the IRS has eliminated its determination letter program for many individually designed plans.⁴ The IRS also provided that while the rate used to determine investment credits cannot be based on the rate of return for regulated investment companies (RICs), the actual rate of return can be used even if the plan assets contain RIC returns.

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Planning Point: The Moving Ahead for Progress in the 21st Century Act (MAP-21)⁵ enacted on July 6, 2012, contained interest-rate stabilization provisions for defined benefit plans. In August 2012, the IRS issued Notice 2012-55,⁶ which outlined the MAP-21 segment rates to be used for plan years beginning in 2012.⁷ MAP-21 revises the three segment rates used under the single employer funding rules. The Highway and Transportation Funding Act of 2014 amended the MAP-21 segment rates effective for plan years beginning on or after January 1, 2013;⁸ however, the plan sponsor could elect to defer use of the HAFTA segment rates until the plan year beginning in 2014. Guidance for making the election to defer is found in Notice 2015-42.⁹

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IRS Notice 2012-61¹⁰ provides guidance on pension funding stabilization under MAP-21. The guidance gives flexibility to plan administrators of plans that use the third segment rate by allowing the administrator to interpret the plan terms as requiring either the pre-MAP-21 third segment rate or the MAP-21 third segment rate, as long as the interpretation is applied for interest credited after the first plan year to which MAP-21 is applied for purposes of funding. An amendment to reflect that interpretation will not be considered a plan cutback.

In 2014, the IRS amended Treasury Regulation Section 1.411(b)(5)-1(d)(1)(iii), which provides guidance on the definition of “market rate,” to expand the definition of “market rate” and to clarify that the definition is effective for plan years beginning on or after January 1, 2016.¹¹ Transitional rules were issued in 2015.¹²

In 2017, an IRS internal guidance memo¹³ to its plan examiners provided guidance on whether a cash balance plan meets the definitely determinable benefits requirement when the formula is based upon partial compensation. The memo indicates that the benefits formula will be determinable if the plan terms provide a formula under which the pay credit is arrived at by looking at compensation information otherwise available, even if outside the terms of the plan (e.g., W-2 compensation documentation).

The recent history of cash balance plans began with the IRS directive released on September 15, 1999 instructing field offices to stop reviewing determination letters applications for cash balance plans. The Economic and Tax Relief Reconciliation Act of 2001 (EGTRRA) added additional disclosure requirements in situations involving the conversion of a traditional defined benefit plan to a cash balance plan and imposed an excise tax on plan sponsors failing to comply with these disclosure requirements. The law also imposed an excise tax if the plan sponsor specifically fails to notify participants of a plan benefit reduction in accruals, which often occurs for older plan participants in a conversion and created much of the early controversy around such plans. IRS Notice 2007-6¹ was then issued in 2007 providing additional detailed guidance on the creation of cash balance plans, and reopening the letter determination programs for such plans then being held for review. This plan design has flourished since.

A traditional defined benefit plan that is converting to a cash balance plan is currently subject to certain rules on the crediting of participant benefits. The plan’s benefit after conversion must not be less than the sum of the participant’s accrued benefit for years of service before the conversion under the prior formula, plus the benefit the participant earns under the new formula for service after the conversion.² This formula is known by actuaries as an “A+B” approach.

The A+B approach is designed to eliminate a plan issue referred to as “wearaway,” which refers to situations where certain participants in the plan do not accrue any additional benefits until benefits under the prior plan are worn away to equal benefits under the new plan. This occurred in some conversions where older employees might not accrue additional benefits under the cash balance formula until their new hypothetical account balance caught up with their prior accrued benefit. Requirements for calculation of the present value of a participant’s accrued benefit in such cases are set forth in IRC Section 411(a)(13)(A) (effective for distributions made after August 17, 2006).

For plan years beginning after 2007, benefits in cash balance plans must be 100 percent vested after three years of service.¹

The Pension Protection Act of 2006 ended a long period of uncertainty for cash balance plans by amending the IRC, ERISA, and the Age Discrimination in Employment Act of 1967. The effect of the legislative changes provides that cash balance plans will not be age discriminatory if certain requirements are met.

A preexisting IRC requirement under which cash balance plans had been attacked stated that an employee’s benefit accruals may not cease, and the rate accrual may not be reduced, because of the attainment of any age.¹ Three parallel amendments provide that a plan will not be treated as failing this requirement if a participant’s accrued benefit, 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.² Except as otherwise indicated below, the provisions of PPA 2006 applicable to cash balance plans are effective for periods after June 28, 2005.³A participant is “similarly situated” if he or she is identical to another individual in every respect except for age; in other words, in circumstances such as period of service, compensation, date of hire, work history.⁴

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Planning Point: When modifying a pension plan to become a cash balance plan, even if all the assumptions may be reasonable, the communications to the participants are extremely important and care should be taken with their preparation to accurately state the impact of the changes on those participants.  Communications must not be in any respect misleading or, of course, false.⁵

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“Accrued benefit” is defined by the plan terms; it may be expressed as an annuity payable at normal retirement age, the balance of the participant’s cash balance plan account, or some other means. Early retirement subsidies, permitted disparity, and certain other plan features are disregarded for this purpose.⁶

Prior to the passage of the PPA, the Seventh Circuit Court of Appeals held that a cash balance plan formula that was age neutral did not give rise to age discrimination under ERISA, and that an employer’s choice to convert from a defined benefit plan (which tends to favor older employees) to a cash balance plan (which does not) is not per se age discrimination.⁷

Editor’s Note: The CARES Act gave sponsors the option of using the adjusted funding target attainment percentage for the last plan year ending before January 1, 2020.

Contributions to certain defined benefit plans (other than multiemployer or CSEC plans) subject to the minimum funding standard (Q 3742 to Q 3748) must be made, on an estimated basis, at least quarterly, and the new mortality tables released by the IRS on October 3, 2017 will impact these calculations. The quarterly contribution requirement is imposed on plans with a funding shortfall in the prior year.¹

The required amount for each quarterly installment is 25 percent of the Required Annual Payment (“RAP”).² The RAP is the lesser of the following:

(1)    90 percent of the minimum required contribution amount the employer is required to contribute for the plan year under the minimum funding requirements; and

(2)    100 percent of the minimum required contribution for the preceding plan year (determined without regard to a Section 412(c) waiver), but only if the preceding plan year consisted of 12 months.³

Quarterly contributions are determined without regard to increased contributions.

Defined benefit plans subject to the quarterly contributions requirement also must meet a liquidity requirement⁴ and generally must maintain liquid plan assets. A plan will be deemed to have a liquidity shortfall if, with respect to a quarter, the plan does not have liquid assets in an amount approximately equal to three times the total adjusted disbursements from the plan trust during the 12 month period ending on the last day of each quarter for which the plan must pay a required quarterly installment.⁵ A special rule permits this amount to be determined without regard to nonrecurring circumstances, under certain conditions.⁶

The minimum funding requirement for a plan year generally is determined without regard to any credit balance or prefunding balance as of the beginning of the plan year. A credit balance in the plan’s funding standard account may not be treated as a contribution to satisfy the liquidity requirement.

If a required installment is not paid to the plan by its due date, the funding standard account is charged with interest on the amount by which the required installment exceeds the amount, if any, paid on or before such due date. This interest is charged for the period from the due date until the date when the installment actually is paid.⁷ The installment due dates are April 15, July 15, October 15, and January 15 of the following year,⁸ or, if the plan year is not a calendar year, the 15th of each corresponding month in the plan year.⁹ The rate of interest charged is the rate of interest used to determine liability plus 5 percent.¹⁰ Additional payments necessary to satisfy the minimum funding requirement are due within 8.5 months after the end of the plan year.

A statutory lien may be imposed on an employer, determined on a controlled group basis (Q 3933), for failure to make a required installment or any other payment required by the minimum funding rules if the aggregate unpaid balance of the contributions or payments (including interest) exceeds $1,000,000.¹¹