The Internal Revenue Service on November 4 issued Notice 201667, which says that a pension equity plan (sometimes referred to as a "PEP") is subject to the hybrid plan market rate of return rules only if the plan explicitly provides interest credits to participant accounts.
Accordingly, the interest that is implicit under a PEP does not need to be examined to determine whether that interest is too high to comply with the market rate of return rules — at least not yet.
For those plan sponsors who had questions about whether the market rate of return rules apply to their PEP, the guidance is significant because it potentially saves the plan sponsor from making a well-intentioned last minute plan amendment that would have been intended to bring the plan into compliance with the market rate of return rules but that actually, under current law, would have been an impermissible cutback of benefits under the plan.
However, the notice also introduced uncertainty regarding how PEPs that provide interest implicitly will be treated in the future by including a request for comments regarding whether the rules should be changed to subject implicit interest to the market rate of return rules.
Pension equity plans are a type of hybrid pension plan. Hybrid plans, which also include cash balance plans, are defined benefit plans that generally have the look and feel of a defined contribution plan from the perspective of a plan participant. This includes defining a participant’s benefits under the plan at any point in time as the single lump sum benefit the participant would receive if the participant were eligible for a distribution at that time and selected the lump sum form of payment.
In a cash balance plan, this typically involves crediting the participant’s account with a principal credit each year (typically a percentage of pay) and then growing the account each year in a predetermined manner to account for time value of money — often referred to as an interest credit. In a PEP, the participant’s account at any time is often a percentage of the participant’s final average pay, with the account growing each year by an additional percentage of pay plus a percentage of any increase in the final average pay compared to the prior year.
For example, under a simple design that credits seven percent of final average compensation each year, a participant’s account would equal 70 percent of final average pay after 10 years of service and 77 percent of final average pay after 11 years of service.
When a cash balance participant stops working, the participant’s account continues to receive an interest credit each year the account remains in the plan. When the participant starts benefits, the amount of the annuity benefit payable is typically determined using an immediate annuity factor. When a PEP participant stops working, some PEPs provide an interest credit each year (sometimes referred to as an “explicit interest PEP”). At this point, this type of PEP effectively becomes a cash balance plan, with an immediate annuity factor typically applied to the account balance to determine the annuity payable when the participant starts benefits.
Other PEPs do not provide any adjustment to the account balance after a participant stops working. Instead, the annuity benefit payable to the participant is often determined using a deferred annuity factor — typically deferred to normal retirement age.
Even though no interest credit is applied to the account balance under this type of PEP, there still is an adjustment to the participant’s benefit that is ultimately payable for preretirement interest. This adjustment is included within the deferred annuity factor, which also may include preretirement mortality (as a result, this type of PEP is sometimes referred to as an “implicit interest PEP”).
Interest crediting under a hybrid pension plan (including under a PEP) is generally subject to the market rate of return rules. Under these rules, in order to satisfy age discrimination rules, interest credits are not permitted to be greater than a market rate of return. This is because if interest credits were provided at a rate greater than a market rate of return, that additional benefit (the incremental interest that is in excess of market) would accrue to the benefit of younger participants over a longer period of time than it would accrue to the benefit of older participants who are similarly situated except for their age.
The Treasury Department and the IRS have published final regulations for the market rate of return rules that include specific maximum interest crediting rates that satisfy the market rate of return rules. These regulations, which apply to plan years starting on and after Jan. 1, 2017, require the plan sponsor of a plan that provides interest credits exceeding a market rate of return to reduce the interest crediting rate to a rate that complies before the regulations become applicable.
Relief from the anticutback rules was also included in these regulations to allow plan sponsors to reduce benefits to comply with the market rate of return rules. Without this relief, a reduction in the interest crediting rate would generally be an impermissible cutback.
The requirement to bring plans into compliance with the market rate of return rules before the first plan year starting on or after Jan. 1, 2017, led to questions from stakeholders about whether implicit interest PEPs were subject to these rules. The IRS notice answered this question clearly — the interest that is implicit in a deferred annuity factor under an implicit interest PEP is not subject to the market rate of return rules.
However, after clarifying that issue, the notice then went on to say that Treasury and the IRS are thinking about whether new rules should be proposed that would subject the interest that is implicit in a deferred annuity factor under an implicit interest PEP to the market rate of return rules and included a request for comments on whether these new rules should be proposed.
The IRS requested that any comments take into account both the statutory intent of the market rate of return rules as well as the difference between interest credits and interest that is implicit in a deferred annuity factor.
The notice also recognized that some plan sponsors may have already amended their implicit interest PEP in an effort to comply with the market rate of return rules, which may constitute an impermissible cutback in benefits if the interest provided implicitly does not become subject to the market rate of return rules because of a future change.
The IRS requested comments on corrections that may be needed for these plans in that case. So, while the notice provided a clear answer to whether implicit interest PEPs are subject to the market rate of return rules, it essentially answered that question with additional questions — should these PEPs be subject to the market rate of return rules and how should cutback violations be corrected in the case of a plan sponsor who got the answer to the first question wrong — leading to new uncertainty for sponsors of, and other stakeholders who work with, implicit interest PEPs.