Cash Balance
Interest Credit Rates
Thomas J. Finnegan
The Savitz Organization
May 13, 2010
PHILADELPHIA ACTUARIES CLUB
Plan Design and Tech Issues
• Cash Balance Plans in 2010
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Nature of Cash Balance accrued benefit
Impact of market rate of return
Ability to change Interest Credit Rate
PPA 411(d)(6) relief
General 411(d)(6) relief
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Existing guidance
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Notice 96-8
Notice 07-06
Proposed regulations under 411(a)(13) and 411(b)(5)
Announcement 09-82
Notice 09-97
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Notice 96-8
• Some would argue that notice 96-8 no longer applies,
and was rendered obsolete by PPA
• While certain portions of notice 96-8 no longer apply (for
example, issues regarding minimum lump sums), other
portions still do (such as requirement to include rules on
how to determine the accrued benefit)
• Notice 96-8 was also famous for its list of safe harbor
interest rates that provided relief from whipsaw if one of
these was your interest credit rate
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Notice 96-8
• To understand WHY 96-8 applies, first, it is important to
understand what 411(b)(5) did
• 411(b)(5) defines an applicable defined benefit plan, and
then, exempts such a plan from the requirements of
417(e)
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Notice 96-8
• 411(b)(5) does not
– change 411(a)(7) (the definition of an accrued benefit
for other purposes), nor
– change how 401(a)(4), 411(b)(1) (minimum accrual
rules), and 417(a) (rules regarding relative values,
and some other rules governing distributions) apply,
nor
– the requirements of 401(a)(25) (rules regarding
benefits being definitely determinable)
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Notice 96-8
• Thus, assuming that the plan provisions other than
417(e) and vesting are the same post PPA as they were
pre PPA, then
– the 411(a)(7) accrued benefit would be the same, and
– the 401(a)(4) [nondiscrimination], as well as the
411(b)(1) testing [backloading] would be the same
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Notice 96-8
• Consider an applicable defined benefit plan,
– effective on 1/1/2010,
– hypothetical interest crediting rate of 6% (which may
not be allowed)
– conversion factors of 6% interest and applicable
mortality
• Assume that the pay credit is
– 5% of pay for the first 10 years,
– 7% for the next 10 years, and
– 10% after 20 years
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Notice 96-8
• Consider a new hire
– age 40
– earning $50,000 a year
– Assume NRA of age 65
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Notice 96-8
• 411(a)(7)(A)(i) still defines the accrued benefit as
– “in the case of a defined benefit plan, the employee’s
accrued benefit determined under the plan and,
except as provided in subsection (c)(3), expressed in
the form of an annual benefit commencing at normal
retirement age”
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Notice 96-8
• Thus, even if the accrued benefit under the plan is the
account balance,
– the 411(a)(7) accrued benefit is the actuarial
equivalent of the account balance,
• expressed in the form of an annuity at normal
retirement age
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Notice 96-8
• So, the annuity at normal retirement age is
– the current notional account (one pay credit of 5% of
$50,000, or $2,500)
– increased with interest at the plan rate of 6% for 25
years, to $10,730,
– then converted to an annuity of $80.79 per month
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Notice 96-8
• Calculation recognizes that the future interest credits at
6% are part of the participant’s accrued benefit
• This would mean that the right to the 6% future interest
credits is 411(d)(6) protected (we will come back to a
special rule, while regulations are pending)
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Notice 96-8
• For 401(a)(4) and 411(b)(1) purposes, the accrued
benefit is $80.79
• Under the formula, if all other relevant factors remain
constant,
– the pay credit at age 60 will be 7% of $50,000, or
$3,500, and
– the pay credit at age 61 will be 10% of $50,000, or
$5,000
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Notice 96-8
• Repeating the calculation of the accrued benefit,
– at age 60 the increase in accrued benefit is $35.27
(using a 7% pay credit), and
– at age 61 it is $47.53 (using a 10% pay credit)
• $47.53/35.27=134.76%
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Notice 96-8
• the plan fails the requirement that the increase in
accrued benefit in any future year can not exceed the
increase in any earlier year between the current year
and that year by 33 1/3%
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Notice 96-8
• Assume, instead, that the pay credits were 5% for all
plan years, but that the plan only accrued the participant
in the right to the first 3.25% of the 6% interest credit
• In other words, the plan only 411(d)(6) protects 3.25% of
the interest credit, and the other 2.75% of the interest is
only accrued at the time the interest credit becomes part
of the notional account
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Notice 96-8
• A participant would accrue a benefit of $79.39 at age 20
• At age 64, the notional account would be $499,395, with
an associated accrued benefit of $3,882.43
• At age 65, the notional account would be $531,859, with
an associated accrued benefit of $4,004.66
• The increase in accrued benefit between age 64 and 65
is $122.23
• $122.23 is 154% of $79.39, and since that exceeds 133
1/3%, the plan fails 411(b)(1)
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Notice 96-8
• 401(a)(25) “A defined benefit plan shall not be treated as
providing definitely determinable benefits unless,
whenever the amount of any benefit is to be determined
on the basis of actuarial assumptions, such assumptions
are specified in the plan in a way which precludes
employer discretion.”
• Notice 96-8 applies in that it requires that manner in
which the account is projected to retirement, and
converted to an accrued benefit, must be specified in the
plan document
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Notice 07-06
• Notice 07-06 and proposed regulations indicate that if a
plan uses one of the safe harbor rates specified in notice
96-8, that those rates will be considered to not exceed
the market rate requirement under the new rules
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Proposed Regulations
• The proposed regulations (and PPA) break the world of
interest crediting rates into three zones
– Fixed rate
– Variable rate
– Greater of fixed rate or variable rate
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Proposed Regulations
• In the preamble, the discussion of allowable fixed rates
makes the following comment
– Under one possibility, the regulations might set forth a
specific interest crediting rate (such as 4 percent or 5
percent) that a plan may be permitted to use.
• At the hearings, one commenter suggested that a fixed
rate up to 8.5% should be allowed (hehehe)
• Allowable fixed rates are still up in the air…may vary
based on the effective date of the plan or conversion
date
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Proposed Regulations
• Variable rates give rise to the most issues
– The rules contain what is called a preservation of
capital provision
• that requires that the notional account can never
be less than the sum of the pay credits
– Preservation of capital is a “to date” rather than
annual concept
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Proposed Regulations
• In application, it might require that the interest crediting
rate not fall below zero,
• In some years, long term participants get a
negative return, until all prior positive returns are
gone
– Different for every participant
– Do you accumulate negative returns that
cannot be credited to offset future positive
returns?
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Proposed Regulations
• So the question is, what exactly does “market rate”
mean?
• There seems to be an unspoken interpretation that
market rate means a rate that will not exceed the 417(e)
rate, on average, over an extended period of time
– Allowing rates well in excess of 417(e) would allow
conversions to avoid 417(e)
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Proposed Regulations
• The third group is the greater of a variable rate and a
fixed rate
• The primary question is whether the maximum variable
rate has to be lowered to accommodate a minimum fixed
rate, and if so, how?
• The logic is that a rate of, for example, the 30-year
treasury rate, but not less than 5% is worth more than
just the 30 year rate
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Proposed Regulations
• There are still unanswered questions regarding a benefit
that is the greater of a cash balance benefit and a non
cash balance benefit
• Consider, for example, a cash balance plan with a top
heavy minimum
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Proposed Regulations
• It could be argued that so long as the accrued benefit
associated with the cash balance benefit exceeds the TH
min, that the TH min has been satisfied, and thus, the
notional account balance can be paid as a lump sum,
without violating 417(e)
• But if the interest credit is greater than the 417(e) rate,
the notional account balance that provides the TH min
benefit is far lower than the 417(e) min value of the TH
min
• If the max market rate approximates the 417(e) rate, the
problem vanishes
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Proposed Regulations
• An alternative interpretation is that the top heavy
minimum is applied to the benefit form selected,
• in other words, if a lump sum is selected,
– the minimum lump sum is the greater of the 417(e)
minimum lump sum on the top heavy minimum, and
the notional account balance
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Proposed Regulations
• A similar type issue exists on the application of the 415
maximum
• The two largest issues are
– Can the notional account balance exceed the
maximum immediate lump sum?
– What is the plan rate (under 415(b)(2)(E)) that is used
when determining the immediate lump sum?
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Proposed Regulations
• Converting a non-cash balance plan to a cash balance
plan also has issues
• Under the regulations, it would appear acceptable to
convert the accrued benefit into an opening account
balance on the conversion date, equal to what the
immediate lump sum would be on that date
• Is it necessary to recheck the account balance
attributable to the prior accrued benefit, to confirm that it
is larger than the lump sum value of the prior accrued
benefit at payment?
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Proposed Regulations
• The proposed regulations indicate that the final
regulations will have guidelines on how to deal with a
change in the interest crediting rate, but do not hint what
the guidance will be
• Set and check
OR
• Set and forget
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Section 1107 Relief
• Section 1107 of PPA gave 411(d)(6) relief to amendment
made in accordance with PPA
– This relief applied whether the relief was needed or
not
• 1107 relief only applies to amendments adopted by
12/31/09
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Section 1107 Relief
• Example: While there was no mandate in PPA to
remove whipsaw, Section 1107 relief allowed plans to
amend to remove it, even though removal reduced
otherwise 411(d)(6) protected lump sums
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Section 1107 Relief
• With respect to interest credit changes, prior to 2010 we
were operating on a reasonable interpretation of the
statute
• Some plans that provided an interest credit rate that the
sponsor believed to be in excess of a market rate
amended the rate to any 96-8 rate or the third segment
rate
• IRS agreed (from podiums at least) that this amendment
had 411(d)(6) relief under PPA 1107, and relief was
supported by promised relief in 2007-6
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Section 1107 Relief
• For interest credit rates, there was little restriction on
these amendments
– If the sponsor made a reasonable interpretation of the
statute that the plan’s rate was above a market rate
• the sponsor could change to any allowable rate
below market and was in no way limited to the
“highest” such rate
– No adjustment was needed to the notional
account
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Section 1107 Relief
• Example:
– Plan sponsor has a plan with a 7% interest credit rate.
– Believing the rate to be above market, he amends to
the thirty year treasury rate.
– As long as this was done prior to 12/31/09; it
apparently could be done without adjusting the
notional account and is exempt from 411(d)(6)
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Announcement 09-82
• This announcement acknowledges the problem that a
plan must comply with the new rules effective in 2010,
even though some of those rules have not been
published (even in proposed form) yet
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Announcement 09-82
• The announcement implies that three levels of relief will
be given
– The deadline for amending a plan to comply with
certain PPA elements will be extended
– To the extent that the interest credit rate exceeds the
maximum allowable rate, the plan will be allowed to
lower the rate without a 411(d)(6) violation
– Relief on 204(h) notice will also be provided
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Announcement 09-82
• The relief on the change of interest rate appears to work
as follows
– Assume that the plan has an interest crediting rate of
6%
– Assume that the maximum allowable interest crediting
rate is set as 5%, effective 1/1/2011
– Assume a participant with pay credits of $10,000, and
the first pay credit on 12/31/2009
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Announcement 09-82
• The 1/1/2010 notional account would be $10,000
• On 12/31/2010 the notional account would be $10,000 +
$600 as an interest credit and $10,000 as a pay credit,
for a total of $20,600
• On 1/1/2011 the interest credit rate drops to 5%
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Announcement 09-82
• Normally, the participant would have a 411(d)(6) protected
right to the 6% interest
• In that case, in order to lower the interest rate, it might be
required (no guidance has been hinted at yet) that the
notional account will have to be increased, in something
similar to a whipsaw calculation
• It may be that, with relief, the interest rate can be lowered
without an increase in the notional account, but it is not
clear
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Announcement 09-82
• Consider a 40 year old
• $100,000 notional account balance
– if the interest rate is changed from 6% to 5%, the
notional account would have to be increased to
– $100,000 * 1.06^25/1.05^25 = $126,740
– to protect the value of the additional 1% for the next
25 years
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Announcement 09-82
• In other words, the account would have to be increased
so that the 411(a)(7) accrued benefit does not decrease
• It appears that in the initial compliance with PPA,
411(d)(6) relief will be provided (per 07-06) to lower the
rate to comply with PPA, but this has not been finalized
– This relief was granted under Section 1107 of PPA
which expired on 12/31/09
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Announcement 09-82
• Further, 09-82 provides similar 411(d)(6) relief for a
change in interest credit rate to comply with final
regulations, to the extent the interest credit rate is too
high prior to final regulations
• While 09-82 extended relief on interest credit rate
amendments to the extent necessary, it did NOT extend
the deadline for eliminating whipsaw
– Still 12/31/09
• What is the extent necessary???
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Notice 2009-97
Announcement 09-82 Revisited
• As noted earlier, 09-82 provides similar 411(d)(6) relief
for a change in interest rate to comply with final
regulations, if the interest rate is too high prior to final
regulations
• This relief is based on the general provision that
411(d)(6) relief is provided to the extent necessary to
maintain qualified status after a change in the law.
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Notice 2009-97
• Section 1.411(d)-4, A-2(b)(2)(i), provides that a plan may
be amended to eliminate or reduce a § 411(d)(6)
protected benefit, if the following three requirements are
met:
– the amendment constitutes timely compliance with a
change in law affecting plan qualification;
– there is an exercise of § 7805(b) relief by the
Commissioner;
– and the elimination or reduction is made only to the
extent necessary to enable the plan to continue to
satisfy the requirements for qualified plans.
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Notice 2009-97
• Notice 2009-97 announces that the IRS will be
exercising 7805(b) relief with respect to above market
interest credit rate amendments
• But what does this mean???
– The elimination or reduction is made only to the
extent necessary to enable the plan to continue to
satisfy the requirements for qualified plans.
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Prior Example
• We already showed that by increasing the notional
account balance, there is no need for 411(d)(6) relief..so
the extent necessary would be zero
– Consider a 40 year old
– $100,000 notional account balance
• if the interest rate is changed from 6% to 5%, the
notional account would have to be increased to
• $100,000 * 1.06^25/1.05^25 = $126,740
• to protect the value of the additional 1% for the
next 25 years
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Notice 2009-97
• So for 2009 and earlier, it appears that
– if you could reasonably interpret the statute in such a
way as to argue that your plan’s interest credit rate
was above a market rate
• You could amend the interest credit rate to any
acceptable 2007-6 rate without having to protect
associated, otherwise protected, 411(d)(6) benefits
• What is a reasonable interpretation of “market rate”?
– No one knows and apparently many plans did not
amend
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Notice 2009-97
• IRS has indicated that if you are above market, post
2009 you can change rates, but only to the extent
necessary to comply with the law
• Three potential meanings
– You can switch to any allowable rate or
– You can only switch to the “highest” allowable rate or
– You must adjust the nominal balance, in which case
the choice of rate is immaterial because you are
getting no 411(d))(6) relief
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Notice 2009-97
• IRS admits it did not have authority to extend the PPA
1107 period
• A close reading of the 411(d)(4) rules show that the IRS
has clear limits on its authority to grant 411(d)(6) relief
beyond the 1107 period to changes to the extent
necessary to comply with the law
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Notice 2009-97
• That is why they couldn’t extend the whipsaw
amendment period
– because you’re not required to get rid of whipsaw
• But its hard to believe that everyone would lose
411(d)(6) exemption because IRS never issued the regs
that 2007-6 promised in a couple of months
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Questions?
• Thanks to
– Carol Zimmerman
– Larry Deutsch
– Kevin Donovan
• For contributions to outline
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