cash balance interest credit rates

PHILADELPHIA ACTUARIES CLUB

Cash Balance Interest Credit Rates

Thomas J. Finnegan

The Savitz Organization

May 13, 2010

2PHILADELPHIA ACTUARIES CLUB

Plan Design and Tech Issues

• Cash Balance Plans in 2010

– 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


Existing guidance

• Notice 96-8• Notice 07-06 • Proposed regulations under 411(a)(13) and 411(b)(5)• Announcement 09-82• Notice 09-97


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


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)


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)


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


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


Notice 96-8

• Consider a new hire– age 40 – earning $50,000 a year– Assume NRA of age 65


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”


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


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


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)


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


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%


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%


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


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)


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


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


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



• 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



• 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



• 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?



• 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)



• 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



• 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



• 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



• 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



• 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?



• 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?



• 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


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


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


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


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


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)


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


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


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


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%


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


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


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


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???


Notice 2009-97Announcement 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.


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.


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.


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


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


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


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


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


Questions?

• Thanks to– Carol Zimmerman – Larry Deutsch– Kevin Donovan

• For contributions to outline

cash balance interest credit rates

Documents