Just Because You Can Design a Plan This Way · 11/1/2018 · Just Because You Can Design a Plan...

Just Because You Can Design a Plan This Way Doesn’t Mean You Should

Kevin J. Donovan, CPA, EA, FSPA, FCAPresident

Pinnacle Plan Design, LLC

Thomas J. Finnegan, FSPA, FCA, CPC, QPAExecutive Vice President

CBIZ Retirement Plan Services

Midnight K Plans

2

Midnight k Plans

• You run an illustration for a 401(k) cash balance combo plan for 2018

– Now, after deadline for 2018 to be safe harbor

• Dr age 44; spouse same age

• Compensation: Dr $275K; spouse $50K

• Dr wants full $55K DC plus $115K CB

• Total NHC payroll is $400K

3

Midnight k Plans

• NRA both plans 62/5

• Actuarial equivalence factors interest 4% pre-and post-retirement, 2018 AMT post only

– Testing based on GAM 71 male, 8.5%/8.5%

• Owner pay credit $115K

• Employees’ pay credit 2% of comp

• Exclude spouse from cash balance

4

Midnight k Plans

• A young employee results in rate group testing passing at 5% PS for EEs whether or not Dr is able to defer

– i.e., whether Dr DC is $36,500 PS and $18,500 deferral or $55,000 PS and no deferral rate groups pass

• Without deferral however gateway goes from 5% to 7% as demonstrated on following slides

– (With $400K of EE comp cost of additional GW = $8K)

5

Midnight k Plans

• Aggregate Normal Allocation Rate - which is what determines gateway – is equal to “Normal Allocation Rate” from DB plan plus “Allocation Rate” from DC plan

6

Midnight k Plans

• Dr’s DB Normal allocation rate = 11.08%

– $115,000 * (1.04 ^ 18) = $232,969 (CB at NRA)

– $232,969 / 179.1501 = $1,300.41 (accrued benefit)

– $1,300.41 * 101.718 = $132,275 (FVAB test factors)

– $132,275 / (1.085 ^ 18) = $30,461 (equivalent allocation)

– $30,461 / $275,000 = 11.08%

7

Midnight k Plans

• At $55,000 DC Allocation Rate =

– $55,000/$275,000 = 20.00%

• And Aggregate Normal Allocation Rate =

– 11.08% + 20.00% = 31.08%

• And gateway = 7%

8

Midnight k Plans

• At $36,500 DC Allocation Rate =

– $36,500 / $275,000 = 13.27%

• And Aggregate Normal Allocation Rate =

– 11.08% + 13.27% = 24.35%

• And gateway = 5%

• But we’re past safe harbor adoption so how do we get Dr full deferral?

9

Midnight k Plans

• 401(k)(3) and 401(m)(3) provide ADP and ACP tests may be run on a prior-year or current-year basis

• In the case of the initial plan year 401(k)(3)(E) and 401(m)(3) (last sentence) provide that an employer may use prior year testing

– With NHC ADP and ACP at 3%

10

Midnight k Plans

• This effectively allows first year ADP and ACP of HCEs to be 5% irrespective of NHC deferrals

• Common strategy when it’s too late to set up a safe harbor plan (i.e., post 10/1) is to use this approach in year one, switching to safe harbor in year two

• How late may/should this be done?

11

Midnight k Plans - Example

• Final payroll will be Monday, 12/31/18

• Owner will take bonus of $185K

• Spouse will receive regular (small) paycheck

• Plan adopted Wednesday, 12/26/18

• Deferral election forms provided at same time with instruction to be completed by end of day Thursday, 12/27

12


• Owner defers $18,500 (10%); spouse $0

– So ADP 5%

• $1 for $1 Discretionary match

• So match of $18,500 and ACP of 5%

• Owner gets $37,000 before any PS

• Top-heavy requirement likely allows PS to get owner close to or at 415 max

– At cost of 3% of comp to employees

13


• Or going back to our example

• Spouse defers nothing and Dr defers $18,500

• ADP will pass using first year/prior year

• And gateway will go from 7% to 5% saving Dr $8K in contributions for the employees

• Is this OK? How late in the year can such a plan be adopted?

– There is no specific rule but IRS has indicated some concern with this approach if too late in the year

14

“Late” Plan Adoption

15


• Employer’s tax year ends 6/30/18

• Has calendar-year 401(k) plan

• Would like to add a calendar year cash balance plan (now, 4 months after tax year-end) effective 1/1/18 and take deduction in fiscal year ended 6/30/18

– So plan is effective before end of tax year

16


• Engineered Timber Sales, Inc. v. Comr, 74 T.C. 808 (7/22/80)

– Plan must be in existence and executed prior to end of tax year for deduction to be taken

– IRS reiterated in Revenue Ruling 81-114

– Also RR 76-28 states deduction allowed for contributions by due date of tax return “providing the plan was in existence in such year”

• Note that this strategy is being marketed!

17

Entry Dates and Testing Comp

18


• When performing testing under IRC 401(a)(4) testing can be performed using either the annual method or the accrued to date method (if testing on benefits basis)

• When testing on an annual basis may use “Plan Year Compensation”

– Whereas when testing accrued to date must use average compensation

19


• Reg. Section 1.401(a)(4)-12 defines plan year compensation to include “period of plan participation during the plan year”

• In a dual-entry plan this is often used to test based on half-year compensation while the allocation may be a top-heavy minimum

– Even in plan tested on contribution basis this effectively doubles the EBAR

20


• What about monthly entry after year of service?

• So e.g., a 11/15/2017 hire enters the plan on 12/1/18

– Receives 3% TH minimum on full-year comp

– Plan comp ~ 1/12 of full year

– 36% EBAR on DC basis?

21


• How about entry dates of 7/1 or 12/31 after year of service?

• Back to our 11/15/2017 hire – enters the plan on 12/31/18 –assume paid semi-monthly

– Receives 3% TH minimum on full year comp

– Plan comp ~ 1/24 of full year

– 72% EBAR on DC basis?

22


• Consider a small medical practice

• Dr age 44 and four eligible employees

– Based on 21/1, dual entry

• Three eligible employees are same age or older than Dr, other age 28

– 11/15/17 hire (EE5) age 54 not yet eligible

• Dr wants combo similar to earlier example

23


Yrsto TA Comp CB PS 401(k) TOTAL

Dr 44 18 $275,000 $80,000 $36,500 $18,500 $135,000

EE1 44 18 60,000 1,200 4,200 0 5,400

EE2 28 34 60,000 1,200 4,200 0 5,400

EE3 44 18 60,000 1,200 4,200 0 5,400

EE4 44 18 60,000 1,200 4,200 0 5,400

EE5 54 NA 60,000 NA NA NA NA

24


PlanSLA@62

TestSLA@62

Plan 50% QJSA@ AA

Test 50% QJSA@ AA

Dr 179.15 101.718 247.659 135.033

EE1 179.15 101.718 247.659 135.033

EE2 179.15 101.718 274.653 143.508

EE3 179.15 101.718 247.659 135.033

EE4 179.15 101.718 247.659 135.033

EE5 NA NA NA NA

25

Relevant actuarial factors


DC proj. to TA @

8.5%DC

EBAR CB @ 62DB NAR Agg.

NARImm. JS Monthly

DB MVAR

AggMVAR

Dr 158,500 6.80% $162,065 3.95% 10.75% $323.02 8.13% 14.93%

EE1 18,238 3.59% 2,431 .27% 3.86% 4.85 .56% 4.15%

EE2 67,276 13.23% 4,553 .51% 13.74% 4.37 1.97% 15.20%

EE3 18,238 3.59% 2,431 .27% 3.86% 4.85 .56% 4.15%

EE4 18,238 3.59% 2,431 .27% 3.86% 4.85 .56% 4.15%

EE5 NA NA NA NA NA NA NA NA

26

Rate Group Testing


• ABPT:

– Average NHC Normal Accrual rate = 6.33%

– HCE NAR from prior slide = 10.75%

• Must add EBAR from deferral = 3.45%

• Total NAR = 14.19%

• 6.33%/14.19% = 44.58% - ABPT fails (bigly)

27


• Rate group testing

• Four NHCs one HCE midpoint = 30.00%

• One of four NHCs in rate group = 25.00%

• And even if at or above midpoint rate group would not pass as ABPT fails

– So rate group would need to pass ratio % test (i.e., would need coverage ratio of 70%)

28


Yrsto 62 Comp

PlanComp CB PS 401(k) TOTAL

Dr 44 18 $275,000 $275,000 $80,000 $36,500 $18,500 $135,000

EE1 44 18 60,000 60,000 1,200 4,200 0 5,400

EE2 28 34 60,000 60,000 1,200 4,200 0 5,400

EE3 44 18 60,000 60,000 1,200 4,200 0 5,400

EE4 44 18 60,000 60,000 1,200 4,200 0 5,400

EE5 54 8 60,000 2,500 0 $1,800 0 1,800

29

Data as follows – with 12/31 entry:


PlanSLA@62

TestSLA@62

Plan 50% QJSA@ AA

Test 50% QJSA@ AA

Dr 179.15 101.718 247.659 135.033

EE1 179.15 101.718 247.659 135.033

EE2 179.15 101.718 274.653 143.508

EE3 179.15 101.718 247.659 135.033

EE4 179.15 101.718 247.659 135.033

EE5 179.15 101.718 NA NA

30

Relevant actuarial factors – with 12/31


DC proj. to TA @

8.5%DC

EBAR CB @ 62DB NAR Agg.

NARImm. JS Monthly

DB MVAR

AggMVAR

Dr 158,500 6.80% $162,065 3.95% 10.75% $323.02 8.13% 14.93%

EE1 18,238 3.59% 2,431 .27% 3.86% 4.85 .56% 4.15%

EE2 67,276 13.23% 4,553 .51% 13.74% 4.37 1.97% 15.20%

EE3 18,238 3.59% 2,431 .27% 3.86% 4.85 .56% 4.15%

EE4 18,238 3.59% 2,431 .27% 3.86% 4.85 .56% 4.15%

EE5 3,457 16.81% NA NA 16.31% NA NA 16.31%

31

Rate Group Testing


• CB does not have special entry so EE5 NA

• EE5 EBAR based on $2,500 plan year comp

– Even though DC allocation is 3% top-heavy on full year comp

32


• ABPT:

– Average NHC Normal Accrual rate = 8.32%

– HCE NAR = 14.19%

• 8.32% / 14.19% = 58.65% - ABPT fails (bigly)

• But look at ABPT on allocation basis

33


• Four NHCs have 7% from DC

• EE five = 72% from DC ($1,800/$2,500)

• HCE from DC = 20% (includes 401k)

• HCE equivalent allocation % from DB using method from above = 7.71% (total 27.71%)

• NHC average = 20% (ignoring DB)

• ABPT = 20.00% / 27.71% = 72.19% - passes

– If you consider NHC DB amounts = 73.53%

34


• Rate group testing

• Five NHCs one HCE midpoint = 27.75%

• Two of five NHCs in rate group = 40%

• Above midpoint so rate group passes as ABPT passes

• Is this all okay?

• Is this an abusive use of plan year comp?

35


• Reg. Section 1.401(a)(4)-1(c)(2):

“The provisions of §§ 1.401(a)(4)-1 through 1.401(a)(4)-13 must be interpreted in a reasonable manner consistent with the purpose of preventing discrimination in favor of HCEs”

36

Very Young Kids on Payroll

37


• Consider everything same as before except there is no EE5

• But there is child of Dr, age nine

• Child is only “employee” other than Dr and four NHCs above

• So everything from example without EE five applies – initially anyway

38


• ABPT -> 6.33%/14.19% = 44.58% - fails

• Rate group coverage – 25%/100% = 25%

• What if DC plans amended for immediate entry and no age requirement?

• Child now eligible but does not defer and is given no PS

39


• For ABPT NHC average stays at 6.33%

• But HCE now 14.19%/2 = 7.10%

• ABPT now = 6.33%/7.10% = 89.16% PASS

• And RG coverage – 25%/50% = 50%

• IS this okay?

– Is nine-year old really an employee?

40

Rate Segment Banding

41

42

Banding 1.401(a)(4)-3(d)(3)

• ii)Grouping of accrual rates:

• (A)General rule. An employer may treat all employees who have accrual rates within a specified range above and below a midpoint rate chosen by the employer as having an accrual rate equal to the midpoint rate within that range. Accrual rates within a given range may not be grouped under this paragraph (d)(3)(ii) if the accrual rates of HCEs within the range generally are significantly higher than the accrual rates of NHCEs in the range...

• (B)Size of specified ranges. In the case of normal accrual rates, the lowest and highest accrual rates in the range must be within five percent (not five percentage points) of the midpoint rate. In the case of most valuable accrual rates, the lowest and highest accrual rates in the range must be within 15 percent (not 15 percentage points) of the midpoint rate...

Banding 1.401(a)(4)-3(d)(3)

• HCE has NAR and MVAR of 10.5% and 12.65% respectively

• Band created would be those within 5%/15% of an NAR of 10% and an MVAR of 11%

– i.e., 10.5% is 5% more than 10% and 12.65% is 15% more than 11%

• Sole NHC has NAR and MVAR of 9.5% each

43

Banding 1.401(a)(4)-3(d)(3)

• Sole NHC has NAR and MVAR of 9.5% each

– 9.5% is within 5% of 10% and within 15% of 11%

– So sole NHC would be in rate group

– Again HCE is at 10.5% and 12.65%

– Does this work?

– Uh … no “Accrual rates within a given range may not be grouped under this paragraph (d)(3)(ii) if the accrual rates of HCEs within the range generally are significantly higher than the accrual rates of NHCEs in the range”

44

Large DB Accrual in Year One of DBP

45


• Reg. Section 1.401(a)(4)-3(d)(2)(ii)(B):

“For purposes of determining accrual rates …benefits are generally determined without regard to whether those benefits are permitted to be paid under section 415 …”

– Reg goes to provide such limits may be taken into account -not relevant for our purpose

46


• And 2014 Gray Book Q&A 29

• Must the hypothetical balance in a cash balance plan be limited to the maximum lump sum currently payable?

• IRS said no, otherwise e.g., variable interest credits could result in cutback if too high and limiting pay credit could result in 411 back-loading issues

47


• So we have a client that’s making a ton of money, has one employee, but will be hiring several more over next few years

– Would like to fund ~$200K annually but not have to worry about 401(a)(4) issues

• Our client is age 55 – always max comp

– Will use annual method so testing comp $275K

• Current employee age 21 – earns $25K

• Assume PBGC so no combined plan limit

48


• Create cash balance plan that provides for pay credit of $1.6 million for owner (year one only) and 3% of comp for employee

• Interest credit 3%; post-retirement factors 3%/2018 applicable mortality table; NRA/TA 65

• Employee also receives 17% of comp in DC

• Testing factors 8.5% interest pre- and post-retirement, mortality table ‘71 GAM (post only)

49


• IGNORING 415, $1.6 million pay credit results in NAR/MVAR of 51.26%/82.29%

– Note if no early retirement for HCE rates would be 51.26%/51.57% (concept discussed later)

• For NHC above DC and cash balance result in NAR/MVAR of 79.31% / 84.33%

• So testing passes

• Going forward, for purposes of 401(a)(4), owner cash balance interest only so no accrual

50


• Funding of course must recognize 415 so annual deposits likely in ~$200K range

• But from a testing perspective with no further pay credits owner effectively has no normal accrual rate after year 1

• Yet what he can receive from the plan goes up by ~$200K+ annually (i.e., ~ the funding)

51


• Funding of course must recognize 415 so annual deposits likely in ~$200K range

• But from a testing perspective with no further pay credits owner effectively has no normal accrual rate after year 1

• Yet what he can receive from the plan goes up by ~$200K+ annually (i.e., ~ the funding)

52


• Lets revisit 1.401(a)(4)-3(d)(2)(ii)(B):

– “For purposes of determining accrual rates … benefits are generally determined without regard to whether those benefits are permitted to be paid under section 415 …”

– This regulation was written before the 2007 changes to 415 regs

• One of the primary changes in 2007 was clarification that 415 limits the benefits permitted to be accrued as well as the benefits permitted to be paid

53


• The question is whether the IRS could argue that the exemption for testing benefit unlimited by 415 extend to both the “benefit permitted to be accrued” as well as the “benefit permitted to be paid”

• Most practitioners see no problem here, but it could be the IRS’ first step if they decide to attack this design

54

Life Insurance in DB/DC Combos

55


• Common for DB/DC combos to provide for maximum benefit in DB plan for owner (~ 8% accrual per year) while providing something like .5% per year accrual for employees

• DC plan then provides what’s needed to pass 401(a)(4) (and perhaps 410(b)) testing

– For example 7.5% of comp

56


• Shockingly there are those that wish to buy life insurance in the DB plan on behalf of the owners

• In general incidental benefit rule allows death benefit of 100 times projected benefit

– We’re ignoring RR 74-307 (that if utilized only makes the issue to be discussed worse)

57


• Owner at full benefit would therefore be eligible for approximately $1.8 million of insurance

– Assuming max comp ~650% comp

• How about employee earning $48,000 with ten years in plan

– Projected benefit would be $200/month, insurance would be $20K – or ~ 42% comp

– More would violate incidental benefit rule

58


• Is it okay that the owner’s death benefit when measured in this manner is so much higher?

– We believe it’s a problem

• Some have proposed making additional contributions to the DC plan on behalf of NHCs (that are not counted in amounts testing) and using such additional contributions to buy life insurance – is this okay?

59

No Early Retirement for HCEs

60


• Much easier to pass general test since accrual rates for NHCEs must only exceed NAR for HCEs

• So it’s a GREAT idea

– That NEVER works

– Do the HCEs want to wait until NRA

– Will the plan be around?

– At some point you wind up amending the plan to allow earlier distributions and you have timing problems

61


• In DB/DC, DB benefits for staff are often very small

• Nearly entire benefit is from DC

• So, for NHCEs, NAR is essentially = MVAR

• For HCE’s with DB benefits MVAR>NAR

– If you provide no pre-NRA distributions for HCEs

• MVAR = NAR (As demonstrated earlier)

• Since in DB/DC combos, the MVAR is the difficult portion of the general test to pass

– Eliminating ERBs for HCEs solves this problem

62


• Results in a general test where the HCE benefits are essentially projected at the ICR (often 5% or less) and the NHCE benefits are projected at 8.5% of pay

• Problem is that the HCEs don’t want to wait to NRA to get distributions … so eventually you have to amend or terminate the plan

– Creates an accrual of a huge MV benefit in the year of the amendment/termination

• WILL screw up testing and or cause a problem with timing of amendment, although the longer you wait the smaller the benefit increase

63


• Otherwise have to wait until NRA or until no non-excludable NHCEs left at company

64

Offset ‘em All

65

Offset ‘em All

• Perhaps the most common floor-offset design is one where all of the NHCEs participate in the DB and every single one of them is offset to zero

• CCM 201810008 included an example of such a plan without indicating it was de facto a bad design

– In fact, it discussed ways in which this plan design could meet 401(a)(26) and could access benefits based testing under 401(a)(4)

• So what’s the problem?

66

Offset ‘em All

• The problem is that these are often sold as “owner-only” plans

– But those who are offset out of benefits are still participants

– While they are not necessarily participants for all PBGC purposes

• They are participants for ERISA Reporting purposes

• They must get SPDs, AFNs, etc.

• These documents have penalties for failure to distribute of up to $110 per day per participant

– And yet they seem somehow to get forgotten

67

Offset at NRA Rather Than ASD

68


• Traditional floor-offset plans determine the net accrued benefit at NRA by projecting the DC balance to NRA (using a rate stated in the DB plan for this purpose), converting the DC projected balance to an annuity and subtracting from the DB accrued benefit

• The immediately commencing benefit is then the actuarial equivalent of the net benefit at NRA

69


• This same approach can be used for cash balance floor offset plans, but should it ever be?

• The plan’s accrued benefit is still the hypothetical account balance projected to NRA using the ICR and converted to an annuity and subtracting the DC plan balance projected to NRA and converted to annuity

• But the alternate immediately commencing benefit for CB floor plans is that the immediately commencing lump sum is the difference between the CB hypothetical account balance and the DC account balance

• The immediately commencing annuity benefit is then the actuarial equivalent of the net account balance

70


• Issues:

– If you use the “traditional method” you cannot use a pre-approved document

– If you use the “traditional method”, you are not an applicable DB plan and are subject to 417(e), etc.

71


• Going to court issue:

– In the traditional method, the projection rate for the DC is often higher than the IC rate in the CB Plan

• Sometimes as high as 8.5%

• Consider a 30-year old with a $15,000 hypothetical balance and a DC a balance of $10,000

• If IC rate is 5% and the DC conversion rate is 8.5%, the DC balance will completely offset the CB hypothetical balance when both are projected to NRA

72


• “Yes, that’s right your honor, the participant is entitled to NO DB benefit because the $10,000 he has in the DC plan is bigger than the $15,000 he has in the cash balance plan”

• Good luck with that!

73

Offset ‘em All – Part 2

74


• Consider the following design:

– Two owners each get $150,000 pay credit

– Staff each gets 4% pay credit

– Staff gets 7.5% of pay DC contribution

– Owners each get 3.5% DC contribution

• So that total DC contribution equals 6% ... 404(a)(7)

• Any issues with this design?

75


• CCM 201810008 discusses the concurrent offset rule and the IRS interpretation thereof:

• The plan addressed in the CCM provided an offset of 100% of the DC account balance for NHCEs and no offset for HCEs

76


• “…If each participant in an offsetting defined contribution plan receives an allocation of 6% of compensation (and therefore each participant has uniform benefits)

• And the benefit under the defined benefit plan is offset by 100% of the benefit under the defined contribution plan,

• The offset applies uniformly and may be disregarded under §1.401(a)(26)-5(a)(2).”

77


• “But if the defined contribution plan provides for an allocation of 6% of compensation to one group of participants and 3% of compensation to another group of participants (so that the employees do not benefit under the defined contribution plan on a uniform basis),

– Application of the 100% offset results in the group with the 6% allocation experiencing a larger benefit reduction as a result of the offset than the group with the 3% allocation

• Under § 1.401(a)(26)-5(a)(2), this offset may not be disregarded, because employees who benefit under the defined benefit plan being tested do not also benefit under the offsetting defined contribution plan on a reasonable and uniform basis”

78


• “If instead all allocations to participants under the defined contribution plan are 6% of compensation,

• But the offset under the defined benefit plan is

– 100% of the defined contribution plan benefits for one group of participants and

– 50% for another group,

• The reduction in the benefits in the defined benefit plan being tested is identical to the reduction in the prior alternative offset formulation, which does not satisfy the exception in §1.401(a)(26)-5(a)(2)”

79


• So the CCM says that, in essence, the amount being offset must be the same uniform percentage of pay for all participants

• The CCM implies that the exception to uniformity that allows a uniform allocation formula safe harbor plans for DC to provide a lower percentage of play to HCEs does not apply for purposes of the concurrent offset rules

• So, let’s revisit our example:

80


• Two owners each get $150,000 pay credit and 3.5% DC contribution

• Staff each gets 4% pay credit and 7.5% DC contribution

– So if the offset is based on 100% of the DC balance, the plan will not have a concurrent offset and fails 401(a)(26)

• Because the net offsetting amount is 7.5% of pay for staff and 3.5% of pay for owners

– If the offset is based on the portion of the DC attributable to a 3.5% contribution, the plan has a concurrent offset and passes 401(a)(26)

• But all the staff will benefit under the DB portion of the plan

81

Higher IC Rate for NHCEs

82


• A design has gained some popularity in which the interest credit rate for non-HCEs is higher than the interest credit rate for HCEs

– Generates higher non-HCE Normal Accrual Rates based on the same pay credits

– Allows higher pay credits for HCEs in order to reach 415 limit

– Reduces investment risk for employer for HCEs

– Provides higher “investment” returns for non-HCEs

83


• At first blush, this design seems okay

– Design provides greater benefits to HCEs than to NHCEs

• There are indications, however, that IRS may have problems with it

– These indications were confirmed at the Fall 2016 Intersector meeting and 2016 ASPPA Annual Conference

– IRS appears to believe that the design runs afoul of the nondiscrimination rules for benefits, rights, and features

84


• Bob, age 43, is an non-HCE participant in the ABC Company Cash Balance Plan:

– NRA = 65

– APR 43 = 20

– APR 65 = 12

– NHCE Interest Credit = 5%

– Bob’s age 43 hypothetical balance = 1000

– Bob’s age 43 ERB = 1,000/20 = $50/year

– Bob’s age 65 NRB = 1,000 x (1.05^22)/12 = $244/year

85


• Bill, Bob’s handsome twin, also age 43, is an HCE participant in the ABC Company Cash Balance Plan:

– NRA = 65

– APR 43 = 20

– APR 65 = 12

– NHCE Interest Credit = 4%

– Bill’s age 43 hypothetical balance = 1000

– Bill’s age 43 ERB = 1,000/20 = $50/year

– Bill’s age 65 NRB = 1,000 x (1.04^22)/12 = $197/year

86

Early Retirement With Different ICs

• Again, nothing alarming:

– A non-HCE and an HCE have the same account balance at ERA

– They get the same annuity benefit at ERA

– At NRA, the HCE gets LESS

87

Early Retirement With Different ICs

• The question relates to Early Retirement Factors (ERFs)

– In a traditional DB plan, the ERF is the factor you multiply the NRB by to get the ERB

– Does the same concept apply to cash balance plans and, if so, how? There are no ERFs written into most CB plans; they simply annuitize the current balance

– If a plan uses more than one set of ERFs, is each set a separate BRF requiring testing?

• EA Gray Book 1992-19 states that they are separate BRFs

• But that seems to contradict the regulation, especially for CB plans (and Gray Book 2015-27 – next slide)

88

Early Retirement With Different ICs– GB ‘15-27

• Q. The final hybrid regulations permit an interest crediting rate based on a subset of plan assets … The preamble makes it clear that if all other rules are satisfied, there can be different subsets of assets for different participants. If a cash balance plan has more than one subset of assets, and each subset is used to determine the interest crediting rate for a different set of participants, is assignment to a particular subset considered a BRF that must be tested under the nondiscrimination rules?

• A. The interest crediting rate is part of the accrued benefit, and will be tested as such rather than as a benefit, right, or feature. The differences in rates of return on the subsets of assets will affect §401 (a)(4) amounts testing.

89

Cash Balance ERFs With Different ICs

• Bob (NHCE)

– ERB /NRB = 50/244 = 20.49% ERF

• Bill (HCE)

– ERB /NRB = 50/197 = 25.38% ERF

– Because HCEs have a lower IC rate, their reduction from NRA to ERA is smaller, leaving them with a higher ERB as a percentage of NRB

90

Cash Balance ERFs

• As a result, the smaller the IC Rate,

– The larger the ERF, and

– The larger the ERB in relation to the NRB

• If this results in separate BRF testing,

– Providing a lower interest credit rate to HCEs than non-HCEs would result in the better ERF associated with the lower rate being provided only to HCEs,

• And the group to whom the BRF is available being discriminatory

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BRF Regs

• Of course, cash balance early retirement structures are much different than those for traditional plans

– In traditional plans, the age 65 benefit is described and factors to convert the NRB to ERB are stated or described;

– While in cash balance plans, the ERB is a direct and necessary consequence of the plan benefit formula

• It should be noted that in a cash balance plan, the IC Rate is an inherent part of the Normal Retirement Benefit formula

– The BRF regulations provide that differences in benefits attributable to different Normal Retirement Benefit formulas do not create separate BRFs

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BRF Regs

• 1.401(a)(4)-4(e)(1)(ii)(A) differences in benefit formula or accrual method. A distribution alternative available under a defined benefit plan does not fail to be a single optional form of benefit merely because the benefit formulas, accrual methods, or other factors (including service-computation methods and definitions of compensation) underlying, or the manner in which employees vest in, the accrued benefit that is paid in the form of the distribution alternative are different for different employees to whom the distribution alternative is available.

• Notwithstanding the foregoing, differences in the normal retirement ages of employees or in the form in which the accrued benefit of employees is payable at normal retirement age under a plan are taken into account in determining whether a distribution alternative constitutes one or more optional forms of benefit

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Intersector and IRS Q&A• Q3 Cash Balance Plans with Multiple Formulas• A cash balance plan provides for immediate commencement

upon termination of employment with the distribution actuarially equivalent to the current theoretical balance

• The plan further provides HCEs with a pay credit of $50,000 and all other employees with a pay credit of 5% of pay. For HCEs the Interest Credit Rate is 4% and for NHCEs the interest credit rate is 5%.

• Gray Book Q&A 1992-19 could be interpreted to treat the resulting implicit early retirement reductions as separate BRFs and, since the reduction for HCEs is less than the reduction for NHCEs, find the arrangement discriminatory

• However 1992-19 dealt with a traditional plan. In this circumstance, under a cash balance plan, the accumulation at ERD is the direct result of the benefit formula and appears to meet the exception under 1.401(a)(4)-4(e)(1)(ii)(A).

• Would the ability to take distributions at termination of employment be considered a single BRF?

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IRS Informal Position

• IRS was clear that, it was a long-held service position (albeit informal) that different sets of ERFs result in different BRFs that must be tested. See Gray Book 1992-19 as well as the proposed closed DB regs and the discussions of ERB and 415 a few years ago.

• They continued that the effective ERF in a cash balance plan is treated in exactly the same way as the stated ERFs in a traditional plan, so that if there are different effective ERFs for different people, each must be tested for current and effective availability

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IRS Informal Position

• Since, in this case, the better ERFs applied only to HCEs, so the plan would fail BRF testing

– Correction would likely be raising the IC rate, retroactively, for HCEs

– Practitioners using this design should be careful and perhaps get DLs

• Especially if the HCEs need to have the lower rate in order to meet 415 and / or 401(a)(4)

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Practitioner Reaction

• Many practitioners disagree with the IRS informal position

• They believe that the early retirement benefit is inherent in the benefit formula and thus not a BRF

• IRS has never committed this position to writing but rather it has been a “podium” position

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Return on Subset of Assets as ICR

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• Final cash balance regs issued in 2014 allow for ICR to be based on ROR subset of plan assets

• Subset must be diversified to minimize volatility of returns (as is case with ROR interest-crediting rate)

• Assets in subset must approximate liabilities for benefits to which subset relates

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• Idea per regs is to allow separate investment of traditional dollars in conversion

• Though it appears that different folks could be in different groups (based on something other than age) with different investment objectives and therefore interest credits based on different RORs

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• Preamble to regulations states:

• “… A plan sponsor may wish to credit interest based on a rate of return that differs for different groups of participants (such as using a more conservative, or less volatile, subset of plan assets for long service employees)”

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• Lead to lifestyle/target date CB plans?

• Each sub-pool is a separate investment policy

• Participants assigned to a particular sub-pool

• Assignment is one-time at design inception

• Segment participants by age?

• Age discrimination a risk?

• See inter-sector notes on following slide

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• October 15, 2014 inter-sector notes:

• “The IRS/Treasury representatives explained that any sort of age-based criteria would take you out of the age discrimination safe harbor for lump sum-based plan formulas, which means that the plan would have to satisfy the general age discrimination requirements of IRC section 411(b)(1)(H)(i).They commented that they were careful that the example they provided in the preamble depended on service, not age.”

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• As previously pointed out IRS has indicated that a subset is NOT a separate benefit right or feature that must be tested separately

– Instead it is part of the accrued benefit such that it is taken into account in testing the amount of the benefit under Section 401(a)(4) - 2015 Grey Book Q 27 cited above

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• How does this square with IRC 401(a)(26)?

• Consider Regulation 1.401(a)(26)-2(d)(1)(iii)

– “A defined benefit plan is treated as comprising separate plans if … there is an arrangement (either under or outside the plan) that has the effect of providing any employee with a greater interest in a portion of the assets of a planin a way that has the effect of creating separate accounts…”

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• 1.401(a)(26)-2(d)(1)(iii) - Example 1

– “Employer A maintains a defined benefit plan under which each highly compensated employee can direct the investment of the portion of the plan's assets that represents the accumulated contributions with respect to that employee's plan benefits. In addition, by agreement outside the plan, if the product of the employee's investment direction exceeds the value needed to fund that employee's benefits, Employer A agrees to make a special payment to the participant. In this case, each separate portion of the pool of assets over which an employee has investment authority is a separate plan for the employee.”

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• Do sub-pools result in each separate pool being tested under above 401(a)(26) regs?

• If no, does the ability to use sub-pools equate to individual direction as some have implied?

• As indicated above preamble to regs provides that subsets can be established based on service

• In a professional group where no two partners started on the same day could there be a separate subset for each?

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Cash Balance/401(h) Combinations

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• There are numerous proposals making imaginative claims about what can be accomplished by adding a 401(h) feature to a cash balance plan

• 401(h) can provide sickness, accident, hospitalization, and medical expenses to a retired employee and his/her spouse/dependents

• Contributions coming in are deductible, within the deductible limits that must be determined by a qualified health actuary

• Post-retirement distributions to cover allowable expenses are made tax-free

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• Contributions for key employees must be made to a separate account for that employee and are considered annual additions for 415 purposes

• The 401(h) benefit must be ancillary and thus can be no more than 25% of the total contribution, or one-thirdd of the pension only cost

• Pre approved plans do not provide for 401(h), so an Individually Designed document is required

• If participant leaves or dies before retirement, benefit is forfeited

• Forfeitures must be applied to reduce costs

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• The problem with these plans are the claims of the vendors

• Claims that you can accumulate well over $1 million in ten years in the 401(h) while contributions are limited to the remaining DC 415 limit are simply overblown

• Actuaries considering these plans should consider whether they are qualified to value post -retirement health benefits

• It may work well for business owners limited in their DC by 404(a)(7)

• But the cost of the document and the additional actuarial work may limit the effectiveness

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Questions?

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