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Final regs allow plan amendments to comply with market rate of return requirements

T.D. 9743, 11/13/2015, Reg. § 1.411(a)(13)-1, Reg. § 1.411(b)(5)-1

IRS has issued final regs that allow a plan sponsor of an applicable defined benefit plan that doesn’t comply with the market rate of return requirement, to amend the plan in order to change to an interest crediting rate that is allowed under the previously issued final hybrid plan regs, without violating the Code Sec. 411(d)(6) anti-cutback rules. The regs delay the applicability date of certain provisions under Code Sec. 411(a)(13) and Code Sec. 411(b)(5) in previously issued final hybrid plan regs.

Background. Under Code Sec. 411(b)(5)(B)(i), a statutory hybrid plan is treated as failing to satisfy the requirements of Code Sec. 411(b)(1)(H) (which provides that the rate of an employee’s benefit accrual must not be reduced because of the attainment of any age) if the terms of the plan provide any interest credit (or an equivalent amount) for any plan year at a rate that is in excess of a market rate of return. Code Sec. 411(b)(5)(B)(i) is generally effective for plan years beginning after Dec. 31, 2007.

Code Sec. 411(d)(6) provides generally that a plan does not satisfy Code Sec. 411 if an amendment to the plan decreases a participant’s accrued benefit. A plan amendment that has the effect of eliminating or reducing an early retirement benefit or a retirement-type subsidy or eliminating an optional form of benefit with respect to benefits attributable to service before the amendment is treated as reducing accrued benefits.

In October of 2010 and in September of 2014, IRS issued final regs on hybrid plans (collectively, the final hybrid plan regs) that provided, effective for plan years that begin on or after Jan. 1, 2016, a list of interest crediting rates and combinations of rates that satisfied the requirement of Code Sec. 411(b)(5)(B)(i) that a plan not provide an effective rate of return in excess of a market rate of return. The regs also did not permit other rates. The provisions that provide for a list of rates are set out at Reg. § 1.411(b)(5)-1(d)(1)(iii), Reg. § 1.411(b)(5)-1(d)(1)(vi), and Reg. § 1.411(b)(5)-1(d)(6)(i).

Interest crediting rates can be broadly characterized as either investment-based rates or rates that are not investment-based rates. An investment-based rate is a rate of return provided by actual investments, taking into account the return attributable to any change in the value of the underlying investments. A rate of return that is based on the rate of return for an index that measures the change in the value of investments can also be considered to be an investment-based rate. (Reg. § 1.411(b)(5)-1(e)(3)(vi)(B)(3)) Rates that are not investment-based rates are either fixed rates of interest or bond-based rates (such as yields to maturity of bonds). (T.D. 9743, 11/13/2015)

Reg. § 1.411(b)(5)-1(d)(3) and Reg. § 1.411(b)(5)-1(d)(4) set out permitted rates that aren’t investment-based rates, such as the third segment rate described in Code Sec. 417(e)(3)(D) or Code Sec. 430(h)(2)(C)(iii), the yield on 30-year Treasury Constant Maturities, and a fixed 6% rate of interest. Reg. § 1.411(b)(5)-1(d)(5) sets out permitted investment-based rates, such as the rate of return on certain regulated investment companies (RICs), as defined in Code Sec. 851, and the rate of return on plan assets. As provided in Reg. § 1.411(b)(5)-1(d)(6), certain annual (or more frequent) floors are permitted in combination with the bond-based rates, and cumulative floors (in excess of the cumulative zero floor required under Code Sec. 411(b)(5)(i)(II)) are permitted in combination with either the bond-based rates or the investment-based rates.

Reg. § 1.411(b)(5)-1(e)(3) provides that the right to future interest credits determined in the manner specified under the plan and not conditioned on future service is a factor that is used to determine the participant’s accrued benefit for purposes of Code Sec. 411(d)(6). Accordingly, Code Sec. 411(d)(6) protection applies not only to interest credits that have already been credited but also to future interest credits that are not conditioned on future service.

In September of 2014, IRS issued proposed hybrid plan transition regs (2014 proposed regs) that would permit an amendment to change the interest crediting rate under a hybrid plan from a rate not on the list to a rate on the list of interest crediting rates and combinations of rates that satisfy the requirement of Code Sec. 411(b)(5)(B)(i), for plan years that begin on or after Jan. 1, 2016.

Final regs. The final regs, adopting the 2014 proposed regs with a number of changes, delay the applicability date of certain provisions under Code Sec. 411(a)(13) and Code Sec. 411(b)(5) in the final hybrid plan regs, including those provisions that provide a list of interest crediting rates and combinations of rates that satisfy the requirement of Code Sec. 411(b)(5)(B)(i) that the plan not provide an effective rate of return in excess of a market rate of return.

Before the first day of the first plan year that begins on or after Jan. 1, 2017, a plan that uses an interest crediting rate that is not allowed under the final hybrid plan regs must be amended to change to an interest crediting rate that is allowed under those regs. Although a plan is allowed to be amended to change the interest crediting rate with respect to benefits that have not yet accrued, an amendment that reduces the interest crediting rate with respect to benefits that have already accrued would ordinarily be impermissible under Code Sec. 411(d)(6). However, the final regs permit a plan with a noncompliant interest crediting rate to be amended with respect to benefits that have already accrued so that its interest crediting rate complies with the market rate of return rules. If the applicable requirements of these regs are satisfied, the an amendment is allowed with respect to benefits that have already accrued, but only with respect to interest credits that are credited for interest crediting periods that begin on or after the later of the effective date of the amendment or the date the amendment is adopted (the applicable amendment date within the meaning of Reg. § 1.411(d)-3(g)(4)). (Reg. § 1.411(b)(5)-1(e)(3)(vi)(A)) Such an amendment must be adopted before, and must be effective no later than, the applicability date of the regulatory market rate of return rules, which is generally the first day of the first plan year that begins on or after Jan. 1, 2017. However, collectively bargained plans must be adopted for plan years that begin on or after the later of (i) Jan. 1, 2017; or (ii) the earlier of Jan. 1, 2019 or the date on which the last of the collective bargaining agreements terminates (determined without regard to any extension). (Reg. § 1.411(b)(5)-1(e)(3)(vi)(B)(3))

Like the 2014 proposed regs, the final regs permit amendments that bring the plan into compliance by changing the specific feature that causes the plan’s interest crediting rate to be noncompliant, while not changing other features of the existing rate. If the noncompliant interest crediting rate has more than one noncompliant feature, then each noncompliant feature must be addressed separately in the prescribed manner. (Reg. § 1.411(b)(5)-1(e)(3)(vi)(B)(1))

Because it’s not always readily apparent which specific feature or component rate causes the rate to be noncompliant in many cases, the final regs permit a plan sponsor to choose one of two or more alternative amendments in order to bring a plan into compliance.

Under the final regs, an additional option has been added in cases involving bond-based rates, so that any noncompliant variable rate that is not an investment-based rate (including the greater of two or more non-investment-based variable rates) may be capped at the third segment rate. A rule clarifies that an amendment to correct a noncompliant feature that provides for a greater interest crediting rate than the specific amendment set out in the regs doesn’t violate Code Sec. 411(d)(6). Thus, for example, in any case in which it is permissible to address a noncompliant rate by capping the rate at the third segment rate, it would also be permissible to address the noncompliant rate simply by switching to the third segment rate. Similarly, an amendment to switch to the third segment rate together with a permitted fixed minimum rate would be permissible.

The final regs also provide that if a plan credits interest using a noncompliant investment-based rate and there is no permitted investment-based rate with similar risk and return characteristics as the plan’s impermissible rate, then, as an alternative to the specified corrective amendment that was in the proposed regs, an amendment to switch to the third segment rate with a 4% fixed minimum rate is permitted.

The regs also clarify the specified corrective amendment that was in the proposed regs by providing that it is permissible in such a case to switch to a permitted investment-based rate that is otherwise similar to the plan’s impermissible investment-based rate but without the risk and return characteristics of the impermissible rate that caused it to be impermissible. This provision generally requires the use of a rate that is less volatile than the plan’s impermissible investment-based rate but is otherwise similar to that rate. (Reg. § 1.411(b)(5)-1(e)(3)(vi)(C)(9))

The preamble to the 2014 final hybrid plan regs contained a discussion of statutory hybrid plans that permit participants to choose from among a menu of hypothetical investment options. IRS understands that some of these plans contain one or more hypothetical investment options that provide for a rate of return that isn’t permitted under the final hybrid plan regs. Under the final regs, a special rule provides that the rules of the final regs may be applied separately to correct each impermissible hypothetical investment option. Alternatively, with respect to such a plan that permitted a participant to choose an interest crediting rate from among a menu of hypothetical investment options on Sept. 18, 2014, pursuant to plan provisions that were adopted on or before Sept. 18, 2014, this special rule provides that the entire menu of investment options may be treated as an impermissible investment-based rate for which there is no permitted investment-based rate with similar risk and return characteristics (so that Reg. § 1.411(b)(5)-1(e)(3)(vi)(C)(7) does not apply). As a result, such plans may be amended to eliminate a participant’s ability to choose an interest crediting rate from among a menu of hypothetical investment options under Reg. § 1.411(b)(5)-1(e)(3)(vi)(C)(9). (Reg. § 1.411(b)(5)-1(e)(3)(vi)(B)(6))

To bring a plan into compliance if the plan credits interest using a composite rate that is an investment-based rate of return with an impermissible annual (or more frequent) fixed or variable rate, the final regs provide that it is permissible either to eliminate the fixed minimum rate (or any variable non-investment-based rate) and eliminate any reduction to the investment-based rate, or to switch to the third segment rate (preserving any fixed minimum rate to the maximum extent permitted).

The final regs provide for a special rule that applies with respect to a participant under a plan that a) takes into account a minimum rate of return that applies less frequently than annually or b) determines the participant’s benefit as of the annuity starting date as the benefit provided by the greatest of two or more account balances, where c) that minimum rate or benefit based on two or more account balances does not satisfy the market rate of return rules. If this rule applies, the plan must be amended to provide that the benefit for a participant is based solely on the benefit (and the associated interest crediting rate with respect to that benefit) that is greatest for that participant as of the applicable amendment date for the amendment adopted pursuant to these regs. In addition, the plan must be further amended pursuant to the other rules in these regs if the remaining interest crediting rate does not satisfy the market rate of return rules. (Reg. § 1.411(b)(5)-1(e)(3)(vi)(B)(5))

The final regs provide for a rule rounding interest crediting rates and also provide for Code Sec. 411(d)(6) relief for transitional amendments to comply with this rounding rule. Under the rounding rule, a plan is not treated as failing to meet the requirement that a plan not credit interest at a rate that exceeds a market rate of return merely because the plan determines interest credits for an interest crediting period by rounding the calculated interest rate or rate of return. Under this rule, an annual rate may be rounded to the nearest multiple of 25 basis points (or a smaller rounding interval). If a plan provides for the crediting of interest more frequently than annually, then the rounding interval must not exceed a pro-rata portion of 25 basis points. Notwithstanding the preceding sentence, a plan is permitted to round to the nearest basis point regardless of the length of the interest crediting period. (Reg. § 1.411(b)(5)-1(d)(1)(iv)(E))

In addition, the final regs provide for Code Sec. 411(d)(6) relief for transitional amendments made to enable a plan to comply with the plan termination rules in the final hybrid plan regs. (Reg. § 1.411(b)(5)-1(e)(3)(vii))

Effective/applicability dates. The final regs generally apply to plan amendments made on or after Sept. 18, 2014 (or an earlier date as elected by the taxpayer), and they do not apply for amendments made on or after the first day of the first plan year that begins on or after Jan. 1, 2017. However, for collectively bargained plans, the final regs continue to apply for amendments made before the first day of the first plan year that begins on or after Jan. 1, 2019, unless the last collective bargaining agreement ratified on or before Nov. 13, 2015, expires before Jan. 1, 2019, in which case these regs cease to apply to amendments made on or after the first day of the first plan year that begins on or after the later of the date on which the last applicable collective bargaining agreement expires or Jan. 1, 2017. (Reg. § 1.411(a)(13)-1(e)(2)(ii), Reg. § 1.411(b)(5)-1(f)(2)(i)(B))

References: For cash balance hybrid-type pension plans, see FTC 2d/FIN ¶  H-6271; United States Tax Reporter ¶  4014.191; TaxDesk ¶  280,106; TG ¶  8095.