IRS Regs Conclusion

On Evaluating Defined Benefit Plans Helps Employee Annuity Decisions

Final IRS-issued regs offer employers guidance in evaluating employee benefits under qualified defined benefit pension plans. The rules help to: (1) figure a present value to determine whether an employee's benefit can be cashed out without his and his spouse's consent; (2) determine the amount of a distribution made in any form other than certain non-decreasing annuities. The final regs reflect changes made by the Retirement Protection Act of 1994 (RPA '94), which changed the interest rate and specified the mortality table that must be used for these valuation purposes. The final regs generally adopt the temporary regs that were issued in April 1995, but with some changes in response to comments received since then. (TD 8768. 63 Fed Reg 16895, 4/7/98)þ observation: While these rules are highly technical and will be of greatest concern to plan actuaries and pension benefit specialists, they will have a bottom line impact on (1) plan funding levels, (2) deductible contributions for employers, and (3) the amount of lump-sum benefits received by some employees.

The rules under Code Sec. 417(e)(3) determine the present value of an employee's benefit under a qualified defined benefit pension plan, for purposes of calculating the amount of a distribution, and determining whether the consent of a plan participant and spouse, if applicable, are needed in order to cash-out a participant's benefit in a lump-sum payment. A plan cannot cash out a participant's benefit without consent if the present value of that benefit exceeds $5,000.þ observation: For plan years beginning before August 6, 1997. the cash-out threshold was $3,500.RPA '94 also specified that the long-term Treasury bond interest rate set forth in Code Sec. 417(e)(3)(A) is the minimum rate that may be used in figuring the Code Sec. 415(b) limit on the benefits that can be provided under a qualified defined benefit plan.

þ observation: The lower the interest rate assumption used by a plan, the higher the present value of benefits will be, and the larger the deductible contributions that will be needed to fund a specified benefit .... (because more current dollars are needed to fund a future benefit if it is assumed that current assets will grow at a slower rate). Thus, use of the long-term Treasury bond rate, which currently is below 6% would allow for generous contribution levels and result in high present values for plan benefits.

Before RPA '94's change, Code Sec. 417(e)(3) restricted the interest rate that could be used to calculate the present value of a participant's benefit, but did not specify the mortality table to be used for that purpose. The final regs retain the provision in the temporary regulation that the mortality table to be used for these purposes will be prescribed in revenue rulings, notices or other guidance published in the Internal Revenue Bulletin (Reg § 1.417(e)-l(d)(2)). The mortality table currently used for these purposes is a unisex table based on the 1983 Group Annuity Mortality table. It is found in Rev Rul 95-6, 1995-1 CB 80.The interest rate used under Code Sec. 417(e)(3) is the annual rate on 30-year Treasury securities for the month before the date of distribution or any other time as prescribed by regulation. The final regs retain the rule in the temporary regs that the applicable interest rate for a month is the annual interest rate on 30-year Treasury securities as specified by the IRS for that month. (Reg § 1.417(e)-l(d)(3)) The IRS publishes this interest rate by notice for each month after the end of the month. Currently, this interest rate is the interest rate published in Federal Reserve releases G.13 and H.15 as the average yield on 30-year Treasury Constant Maturities for the month.

As an alternative to using the monthly 30-year Treasury rate for the month before the distribution, the temporary regs permitted use of an average rate for a plan quarter or a plan year as a "stability period" during which the interest rate remains constant. The final regs also allow use of a single rate for a calendar quarter or a calendar year. The final regs also retain the rule in the temporary regs that the rate for this "stability period" may be determined as the 30-year Treasury rate for any one of the five calendar months preceding the first day of the period. Permitting this "lookback" of up to five months provides added flexibility and gives plan administrators and participants more time to comply with notice and election requirements using the actual interest rate (instead of an estimate). In addition, the final regs permit an average of interest rates for two consecutive lookback months to be used. This will further minimize interest rate fluctuations (Reg § 1.417(e)-l(d)(4)).

New Exception

The temporary regs exempted certain distributions under non-decreasing life annuities from the requirements of Code Sec. 417(e)(3), including qualified joint and survivor annuities, qualified pre-retirement survivor annuities, and annuities that decrease due to cessation or reduction of Social Security supplements or certain disability payments. The final regs add an exception for annuities that decrease during the life of the participant because of the death of the survivor annuitant (but only if the reduction is to a level not below 50% of the annual benefit payable before the death of the survivor annuitant) (Reg § 1.417(e)- 1 (d)(6)).

Effective Date

The final regs generally apply to plan years beginning after December 31, 1994. However, for plans in effect on December 7, 1994 that met the requirements of Code Sec. 417(e)(3) as then in effect, the general effective date for the RPA '94 rules was delayed until the first plan year beginning after 1999, unless an employer takes earlier action. For these plans, distributions made before the first post-1999 plan year are valued under the provisions of the plan in effect on December 7, 1994, if the annuity starting date for the distribution occurs before the plan is amended to use both the applicable mortality table and the interest rate rules added by RPA '94. For those plans, the final regs don't become effective until the earlier of the effective date of the plan's amendment adopting the new valuation rules, or the first plan year beginning after 1999 (Reg § 1.417(e)-l(d)(8)).

Relief From Anti-Cutback Rules Due to Adoption of Rules for Determining Present Value.

Code Sec. 411 (d)(6) prevents a plan participant's accrued benefit from being decreased by plan amendment. In general, a plan amendment that changes the interest rate or the mortality assumptions used for purposes of determining the amount of any accrued benefit would be subject to this anti-cutback rule. However, the final regs provide some relief for certain plan amendments that change the time for determining the applicable interest rate. Such a plan amendment won't violate the anti-cutback rules if each distribution made until one year after the change is calculated using the time for determining the applicable interest rate as provided before or after the amendment, whichever produces the larger benefit. For this purpose, all other plan provisions must be applied as in effect after the amendment (Reg § 1.417(e)- 1 (d)(10)(ii)).

Also, RPA '94 provided that a participant's accrued benefit is not considered to be reduced in violation of the anti-cutback rules merely because it is determined in accordance with the applicable interest rate rules and the applicable mortality table rules of section Code Sec. 417(e)(3)(A), as amended by RPA '94. The final regs provide that an amendment replacing an interest rate used for purposes of Code Sec. 417(e)(3) qualifies for this anti-cutback relief if the interest rate replaced is the PBGC interest rate or a rate based on the PBGC interest rate (Reg § 1.417(e)-l(d)(10)(iii)).

The final regs also provide some additional flexibility to employers in determining how to transition between the PBGC interest rate and the applicable interest rate and applicable mortality table, where the transition is combined with a change in the time for determining the interest rate (Reg § 1.417(e)-l(d)(10)(iv)). The final regs also say that where a plan provided for the use of an interest rate not based on the PBGC interest rate, a plan amendment that eliminates the use of that interest rate and the associated mortality table may result in a reduction of a participant's accrued benefit, which would violate the anti-cutback requirement (Reg § 1.417(e)-l(d)(10)(vi)).

Employers Should Not Rely on PBGC Interest Rates

The PBGC has advised the IRS that it may not continue to calculate and publish the relevant interest rates after the year 2000. Therefore, the IRS has advised that in amending plans to comply with these regs, employers should not rely on whether the PBGC will continue to calculate and publish the rate.

Reprinted from Pension and Benefits Week, April 13, 1998 issue, Research Institute of America Group. Subscriptions: 800-421-9025, $275/yr.