1/11/2016
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Workshop 20:
Cash Balance – Interest Credits
Kevin J Donovan, CPA, EA, MSPA, FCA
Pinnacle Plan Design
Thomas J Finnegan FSPA, FCA, MAAA
The Savitz Organization
Contents
• Interest Credits / Preservation of Capital
• Late retirement
• Pre-approved plans
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Interest Credits
• IRC §411(b)(5)(B)(i)(I):
– An applicable defined benefit plan shall be treated as
failing to meet the requirements of paragraph (1)(H)
unless the terms of the plan provide that any interest
credit … for any plan year shall be at a rate which is
not greater than a market rate of return.
– A plan shall not be treated as failing to meet the
requirements of this subclause merely because the
plan provides for a reasonable minimum guaranteed
rate of return or for a rate of return that is equal to
the greater of a fixed or variable rate of return.
– See also Reg. §1.411(b)(5)-1(d)(1)(i)
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Interest Credits
• So:
– … shall be treated as failing to meet … (1)(H)…
• A rate in excess of a market rate results in plan DQ
– shall not be treated as failing to meet …this subclause
merely because the plan provides for a reasonable
minimum guaranteed rate of return
• Statute provides for ‘reasonable’ minimum
– Regs appear a bit more restrictive, at least if
equity based
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Interest Credits
• Final regulations provide exclusive list of rates
that qualify as market rates
– i.e., cannot argue something else (e.g. LIBOR rate)
is market rate
– Reg. §1.411(b)(5)-1(d)(1)(iii)
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Interest Credits
• Acceptable interest rates under final regs
– Fixed rate up to 6%
• Reg. §1.411(b)(5)-1(d)(4)(v)
– First, second or third segment for funding or 417(e)
• Reg. §1.411(b)(5)-1(d)(3); §1.411(b)(5)-1(d)(4)(iv)
– Treas. rates and COLI, with margins, from Notice 96-8
• Reg. §1.411(b)(5)-1(d)(4)(ii) / (iii)
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Interest Credits
• Acceptable interest rates under final regs
– Investment return on plan assets
• If assets diversified to minimize volatility of returns
– Reg references ERISA §404(a)(1)(C):
– “by diversifying the investments of the plan so as
to minimize the risk of large losses, unless under
the circumstances it is clearly prudent not to do
so.”
• Reg. §1.411(b)(5)-1(d)(5)(ii)(A)
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Interest Credits
• Acceptable interest rates under final regs
– Investment return on “subset” of plan assets
• Subset diversified to minimize volatility of returns
• 10% limit in subset on employer securities / R.E.
• Market value of assets in subset must approximate
liabilities for benefits to which subset relates
– IRS podium statements imply that if the market value plus a
seven year amortization covers liability, it is good
• Reg. §1.411(b)(5)-1(d)(5)(ii)(B)
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Interest Credits
• Acceptable interest rates under final regs
– Investment return on mutual funds (RICs)
• Must be the rate of return on an actual mutual fund
– As opposed to an index
• Not significantly more volatile than US markets
– No industry sector
– No single country other than U.S.
– No leverage or derivatives to enhance return
– OK to track indices such as S&P 500 or Russell 2000
through a mutual fund
• Reg. §1.411(b)(5)-1(d)(5)(iv)
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Interest Credits
• “Greater of” rates
– In general a plan may not provide an interest credit equal
to greater of two otherwise compliant rates
• Reg. §1.411(b)(5)-1(d)(6)(i)
– Exceptions (discussed herein) exist for
• Certain minimum rates
• Amendments changing from one compliant rate to
another
• Post retirement increases
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Interest Credits
• Acceptable minimum rates
– 4% annual for segment rates
• Reg. §1.411(b)(5)-1(d)(6)(ii)(A)
– 5% annual for 96-8 rates
• Reg. §1.411(b)(5)-1(d)(6)(ii)(B)
– 3% cumulative (not annual) for any rates
• Reg. §1.411(b)(5)-1(d)(6)(iii)
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Interest Credits
• Reality
– Most new plans are using either
• Fixed rate, or
• ROR on assets, possibly with cap (and/or floor)
• Or some combination of the two
– Most larger plans use treasury rates or segment rates
• Still a significant group of large plans are participant
directed; often using the 401k menu
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Interest Credits
• What is an interest credit?
• “an interest credit for purposes of this
paragraph … means the … adjustments to a
participant’s accumulated benefit under a
statutory hybrid benefit formula, to the extent
not conditioned on current service …”
• Reg. §1.411(b)(5)-1(d)(1)(ii)
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Interest Credits
• What is an interest credit?
– Some plans have an “interest credit rate” that is
greater for active employees
• E.g., the rate is 5% while employed but 3% after
separation from service
– Under regs piece dependent on service (i.e. the extra
2%) not an interest credit
• And is therefore a pay credit and treated as such
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Changing interest rate
• Can interest rate be changed?
• Why would you want to?
– May be having testing issues with current (otherwise
compliant) rate
– Current rate non-compliant
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Changing interest rate - compliant
• Relief for Interest Crediting changes
– Interest crediting is a right to which participant is entitled
once the pay credit has accrued
• i.e., once the pay credit for a year has been earned, the
right to interest on it for all years through distribution is
accrued
• Cannot cut future interest credits, even before they’re
credited
• Except in narrow relief provided in 2014 regs
– Reg. §1.411(b)(5)-1(e)(3)(i)
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Changing interest rate - compliant
– Can change from one compliant rate to another
– Wear-away approach on old balance
• i.e. payout greater of
– balance at date of change, plus interest at old rate, or
– such balance, plus pay credits, plus interest at new rate
• But not for those not active (or no longer benefiting) at
amendment date.
– Otherwise would be receiving greater of two compliant
rates
• Reg. §1.411(b)(5)-1(e)(3)(iii)
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Changing interest rate - compliant
• Consider plan using 30-year Treasury rate
– Recall IRS requires .5% accrual to be receiving
meaningful benefit for IRC 401(a)(26)
– 30-year rate for December 2014 is 2.83%
– Consider employee age 37, NRA 62
– Compensation = $50,000; pay credit 2% of comp.
– APR 2015 applicable table = 156.595 (13.05 annual)
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Changing interest rate - compliant
– Pay credit = $50,000 * .02 = $1,000
• To NRA = $1,000 * (1.0283 ^ 25) = $2,009.07
• Benefit = $2,009.07 / 13.05 / 50,000 = .31%
– Not meaningful
– What if change interest crediting rate to 5% fixed?
• To NRA = $1,000 * (1.05 ^ 25) = $3,386.36
• Benefit = $3,386.36 / 13.05 / 50,000 = .51%
– Meaningful
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Changing interest rate - compliant
– Re change from 30-year rate to fixed rate
• Would need to keep track of pre-amendment balance
and continue to credit interest at 30-year rate
• At ASD such balance would be compared to actual
balance at such date
– Must track through ASD since if interest rates rise
substantially the old rate could re-appear 10 years
later, especially for inactives.
• Of course if 30-year rates stay where they are will be
non-issue
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Changing interest rate - noncompliant
• General rule: correct in most straightforward way
– Reg. §1.411(b)(5)-1(e)(3)(vi)
• Examples:
–
–
–
–
Fixed at 7%: reduce to 6%
S&P 500 index: credit return of specific S&P 500 fund
30-year Treasury yield, with floor of 6%: reduce floor to 5%
Special rules apply for more complicated situations
• Effective January 1, 2017
– Need to amend prior to first day of first plan year beginning on
or after January 1, 2017
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Using rate of return (ROR)
• Why use ROR for interest crediting?
• In general, goal is to invest assets to mirror
crediting rate
– And shift investment risk to employees
– Losses do not create a funding shortfall
– Goal is to simply deposit pay credits
• Especially for multi owner situations
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Using rate of return (ROR)
• Issues with using ROR
– Potentially lower 415 Limits
– Potentially harder to pass 401(a)(4) / 401(a)(26)
– Potential 411(a)(9) issue
– Potential issue with timing of contributions
– Preservation of Capital
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Using rate of return (ROR)
• It is important to recall that a cash balance plan is a
DB plan and IRC §411(a)(7) provides that the
accrued benefit is a life annuity payable at NRA
– PPA added IRC §411(a)(13)(A) to allow the accrued
benefit to be defined as the account balance in a CB
plan, but only for purposes of
• allowing the account balance to be paid as a lump sum i.e. ignoring §417(e), and
• age discrimination
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Using rate of return (ROR)
• To determine the accrued benefit in a cash
balance plan the account balance is projected to
NRA with interest credits and converted to an
annuity using plan factors
– AB = acct bal * (1 + int) ^ (nra – aa) / apr (NRA)
– If crediting Actual ROR, what is “int” ?
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Using rate of return (ROR)
– IRS position-> project at current ROR
– “The IRS has taken the position that the hypothetical
account balance must be projected to normal
retirement date using the interest crediting rate in
effect on the date the projection is made.”
• IRS hybrid training manual
• Consistent with recent cash balance LRMs
• See also §1.401(a)(4)-3(d)(5)(iii)(H) of old 1991
regs
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Using rate of return (ROR) - 415
• CB Plan’s early retirement reduction:
– Benefit at aa = aNRA / (1 + int) ^ (NRA - aa) / aaa
(where int = current interest crediting rate)
• Suppose NRA = 62, aa = 55, ROR = 15%
– $ limit (age 55) = $17,500 * 156.595 / 1.15(7) / 179.172 =
$5,749.91
– LS Limit (age 55) = $5,749.91 * 169.842 = $976,576
– If crediting rate 5%, 415 LS Limit ~ $1.85 million
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Using rate of return (ROR) - 415
• Consider 55-year old law partner
• At age 50 began pay credits of $125k annually
• Averaged 5% ROR; at age 55 balance = $690K
– But last year ROR 15%
• LS limited to 5/10 * $976,576 = $488,288
• $200K less than balance!
• Can be mitigated by capping crediting rate at 5%
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Using rate of return (ROR) – 401(a)(4)
• Normal accrual rate generally = inc. in AB / Comp.
– Assume same data as previous slide
• pay credit $100K; Comp. $250K
–
–
–
–
At 5% NAR = $100K * 1.05 ^ 7 / 13.05 / 250K = 4.31%
At 15% NAR = $100K * 1.15 ^ 7 / 13.05 / 250K = 8.15%
Leverage obtained by testing PS at 8.5% lost!
Again mitigated by capping crediting rate at 5%
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Using rate of return (ROR) – 401(a)(26)
• Recall math from earlier slide re change in crediting rate
– Pay credit = $50,000 * .02 = $1,000
– To NRA = $1,000 * (1.0283 ^ 25) = $2,009.07
– Benefit = $2,009.07 / 13.05 / 50,000 = .31%
• Not meaningful
– What if interest crediting rate 5% fixed?
– To NRA = $1,000 * (1.05 ^ 25) = $3,386.36
– Benefit = $3,386.36 / 13.05 / 50,000 = .51%
• Meaningful
– Lower rate can cause a26 failure – mitigate with 5% fixed for
NHCs
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Using rate of return (ROR)Minimums, maximums and separate NHCE rates
• The use of RoR is meant to exactly match plan liabilities
and assets
– In essence creating a DC plan with DB limits
– Mins and Maxes defeat the entire purpose of ROR
• Minimums needed for 401(a)(26), 411(b), 401(a)(4)
for NHCEs
– Needed for preservation of capital
– Otherwise create shortfalls
• Maximums needed for 415 etc.
– But create excess assets
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Using rate of return (ROR) – 411(a)(9)
• IRC §411(a)(9) and Reg. §1.411(a)-7(c)(1) provide
that “periodic benefit” (i.e., annuity) payable at any
point cannot be less than previously available amount
• Most cash balance plans provide for immediately payable
lump sums upon termination of employment
• Reg 1.401(a)-20 Q&A 17 provides that if a non de-minimis
(over $5K) lump sum is available at any point (referred to as
“earliest retirement age” in the reg) then qualified annuity
forms must be available at same time
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Using rate of return (ROR) – 411(a)(9)
– Assume acct balance $1.5 million at age 64
• Age 64 417e/2015 5% APR = 149.47;
• Life annuity = $10,035
– Loss results in age 65 balance of $1 million
• Even after preservation of capital rule, as there were
substantial previous gains
• Age 65 417e/2015 5% APR = 145.819;
• Life annuity = $6,858
– Participant has right to $10,035 life annuity at 65
• VERY EXPENSIVE
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Using rate of return (ROR) – Timing
• Timing of contributions
– Where contributions not made on last day of year,
crediting ROR may cause interest credits higher than
actual amounts earned
• E.g. assets earn 33.33% first ½ year and lose 10% for
last ½ – result is 20% return for the year
– i.e., P * 1.3333 * .9 = 1.2 P
• Prior year contribution made end of first ½
– Deposit that lost 10% needs to credit 20%??
– How is ROR on plan assets defined?
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Using rate of return (ROR) – Pres. Of Capital
• “Preservation of Capital” rule provides that
distribution to a participant must be no less
than total of participant’s pay credits.
– Imposed at annuity starting date only
– IRC 411(b)(5)(B)(i)(II)
– Where crediting ROR can cause issues if losses
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Using rate of return (ROR) – Pres. Of Capital
•
•
•
•
•
•
Consider partner in plan for three years
Pay credits = $150,000 annually
Plan loses 5% per year
Account balance at year 3 = $427,875
Payout would need to be $450,000
Mitigation here would need to be outside plan
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ROR - Sub pools of assets
• New option in 2014 regs:
– Credit return on sub-pool of plan assets
– Sub-pool option intended to accommodate cash
balance conversions:
• Pool 1: Assets invested to pay traditional DB benefits
• Pool 2: Assets invested to pay ICR = ROR on CB accounts
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ROR - Sub pools of assets
• But Preamble to regs also 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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ROR - Sub pools of assets
•
•
•
•
•
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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ROR - Sub pools of assets
• 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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ROR - Sub pools of assets
• Just gives rise to a second problem
– The “service-based” subgroup generally is intended to
provide that longer service people would invest more
conservatively
– So for example if you complete 20 years of service you are
moved to an IC rate based on a conservative subset of assets
• With a lower expected return rate generally
– This lower rate could cause a lower accrued benefit due to
completing additional year of service
• Violates 411(b)-1(G)
• Count anniversaries not service
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ROR - Sub pools of assets
• Does the ability to use sub-pools equate to
individual direction as some have implied?
• In the words of the great philosopher Eric
Theodore Cartman
– “Uh, no”
• 401(a)(26)
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Late Retirement
• With respect to a participant with an annuity starting
date after NRA, a cash balance plan must either
– provide an actuarial increase after NRA, or
– satisfy the requirements for suspension of benefits under
§411(a)(3)(B).
• Accordingly, a cash balance plan that does not properly
suspend benefits violates the requirements of §411(a)
if the balance of the hypothetical account is not
“increased sufficiently” for post NRA distributions
• Reg. §1.411(a)(13)-1(b)(2)(i)
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Late Retirement
• Consider a plan crediting interest based on the
ROR of plan assets (or other equity based
rate)
• Absent a minimum rate such a plan could
violate the rules for post NRA increases in
years with low or negative returns
• But a minimum rate would violate the market
rate requirement (absent relief)
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Late Retirement
• Reg. §1.411(b)(5)-1(e)(4) provides such relief
• “A statutory hybrid plan is not treated as providing
an effective interest crediting rate that is in excess
of a market rate … merely because the plan
provides that the participant’s benefit, as of each
annuity starting date after normal retirement age,
is equal to the greater of-– (i) The benefit based on the accumulated benefit
determined using an interest crediting rate ... not
in excess of a market rate …; and
– (ii) The benefit that satisfies the requirements of
section 411(a)(2).”
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Late Retirement
• Of course this is not an issue if significant
pay credits are still being received
• i.e. post retirement actuarial increase is
only required if adjusted NRA accrual would
result in a benefit greater than that
received under the terms of the plan
including continued accruals
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Late Retirement
• Consider balance at NRA (65) of $500,000
• Interest credit based on ROR plan assets
• APRs based on 2015 417(e) table and 5%
– Age 65 = 145.819
– age 66 = 142.109
• Assume ‘reasonable’ rate for post retirement
increase is 5% - note there is no guidance here
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Late Retirement
• Accrued benefit at 65 = $3,428.91
– $500,000 / 145.819 = $3,428.91
• Age 66 AB would need to be $3,694.35
– $3,428.91 * 145.819 * 1.05 / 142.109 = $3,694.35
• Balance would need to be at least $525,000
– $3,694.35 * 142.109 = $525,000
• If ROR under 5% and no (or low) pay credit would
need to adjust interest credit upward
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Late Retirement
• Note that this is algebraically the same as
insuring interest credit is enough for
‘reasonable’ adjustment
• So what is reasonable?
– Certainly not a negative rate based on ROR or RIC
– 30-year Treasury? Currently ~ 3%
– 3-year Treasury + 50 bps? Currently ~ 1.5%
– Again, zero guidance
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“Self-directed Investment”
• Statutory hybrid plans with participant directed investment returns
still not addressed…Preamble
– Because of the significant concerns relating to the use of statutory hybrid
plan designs that would permit participants to choose among a menu of
investment options specified in the plan document, the Treasury
Department and the IRS continue to study these issues.
– It is possible that the Treasury Department and the IRS will conclude that
such plan designs are not permitted.
– In that event, it is anticipated that any statutory hybrid plans that
permitted participant choice among a menu of investment options on
September 18, 2014 pursuant to plan provisions that were adopted by
September 18, 2014 would receive anti-cutback relief that would permit
any such plans to be amended to provide for one or more appropriate
alternative replacement interest crediting measures.
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“Self Direction”
• Myriad problems with these plans
– Many derive from the fact that the self directed interest
credit is “theoretical”; the plan is under no obligation to
invest a dime in accordance with participant elections
– Since the participants are not controlling the direction of
plan funds, no 404(c) requirements, no education required,
no fiduciary obligation with respect to menu selections; the
“investment” options are a settlor function
• From a settlor standpoint, the employer is better off if
the employees make lousy investment options or are
offered lousy funds
– If actual investments beat participant elections,
excess reduces employer cost
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“Self Direction”
• Myriad problems with these plans
– With separate IC rate for each participant, some with heavy
equity exposures
• All problems with equity based rates are compounded
– 401(a)(4), 411(b), 415, 401(a)(26)
– Do you use separate rate for projection for each
employee?
» Is it the IRS’ most recent rate concept?
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