IRS Releases Transitional Guidance for Hybrid Plans

The IRS has released guidance explaining how to apply the Pension Protection Act (PPA) to cash balance plans, pension equity plans (PEPs) and other hybrid defined benefit plans. The PPA established — prospectively — that hybrid plans are not inherently age-discriminatory and imposed new rules on hybrid plan conversions, benefit accruals and benefit payouts. This guidance is the first interpretation of those new restrictions and provisions by government regulators.

The guidance clarifies several terms and introduces a few new ones. A “statutory hybrid plan” refers to cash balance plans, PEPs and other hybrid plans (the PPA called them applicable defined benefit plans). The “accumulated benefit” is the benefit tested for age discrimination. A participant’s accumulated benefit may be expressed as an annuity payable at normal retirement age, a hypothetical account balance or the current value of the accumulated percentage of his or her final-average compensation.

Statutory Hybrid Plan

A statutory hybrid plan is a defined benefit plan consisting entirely or partially of either a “lump sum based plan” or a plan whose benefits are similar to those in a lump-sum-based plan. Under such a plan, a participant’s accumulated benefit is the balance of the hypothetical account or the current value of the accumulated percentage of his or her final average compensation. Whether a plan is lump-sum-based depends on how the participant’s accumulated benefit is expressed — not whether the plan offers an optional lump sum form of benefit.

In a statutory hybrid plan, the accrued benefit is either the actuarial equivalent of the hypothetical account balance or an accumulated percentage in the form of a life annuity payable at normal retirement age. Hopefully, this provision means that hybrid plans that define the accrued benefit as the annuity benefit that’s actuarially equivalent to the cash balance account or PEP lump sum are statutory hybrid plans.

Whipsaw Calculation

Before the PPA, many courts and the IRS had ruled that lump sum benefits had to be determined using the “whipsaw calculation” rather than a participant’s hypothetical cash balance account. The whipsaw calculation projects the account balance to normal retirement age using the plan’s interest crediting rate, and then discounts it back to the participant’s current age using a statutorily specified interest rate. If the interest crediting rate exceeds the statutory rate, the lump sum benefit amounts to more than the cash balance account. Otherwise, the cash balance account is paid.

The PPA eliminates the whipsaw calculation for distributions after August 17, 2006, for statutory hybrid plans. The IRS plans to issue regulations shortly interpreting that effective date. But if a plan document calls for the whipsaw calculation, the sponsor must either continue to use it or amend the plan. Under the new guidance, sponsors may amend their plans to eliminate the whipsaw provision for distributions made after the later of August 17, 2006, or the amendment’s effective date. The sponsor must provide an explanatory notice to participants at least 30 days before the amendment takes effect.

Market Rate of Return

Starting in 2008, statutory hybrid plans cannot credit interest at greater than a market rate of return. The IRS plans to release further guidance during 2007 addressing the market-rate standard and clarifying the application of the PPA’s anti-cutback relief to amendments that change the plan’s interest-crediting rate. Until then, sponsors may consider any of the following as market rates of return:

• The interest rate on long-term investment-grade corporate bonds (i.e., the rate used to determine plan liabilities for funding purposes pre-PPA)
• The third segment rate of the corporate bond yield curve (the longest term of the rates used to determine plan liabilities for funding purposes post-PPA)
• The interest rate on 30-year Treasury securities
• Any of the rates, with their associated margin, specified as avoiding the whipsaw calculation in IRS Notice 96-8

The notice does not address fixed interest rates and rates based on equity rates of return, which should be discussed in future guidance.

Conversion Requirements

The PPA essentially requires an A+B conversion for any plan converted to a statutory hybrid plan after June 29, 2005, where A is the benefit based on the pre-conversion formula, taking into account service up to the conversion, and B is the benefit under the new cash balance plan, taking into account only post-conversion service. The act clarifies that the conversion must protect the value of any early retirement subsidy accrued before the conversion (when the participant ultimately satisfies the age and/or service requirements for subsidy eligibility). However, the guidance — like the PPA — is less clear on how this subsidy rule will work in practice, and sponsors will need additional clarifying guidance.

The act directs the IRS to issue guidance on special rules for hybrid plan conversions in connection with a business acquisition, which the IRS says it will do by August 17, 2007. Until then, an interim safe harbor permits sponsors to convert a plan acquired as part of a business acquisition to a statutory hybrid plan under a modified A+B conversion, as if the previous plan and the new hybrid plan operated independently.

Determination Letter Program

The IRS will again issue determination letters to hybrid plans, including those subject to the moratorium established back in 1999. Such plans will not be considered age-discriminatory merely because they front-load interest credits; i.e., provide that interest credits are accrued in the year of the related hypothetical allocation rather than when the benefit is paid out. Thus, it appears that there will be no caveats on the age-discrimination design issue, even for periods before the PPA’s effective date. However, determination letters will not opine on whether the conversion to a hybrid design adopted before June 29, 2005, is age-discriminatory. Additionally, until the IRS releases further guidance on the whipsaw calculation, the agency will not process determination letters for plans that did not comply with the whipsaw calculation for pre-PPA distributions.

Comments Requested

In anticipation of future guidance, the IRS is requesting comments on the following issues by April 16, 2007:

• Determining when two or more amendments, or the coordination of two or more defined benefit plans, constitutes a conversion into a statutory hybrid plan
• Defining market rate of return, including the following issues:
  • The impact of the minimum-rate-of-return rules on the definition of market rate of return
  • The impact of the preservation-of-capital rules on the definition of market rate of return
  • The application of 411(d)(6) to an amendment to the interest-crediting rate specified in a statutory hybrid plan, and the circumstances under which the 411(d)(6) relief provided under the PPA should apply to such an amendment
• Applying the special rules for hybrid plans to a plan in which only certain participants’ accrued benefits, or only a portion of a participant’s accrued benefit, is determined by lump-sum-based accrual methods, including plans in which the benefit payable under one plan is offset by the benefit provided under another plan
• Applying the qualification requirements — other than the age discrimination rules and §417(e) — to a defined benefit plan under which the accrued benefit is calculated as an accumulated percentage of the participant’s final-average compensation (commonly referred to as a PEP), including the treatment of interest credited to terminated vested participants
• Defining a recognized index or methodology for indexing benefits, and whether any indexed plans should not be treated as statutory hybrid plans (other than those described above).

January 2007