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Hybrid Plan Sponsors Concerned About Lack of Regulatory Guidance

The Pension Protection Act of 2006 (PPA) established new rules for the operation and administration of hybrid pension plans, but plan sponsors are still waiting for guidance. The lack of final (or in a number of cases even proposed) guidance leaves hybrid sponsors in a difficult position — required to act without knowing the rules for doing so. Watson Wyatt recently conducted a survey to identify the issues most important to these plan sponsors.

Hybrid plans are defined benefit (DB) plans in which benefits accrue under a formula determined by the employer, like in traditional DB plans, but the benefit is defined as a lump-sum account balance rather than an annuity-style monthly benefit. A cash balance plan is one type of hybrid plan (by far the most prevalent), with the benefit based on the percentage of employee pay credited annually by the employer plus interest, which is based on a chosen interest crediting rate. In a pension equity plan (PEP), percentage credits are posted to employees’ accounts annually. To calculate the lump-sum account balance at retirement, the total of the percentages is multiplied by the employee’s final average pay.

Many companies find hybrid plans appealing because their funding is more predictable and they are easier to explain to employees compared with other DB plans. But while their popularity has increased over the last two decades, their legal status has remained in limbo. In 1999 and subsequent years, hybrid plans became controversial as they were accused of being inherently age discriminatory. The PPA, however, clarified and established that this was not the case and imposed specific requirements for hybrid plans for the first time. The scope of the new rules is broad, so sponsors still face some uncertainties, albeit of a regulatory nature. Some provisions took effect as early as 2006 and all are in effect for the 2008 plan year, but sponsors are still waiting on implementing guidance from the IRS.

Watson Wyatt’s survey set out to identify what issues companies are concerned about regarding the regulations and on what issues they most want guidance. The survey was completed by 76 companies that sponsor 106 hybrid plans. Eighty-three percent of the hybrid plans are cash balance plans, 12 percent are PEPs, and the rest are other hybrid plans. The hybrid plans have 7,000 active employees on average.

One-fifth of respondents also sponsor traditional DB plans. Reflecting trends and turmoil in the pension system, some respondents plan to freeze or close their hybrid plan in the near future. However, 76 percent of responding employers say they intend to maintain an ongoing hybrid plan, and some plan to expand to other employees or change the benefit formula.

Perplexing uncertainty
The PPA established an almost entirely new compliance regime for hybrid plans, imposing new vesting and conversion standards, clarifying the application of age discrimination standards and eliminating the “whipsaw” methodology for calculating lump-sum distributions. Settling the age discrimination issue enabled the IRS to start processing determination letters for cash balance plans (though the IRS still declines to consider PEPs for determination letters prior to issuing guidance for such plans). Through the determination letter program, the IRS raised another issue for some cash balance plans, the “greater-of” issue.

After a conversion from a traditional DB plan to a hybrid, many sponsors establish a greater-of transition period, which gives participants ultimate retirement benefits under whichever formula gives them the larger benefit: the old DB plan formula or the new hybrid plan formula. In the context of the determination letter process, the IRS had claimed these greater-of transitions (and particularly the point at which the benefit under one formula exceeded the benefit under the other) could violate the accrual rules, which are designed to preclude “back-loading” (giving employees disproportionately large benefits during the last few years of service). The IRS took the position that the two benefit formulas (traditional and hybrid) had to be aggregated for purposes of the accrual rules and that when this was done the rules often could not be satisfied. However, the IRS subsequently issued Notice 2008-7 and a set of proposed regulations announcing a narrow exception for greater-of conversions to cash balance designs that would allow each formula to be tested separately under the accrual rules. This has generally remedied the potential accrual problem for hybrid conversions, but the proposed greater-of regulations (which have not yet been finalized) pose a number of problems for other DB plan designs.

The PPA’s new requirements coupled with the absence of implementing guidance create significant uncertainty for hybrid plan sponsors. While the IRS has indicated that reasonable, good-faith efforts to apply the new funding rules will suffice until final regulations are in place, similar standards have not been adopted for hybrid plan requirements prior to the effective date of final regulations.

As a result, sponsors are concerned that participants or the federal government might challenge their good-faith operations in the meantime. As of now, few respondents are involved in ongoing litigation concerning their hybrid plan. Of 76 respondents, only three reported outstanding litigation involving their hybrid plan. Notably, none of the plans is facing an ongoing age discrimination claim.

When asked about the relative importance of guidance on various hybrid plan issues, the message from plan sponsors is clear, as shown in Figure 1. Clarifying the market rate of return standard (explained below) is the highest priority, with 62 percent viewing this guidance as somewhat or very important. Sixty percent of respondents consider clarification of a reasonable, good-faith standard for periods before regulatory guidance takes effect to be important. Only about 3 percent consider it unimportant or not very important.

Plan sponsors are also eager for guidance on applying the new age discrimination test, with 60 percent saying it is somewhat or very important. The potential violation of the accrual rules in greater-of conversions is also of concern to most plan sponsors, with 54 percent ranking it as somewhat or very important. Twenty percent are unconcerned with the issue, which might be because the issue affects only those hybrid plan sponsors that used greater-of conversions.

Figure 1
Importance of guidance on hybrid plan issues

N=76
Source: Watson Wyatt

While some sponsors remain eager for guidance on the application of the whipsaw calculation for pre-PPA periods, 37 percent are neutral and more than one-fifth have little to no concern. Slightly more than one-third of respondents are worried about guidance on the effective date of the PPA’s elimination of the whipsaw calculation.

Market rate of return
Perhaps the most significant of the new requirements for hybrid plans — for both sponsors and participants — is not allowing the plan’s interest crediting rate (ICR) to exceed a market rate of return. Arising from the accusations that cash balance plans are inherently age discriminatory, the market-rate-of-return ceiling prevents plans from crediting too high an ICR.

Critics of cash balance plans had argued that crediting interest on pension accruals was inherently age discriminatory because, for example, a 55-year-old — having less time for compound interest to work its magic — would obtain a smaller benefit at normal retirement age than a 25-year-old with the same service. While appellate courts rejected this argument — finding that compound interest in a pension plan is not age discriminatory — Congress stepped in to limit compound interest to a market rate of return.

While there has been little argument from the sponsor community about the policy basis for the market rate ceiling, there is significant concern about how future IRS guidance will interpret the details. The statute establishes a broad standard, specifically permitting plans to provide for a reasonable minimum guaranteed rate of return or for a rate of return based on the greater of a fixed or variable rate (often called a combination rate). The PPA also essentially imposed a combination rate on every hybrid plan, requiring that the cumulative rate of return cannot be less than zero, thereby ensuring that participants’ benefits are based on at least the pay credits earned under the formula. Rules governing combination rates are also of concern because the IRS is requiring every hybrid plan with a graded schedule of pay credits to apply a fixed minimum rate of return in compliance with benefit accrual rules.

Hybrid plans commonly increase the rate of pay credits for increasing age and/or service. The IRS requires such plans to credit a minimum ICR to avoid back-loading benefits. So a plan with increasing pay credits that wants to credit a variable ICR must also have a fixed minimum ICR, resulting in a combination rate. While the IRS policy regarding plans with increasing pay credits has been long-standing, it was not widely acted on until the issue arose repeatedly in the determination letter program. As a result, although combination rates were relatively common prior to the PPA, they are likely to be more prevalent now, given that almost three-quarters of hybrid plans tier pay credits based on some combination of age and service.¹

Judging from public comments filed by hybrid plan sponsors and informal comments by government officials, combination rates could potentially set off disagreements between plan sponsors and government regulators. Sponsors interpret the statutory provision for a reasonable minimum guaranteed rate of return as approval for plans that provide the greater of a reasonable variable rate or a reasonable fixed rate — such as an ICR based on the better of Treasury bond rates or a fixed rate of 4 percent or higher.

From the perspective of government regulators, on the other hand, the ICR should be available on the commercial market or equivalent to a commercially available rate. Few commercially available investments combine a variable rate with a fixed minimum, and government officials have suggested the variable rate might need to be reduced — or take a “haircut” — for the combination rate to satisfy the market rate standard. This is especially likely if the variable rate is based on equity rates of return, such as the S&P 500. If a haircut is not required for plans using a bond-based rate of return combined with a fixed minimum rate (as opposed to those using an equity rate combined with a fixed minimum), sponsors might not have much to worry about. Few plans currently base their ICR on equity-based rates of return — and interest in doing so has all but evaporated in the wake of the recent stock market turmoil, although that could change in the future.

Because of the variety of plan issues potentially affected by a plan’s ICR and the range of ICRs in plans before the PPA’s enactment, plan sponsors are apprehensive about how the IRS will define the standard and whether they will need to change their plans (see Figure 2). Among survey respondents with cash balance plans, 22 percent believe they are somewhat or very likely to have to change their ICR to satisfy future market rate of return guidance and 19 percent are not sure. Only 12 percent of survey respondents are somewhat or very likely to change their ICR for some other reason.

Figure 2
Cash balance plan sponsors’ ICR expectations

Source: Watson Wyatt

As Figure 3 shows, PEP sponsors are more confident that their current interest rate credited on PEP lump sums for terminated vested participants will satisfy future guidance. Only 9 percent of these respondents believe they will need to change their rates to comply with future guidance, and almost 90 percent say they are not at all likely or not very likely to change the rate for some other reason.

Figure 3
PEP sponsors’ ICR expectations

Source: Watson Wyatt

We were able to determine the ICR for over 90 percent of the cash balance plans sponsored by survey respondents. Among the plan sponsors that believe they are somewhat or very likely to have to change the plan’s ICR to satisfy future guidance, virtually all credit interest based on Treasury bond yields, with most using 30-year Treasury bond rates. It is not clear whether these plans combine the variable rate with a fixed minimum ICR or credit only the rate of Treasury bonds of different durations (i.e., one-year, 10-year and 30-year Treasury bonds).

Interestingly, for each Treasury bond rate, some sponsors believe it will have to be changed under future guidance, while others think such a requirement is not at all or not very likely. Additionally, to the extent it can be determined, none of the hybrid plan respondents sponsors a plan that credits interest based on equity rates of return — all the plans use variable rates based on government bond rates or current certificate of deposit rates. Some plans combine variable rates with fixed minimum rates, with the highest fixed minimum rate being 7 percent. Regardless of the basis for the variable rate (tax code §417(e) rates in this highest case) in such combination approaches, informal comments from IRS and Treasury officials suggest little chance of approval for a fixed minimum rate as high as 7 percent.

In addition to the confusion surrounding interest crediting rates, plan sponsors that do change the rate must do so by the end of the 2009 plan year to qualify for the relief (so-called anti-cutback relief) provided by Congress, which allows companies to amend their plans to comply with new PPA requirements. Federal laws strictly govern any changes to a pension plan, especially those that could affect benefits already earned by a participant. Even if guidance were released immediately, sponsors would not have much time to prepare an amendment before the end of 2009. Giving plan sponsors more time would be appropriate, but the IRS has not yet indicated that an extension of the anti-cutback relief is forthcoming.²

Also, the concept that the market rate standard should not be limited by actual market investments is tacitly accepted in IRS proposed regulations and other IRS guidance, which recognize the yields on 30-year Treasury bonds and on long-term investment-grade corporate bonds as market rates. These rates reflect the current yield on long-term government and corporate bonds available at the time the rate is determined. If yields on long-term bonds rise from one period to the next, the price of the bonds will decline. Cash balance accounts, however, typically do not reflect any such market-value adjustment. Simply put, the market offers no investment with the risk and return profile of the monthly yield on long-term government or corporate bonds.

Conclusions
The absence of final guidance on the PPA rules for hybrid plans has created uncertainty for plan sponsors. Companies are particularly anxious for more guidance on the market rate of return and clarification of what constitutes a reasonable, good-faith standard before regulatory guidance takes effect. Until final guidance is issued, companies should be very careful in making decisions for their plans.

Companies that sponsored hybrid plans before the PPA was enacted should comply with proposed regulations. Most are holding off on other changes for now. The lack of clarity on ICRs particularly puts sponsors between a rock and a hard place, as they must amend their plans by year-end 2009 to be eligible for the plan amendment relief. Companies don’t know when guidance will be released or whether they will get an extension to meet the new guidance.

Companies that are considering whether to convert their traditional DB plan to a hybrid plan should be cautious in using a conversion method other than one currently available under PPA. Plan sponsors and those considering adopting a hybrid plan should exercise care in adopting an ICR other than a safe harbor rate set forth in the IRS proposed regulations. They should also consider administrative changes making it easier to track the details of participant benefit accruals, so that once final guidance is out, they will know where they stand and can make any necessary changes.

¹ 2008 Watson Wyatt Comparison Statistical Summary.

² In light of the absence of final guidance on permissible interest crediting rates, Watson Wyatt is working with others in the benefits and business communities to encourage the Treasury Department and IRS to extend anti-cutback relief and provide for a reasonable interpretation standard for the period before final regulations take effect.