The law allows employers to terminate or amend the terms of a retirement plan. A significant amendment to a plan, especially of the rate at which participants earn future benefits, can actually convert a particular type of plan to another type of retirement plan. However, a plan amendment or conversion has to comply with the “anti-cutback rules” that prohibit a reduction or elimination of any protected benefits, such as: accrued benefits, early retirement benefits, retirement-type subsidies, or any optional forms of benefit. Plan features that are subject to protection include payment schedules, timing of payment, commencement of benefits, type of distributions and election rights as to optional forms of distributions. The employer must give notice to affected participants of any plan amendments or conversions that could reduce or eliminate any of their future benefits. The notice must inform the participant of the nature and timing of any changes affecting the participant. Example of plan conversion: Cash balance conversion One type of plan conversion that has recently become popular is within a defined benefit plan. It involves a change in the plan’s formula as to how participants will earn future benefits. The conversion may not reduce any benefits already earned by participants. A cash balance plan bases a person’s benefit amount on certain credits stated in the plan. Usually, an employee receives an annual credit of some percentage of his or her salary and an annual interest credit (either fixed or variable, linked to an index). These credits accumulate for every year of employment. When the employee retires or terminates employment, they may choose (with the consent of the spouse, if applicable) to receive the total amount based on these credits either in a lump sum or as an annuity. A participant who elects to receive a lump sum payment of benefits, if available under the plan, may roll over the lump sum distribution into an IRA or another plan. Lump-sum distributions before normal retirement age Generally, cash balance plans allow an employee who leaves employment before normal retirement age to receive a lump sum distribution. Prior to August 17, 2006, there was some disagreement as to which of the following methods a cash balance plan had to use to compute the amount of the lump sum distribution: The current accrued benefit amount computed using the annual salary and interest credits as stated in the plan up to the employee’s date of severance. The present value of the accrued benefit expressed as an annuity which required the plan to: add to the current accrued benefit any future interest credits, at the plan’s stated rate, up to the plan’s normal retirement age, convert the balance to an annuity payable at the plan’s normal retirement age, and determine the present value of that annuity using interest and mortality assumptions established by law. A plan’s use of the present value method (2 above) usually resulted in the value of the lump sum distribution being greater than the participant’s current accrued benefit. This was known as the “whipsaw effect” due to the plan using a rate of future interest credits higher than the discount rate used to determine the present value of the annuity. The law has now been clarified so that if an annuity payable under the plan has a starting date after August 17, 2006, a cash balance plan may make a lump sum distribution of the current accrued benefit amount (method A above) if otherwise allowed under the plan. Choice of plan formulas A plan may: Apply the new cash balance plan formula to all existing and new employees Allow existing employees to remain under the old formula and only apply the new formula to new employees Only allow employees who have reached a certain age or been employed for a certain period to continue under the old formula Wear away In some situations, a participant benefit earned under a plan’s old formula may exceed the amount under the new cash balance plan formula. In this instance and only for plan conversions that occurred on or before June 29, 2005, the participant might be subject to “wear away” which means that he or she may not earn any additional benefits under the new cash balance plan formula until the balance under the new formula exceeds the old formula’s benefit amount. For plans converting after June 29, 2005, each participant must receive the sum of the: pre-conversion accrued benefit determined under the prior plan formula; post-conversion accrued benefit determined under the cash balance plan formula; and amount of any early retirement benefits or retirement-type subsidies if the participant has met the requirements for the benefit or subsidy under the prior plan. Age discrimination A plan is not allowed to amend or convert the plan in any way that would discriminate based on age. A cash balance plan formula that uses age neutral pay credits is considered non-discriminatory based on age. Additional resources U.S. Department of Labor, Employee Benefits Security Administration, What You Should Know About Your Retirement Plan PDF U.S. Department of Labor, Cash Balance Plans Questions & Answers Guidance on the anti-cutback rules of Section 411(d)(6) Notice 2007-6
