Issues covered: Protecting the old interest crediting rate on the account balance earned as of the date of the amendment. Using the A plus B approach in an ongoing plan. Wearaway and restrictions on “greater of” interest crediting rates under the market rate of return rules. Plans terminating to avoid wearaway. IRC Section and Treas. Regulation IRC Section 411(b)(5)(B)(i) IRC Section 411(d)(6) Treas. Reg. Section 1.411(b)(5)-1 Resources (court cases, Chief Counsel Advice, Revenue Rulings, internal resources) Notice 96-8, 1996-1 C.B. 359 Analysis I. Overview Cash balance plans base benefits on a hypothetical account balance, increased with principal credits, and adjusted with interest credits. Interest credits cannot exceed a market rate of return (discussed briefly, later in this snapshot). Cash balance plans are included in the definition of applicable defined benefit plans under IRC Section 411(a)(13) and are included in the definition of statutory hybrid plans under Treas. Reg. Section 1.411(a)(13)-1. This issue snapshot discusses the issues when a plan amendment reduces (or potentially reduces) the interest crediting rate. II. Background IRC Section 411(d)(6) provides that an accrued benefit may not be decreased by amendment. IRC Section 411(b)(5)(B)(i) provides that an applicable defined benefit plan fails the requirements of IRC Section 411(b)(1)(H) if the plan provides interest credits that exceed a market rate of return. Treas. Reg. Section 1.411(b)(5)-1(d) provides a list of rates that are acceptable under the market rate of return restrictions. In general, an interest crediting rate is not in excess of a market rate of return only if the plan terms provide that the interest credit for each plan year is determined using one of the interest crediting rates specified in the regulations (or cannot exceed one of those rates). The regulations also address combinations of rates. The chart below summarizes some of these combinations. Please refer to the regulations for details. Underlying rate Highest permitted guaranteed rate How guarantee may be applied Fixed rate 6% Annual 1st, 2nd, or 3rd segment rate 4% Annual or cumulative Government bond rates with margin or cost-of-living increases 5% Annual or cumulative Investment-based rates 3% Cumulative only As an example, the interest crediting rate could be the greater of the 3rd segment rate or 4%. The 4% guarantee could be determined on a year by year basis, or cumulative to the determination date. Treas. Reg. Section 1.411(b)(5)-1(e)(2) provides rules relating to plan termination. Briefly, it provides that the interest crediting rate after the plan termination date must be equal to the average of the interest crediting rates during the 5-year period ending on the plan termination date. However, for plans that use investment-based interest crediting rates, the 5-year average is determined using the second interest segment rate under IRC Section 430(h)(2)(C)(ii) (without the 25-year average adjustment in IRC Section 430(h)(2)(C)(iv)) instead of the plan’s actual interest crediting rates. III. Protecting the old interest crediting rate on the account balance earned as of the date of an amendment Treas. Reg. Section 1.411(b)(5)-1(e)(3)(i) provides rules relating to IRC Section 411(d)(6). In part, it provides that the right to interest credits in the future that are not conditioned on future service constitutes a protected benefit under IRC Section 411(d)(6). If the terms of a statutory hybrid plan entitle the participant to future interest credits, a plan must comply with IRC Section 411(d)(6) by protecting the old interest crediting rate for the accrued benefit if (1) the plan is amended to change the interest crediting rate, and (2) under any circumstances the revised rate could result in interest credits that are smaller than the interest credits that would be provided without regard to the amendment. There are two methods commonly used to satisfy IRC Section 411(d)(6) when a cash balance plan is amended to change the interest crediting rate: the “A plus B approach” and “wearaway.” 1. A plus B approach Under the A plus B approach, there are in essence two separate hypothetical accounts. The “A” account is the original account which continues to accumulate interest credits at the old interest crediting rates, with no additional principal credits. The “B” account is a new account with an opening balance of zero. Future principal credits are credited to this account, and interest credits are credited at the new interest crediting rate. The participant’s benefit is based on the sum of the “A” account and the “B” account. Examples - A plus B method Let’s use several examples to illustrate the A plus B method. Examples 1 and 2 - Facts For both examples, assume that the cash balance account is $10,000 at the date the change in interest crediting rate becomes effective, January 1, 2018. The principal credit is $500 for the first year and $600 for the second year. Principal credits and interest credits are added at the end of the year. Example 1 - Decrease from fixed 6% to fixed 5% In example 1, the interest crediting rate is reduced from a fixed rate of 6% to a fixed rate of 5%. As you can see in the example below, the 6% rate is used to determine interest credits to the A account. Principal credits and interest credits at 5% are credited to the B account. The total account balance is the sum of the A and B account. Benefit earned as of 1/1/2018 (A) Benefit based on service after 1/1/2018 (B) Total Benefit (A + B) Account balance at 1/1/2018 $10,000 $0 $10,000 Interest credit at 6% 600 0 Principal credit at $500 0 500 Account balance at 12/31/2018 10,600 500 11,100 Interest credit at 6% (A) /5% (B) 636 25 Principal credit at $600 0 600 Account balance at 12/31/2019 $11,236 $1,125 $12,361 Example 2 - Change from fixed 6% to variable 30-year Treasury In example 2 the interest crediting rate is changed from a fixed rate of 6% to the variable 30-year Treasury rate. In this example, the A account is credited with interest credits at the fixed interest rate of 6% while the B account is credited with principal credits and interest credits at the 30-year Treasury rate. For purposes of this example, assume the following; 2018 – 30-year Treasury rate = 5% 2019 – 30-year Treasury rate = 7% Benefit earned as of 1/1/2018 (A) Benefit based on service after 1/1/2018 (B) Total Benefit (A + B) Account balance at 1/1/2018 $10,000 0 $10,000 Interest credit at 6% (A)/5% (B) 600 0 Principal credit at $500 0 500 Account balance at 12/31/2018 10,600 500 11,100 Interest credit at 6% (A) /7% (B) 636 35 Principal credit at $600 0 600 Account balance at 12/31/2019 $11,236 $1,135 $12,371 2. Wearaway and restrictions on “greater of” interest crediting rates under the market rate of return rules Under the wearaway method, the account balance is the greater of: The hypothetical account balance at date of change, increased with interest credits at the old interest crediting rate; and The hypothetical account balance at the date of change, increased with principal credits and interest credits at the new interest crediting rate. Treas. Reg. Section 1.411(b)(5)-1(e)(3)(iii) provides a special market rate of return rule allowing the wearaway method to be used for participants who were still earning pay credits as of the date the interest crediting rate was changed, even if the combination of the old and new interest rates would otherwise violate the market rate of return rules. As discussed in section 3 below, this special rule does not apply to participants who were no longer earning principal credits as of the date the interest crediting rate was changed. Let’s use the same facts as in the earlier examples to illustrate the results of the wearaway approach. Example 3 - Decrease from fixed 6% to fixed 5% In this example, the interest crediting rate is decreased from a fixed 6% rate to a fixed 5% rate. The protected balance is increased at the prior fixed rate with no further principal credits, while the total balance is increased at the new rate plus principal credits. As you can see, by the end of the first year in this example, the protected balance has “worn away” and the new total balance is the larger amount. Benefit earned as of 1/1/2018 Total Balance Applicable Balance (greater of) Account balance at 1/1/2018 $10,000 $10,000 $10,000 Interest credit at 6%/5% 600 500 Principal credit at $500 0 500 Account balance at 12/31/2018 10,600 11,000 11,000 Interest credit at 6%/5% 636 550 Principal credit at $600 0 600 Account balance at 12/31/2019 $11,236 $12,150 $12,150 Example 4 - Change from fixed 6% to variable 30-year Treasury rate In this example, the interest crediting rate is changed from a fixed 6% rate to the variable 30-year Treasury rate. For purposes of this example, assume the following; 2018 – 30-year Treasury rate = 5% 2019 – 30-year Treasury rate = 7% Also, in this example, the protected balance “wears away” after one year and the total balance overrides. Benefit earned as of 1/1/2018 Total Balance Applicable Balance (greater of) Account balance at 1/1/2018 $10,000 $10,000 $10,000 Interest credit at 6%/5% 600 500 Principal credit at $500 0 500 Account balance at 12/31/2018 10,600 11,000 11,000 Interest credit at 6%/5% 636 770 Principal credit at $600 0 600 Account balance at 12/31/2019 $11,236 $12,370 $12,370 3. Participants who are no longer accruing principal credits Let’s modify these examples to assume that the participant has terminated at the date of change of the interest crediting rate or is otherwise not earning any principal credits. The A plus B approach has no effect since the terminated participant is not earning any principal credits, and therefore does not have a “B” account. To avoid any cutback in benefits, the terminated participant would continue to receive interest credits at the prior interest crediting rate. Under Section 1.411(b)(5)-1(e)(3)(iii) of the regulations, the wearaway approach cannot be used for participants who are no longer benefitting (i.e., earning principal credits) as of the date of the amendment changing the interest crediting rate, if the combination of the old and new interest crediting rates would not meet the market rate of return restrictions. This is because if a participant is not earning any additional principal credits, there are no new benefit accruals to wear away the protected benefit, and the wearaway method essentially defaults to applying the greater of the old or new interest crediting rate to the participant’s hypothetical account balance. In example 2, the interest crediting rate was changed from 6% to the 30-year Treasury rate (5% in year 1 and 7% in year 2). Since the 6% interest crediting rate must be preserved, using the wearaway approach means that the terminated participant’s hypothetical account balance is credited with interest at the greater of 6% and the 30-year Treasury rate. As shown in the table in Section II of this issue snapshot, using the “greater of” approach with a 30-year Treasury rate (a government bond rate) is limited to a maximum guaranteed rate of 5%, not 6%. If the combination of old and new interest crediting rates would fall within the market rate of return rules, then the wearaway approach could be used for all participants, including those who were no longer earning principal credits as of the date of the amendment changing the interest crediting rate. For instance, if a plan using a 5% interest crediting rate was amended to use the 30-year Treasury rate, and the amendment extended the change to terminated vested participants, the wearaway approach would mean that the plan would credit the greater of 5% or the 30-year Treasury rate for participants no longer earning principal credits. This combination is permitted under the market rate of return rules. Note that once the plan is amended, the wearaway approach continues to apply to participants who were earning principal credits as of the date of the amendment, even if they later terminate employment or otherwise cease to earn principal credits. 4. Plans terminating to avoid wearaway Some plans may have terminated in order to reduce their ongoing interest credits. The plan sponsors who take this approach are hoping to terminate the current plan and establish a new plan with a different interest crediting rate, and therefore avoid the need to protect the old interest crediting rate on participants’ accrued hypothetical account balances. Section 1.411(b)(5)-1(e)(2) of the regulations provides special rules that apply with respect to interest crediting rates after a plan termination, so the plan sponsor could not completely ignore the old interest crediting rate. However, the plan sponsor may hope that some participants elect to receive a distribution of the total of their cash balance account shortly after plan termination, so that no additional interest would be credited to those accounts at the old interest crediting rate. The approach of terminating the plan and reestablishing the same plan shortly after raises questions on whether this is a bona-fide plan termination, which should be reviewed by the agent. Issue indicators or audit tips Review any plan amendments to see if they potentially decrease the interest crediting rate. If there are reductions in the interest crediting rate, make sure that the plan protects the interest crediting rate “promise” in effect before the amendment. Either the A plus B or wearaway approach will accomplish this. Ensure that if the wearaway approach is used, the resulting rate does not exceed a market rate of return for participants who are not actively accruing benefits (i.e., principal credits) as of the date of the amendment. If correction is needed, notify your manager and work with the field actuaries to develop a correction.
