Rev. Rul. 81-195

ISSUE

How to compute costs for a plan year under a reasonable funding method, in the situations described below.

FACTS

Situation 1. A qualified defined benefit pension plan with a calendar limitation year and plan year provides for a single life annuity benefit payable beginning at age 65. The plan benefit equals 90 percent of a participant's highest average compensation over three consecutive years. Also, it provides that as of January 1 of each calendar year the dollar limitation under section 415 of the Internal Revenue Code as determined by the Commissioner of Internal Revenue for that calendar year will become effective as the maximum benefit payable as a life annuity under the plan.

The plan costs are determined using a funding method that is reasonable for purposes of section 412(c)(3) of the Code by projecting each participant's current salary to the expected date of retirement and determining the plan benefit payable (and the resultant costs) based on that salary history.

Based on reasonable actuarial assumptions, for the 1980 plan year, the projected final average compensation for participants A and B are shown below.

 Participant                  1980                  Projected

LAW, ANALYSIS AND HOLDING

Sections 404 and 412 of the Code provide that, for purposes of those sections, all costs shall be determined on the basis of actuarial assumptions and methods which are reasonable.

Section 1.412(c)(3)-1(d) of the Income Tax Regulations provides that a reasonable funding method generally does not anticipate changes in plan benefits that become effective in a future plan year.

Section 1.412(c)(3)-1(c) of the regulations requires that the salary reflected in projected benefits under a reasonable method must be the projected salary on which benefits would be based under the plan at the age when the receipt of benefits is expected to begin.

Section 415 of the Code requires that, in order to satisfy the requirements of section 401(a), a defined benefit plan must limit the benefits payable to the lesser of 100 percent of a participant's highest average compensation over three consecutive years or the maximum dollar limitation effective for that year.

Section 415(d) of the Code provides for annual adjustments to the effective maximum dollar limitation and to the 100 percent of compensation limit for a participant who is separated from service.

Section 1.415-5(c) of the regulations provides that although a defined benefit plan may include a provision which automatically adjusts the maximum dollar limitation for changes in the cost-of-living, the provision may only provide for scheduled increases which become effective no sooner than January 1 of each calendar year.

Even though a qualified defined benefit plan may automatically adjust the maximum dollar limitation each year, the scheduled future increases for calendar years beginning after the current plan year may not be effective in that plan year. Accordingly, as provided by section 1.412(c)(3)-1(d) of the regulations, a reasonable funding method may not anticipate these benefit changes in the current plan year.

However, although the benefit provisions of the plan, as in effect in the current plan year, may not be assumed to change under a reasonable funding method, the future salaries of plan participants may be assumed to change without it being considered a benefit change for purposes of section 1.412(c)(3)-1(d) of the regulations. Thus, if a qualified plan provides for benefits based on compensation at separation from service, the costs must be based on projected benefits which reflect the expected salary history of a participant up to the age when that participant is expected to separate, even if those projected benefits exceed the current high three consecutive year average compensation.

In Situation 1, the projected benefits on which the plan costs are based should be determined by applying the plan, as in effect in 1980, to the assumed future compensations.

For participant A, although 90 percent of the assumed future compensation would produce a benefit of $162,000, the plan, as in effect in 1980, would limit all future benefits to the 1980 maximum dollar limitation of $110,625. ¹ Even though the plan may result in an automatic increase in the dollar limitation in future plan years, these scheduled benefit increases are not effective in 1980 and may not be taken into account by a reasonable funding method. Thus, plan costs for A should assume A's ultimate benefit will be a life annuity of $110,625 per year.

For participant B, the 90 percent of average compensation provision would produce a benefit of $90,000. Although this benefit may exceed B's $20,000 current compensation, it does not exceed 100 percent of B's assumed future compensation, nor does it exceed the maximum dollar limitation of $110,625. Therefore, plan costs for B should assume B's ultimate benefit will be a life annuity of $90,000 per year.

Similarly, in Situation 2, the plan costs should be determined assuming that the benefits payable to A and B in the year of retirement are $110,625 and $90,000, respectively. However, the plan costs must also take into account the post-retirement cost of living adjustments. For A, regardless of what increases are assumed in future cost of living, the plan, as in effect in 1980, limits the benefit payable in any future year to $110,625. Thus, plan costs for A should assume A's ultimate benefit will be a life annuity of $110,625 per year.

For B, payments after the $90,000 initial benefit payment can increase with cost of living increases. Under the plan, as in effect in 1980, the benefit payments can continue to increase until the annual payment is $110,625 and the costs should reflect this increase. However, because the plan, as in effect in 1980, limits the benefit payable in any future year to $110,625, the plan costs should assume that no future annual benefit payment to B exceeds this amount. In contrast to this, the assumption that in some future year a payment exceeds $100,000 (the projected high three-year average compensation) does not anticipate a change in the plan benefits in effect in 1980 because the benefit structure in effect in 1980 does not limit B's benefit in years after separation from service to 100 percent of B's actual high three-year average compensation.

¹ The 1980 maximum dollar limitation as released in IR-80-17, on February 5, 1980.