Mercer Comments on Hybrid Pension Plan Rules

Mercer is pleased to provide input to the Treasury Department and the Internal Revenue Service on proposed regulations § 1.411(b)(5)-1(e)(3)(vi), which would provide anti-cutback relief for certain plan amendments adopted to bring cash balance plans, pension equity plans (PEPs), or other applicable defined benefit plans into compliance with final rules limiting interest credits to no more than a market rate of return ("market-rate rules"). In addition, we are also seeking clarification on an important change that was made to the final regulations without an opportunity for comment.

Mercer is a global consulting leader in talent, health, retirement, and investments. Mercer provides consulting and actuarial services to more than 150 US cash balance and pension equity plans, which will be subject to the final market-rate rules when they take effect in 2016. Some of these plans include features that are not addressed in the proposed regulations, and some plan sponsors would like additional transition flexibility.

As discussed in more detail in this letter, we recommend that final transition rules:

• Allow plans to correct any noncompliant interest crediting rate by crediting the lesser of the plan's current crediting rate and a rate described in § 1.411(b)(5)-1(d)(3).

• Provide additional relief to plans that were amended in the past to change crediting rates.

• Provide relief for plans that currently provide a rolling cumulative floor rate determined over a fixed, multi-year period such as six or eleven years.

• Provide anti-cutback relief for plans that change the interest crediting rate from the return on total plan assets to the return on a specified subset of plan assets, or vice versa.

• Clarify that rounding a permissible crediting rate to the nearest multiple of 10 or 25 basis points is not crediting an above-market rate.

Additional flexibility for conforming amendments

The final regulations should allow plans to correct any noncompliant interest crediting rate by crediting the lesser of the plan's current crediting rate and a rate described in § 1.411(b)(5)-1(d)(3) (generally, the third segment rate). That is, a plan should be permitted to correct any noncompliant interest crediting rate by capping the rate at the third segment rate. The proposed rules already provide that three specified types of noncompliant rates are corrected by adding a third-segment-rate cap:

• The greatest of two or more variable bond-based rates

• An impermissible bond-based rate, if there is no permissible bond-based rate that has similar duration and quality characteristics

• An impermissible investment-based rate, if a permitted investment-based rate (such as the return on a mutual fund) that has similar risk and return characteristics cannot be selected.

However, this prescribed solution may not be palatable to the plan sponsor. Most sponsors want to know the following year's crediting rate well before the start of the year to facilitate plan administration, including providing benefit election materials to participants retiring in the first quarter of the following year. But the CPI-U can be fairly volatile over short periods, so determining the interest crediting rate based on the year-over-year increase in CPI-U for August (or the year-over-year increase in average CPI-U for August and September) is also not appealing. In this situation, the sponsor might prefer to continue using the current 12-month average rate, but cap the rate at no more than the average third segment rate for August and September.

As a second example, consider two calendar-year cash balance plans: Plan A credits the greater of the yield on the 30-year Treasury Constant Maturity for November or 5.25%; Plan B credits the greatest of three rates: the yield on the 30-year Treasury Constant Maturity for November, the yield on the 3-month Treasury Bill for November, or 5.25%. In practice, Plans A and B have always credited the same rate because the yield on the 3-month Treasury Bill has never exceeded the yield on the 30-year Treasury Constant Maturity. Yet the proposed rules prescribe very different corrections for Plans A and B. Plan A must change its crediting rate to either (1) a fixed 6% or (2) the greater of the yield on the 30-year Treasury Constant Maturity for November or 5%. In contrast, Plan B must continue to credit the greatest of the three rates (though one of the three never applies), but not more than a third segment rate described in § 1.411(b)(5)-1(d)(3). There's no policy reason to make such a distinction. Plan A should also be allowed to cap its current crediting rate at a rate described in § 1.411(b)(5)-1(d)(3).

In a similar vein, a sponsor currently crediting an impermissible investment-based rate may find the task of reviewing all available mutual funds that might be considered "similar" very daunting. Furthermore, the "similar" standard is vague, leaving sponsors uncertain just how similar the rates must be and how this assessment should be done. Sponsors in this situation may prefer to simply cap the current crediting rate at a third segment rate.

None of these situations is abusive and the solution of capping the crediting rate should be allowed. In addition, proposed rule in § 1.411(b)(5)-1(e)(3)(vi)(B)(1) should be clarified to indicate that capping the crediting rate at a compliant third segment rate cures all noncompliant features. For example, if the current rate uses a noncompliant lookback period, there is no need to correct it, provided the third segment rate cap uses a compliant lookback period

If the service is unwilling to go so far as to allow application of a third-segment rate cap in all cases, then at a minimum the final rules should provide a catch-all rule for situations that are not otherwise addressed by the final rules. Thus, above-market rates for which the final rules do not specify a correction may be corrected -- with anti-cutback relief -- by crediting the lesser of the noncompliant rate and the third segment rate. The cap would apply on a year-by-year basis.

Past plan amendments changing interest crediting rates

Many plans have been amended in the past to change their interest crediting rates. Such amendments -- including many adopted before the market-rate rules were enacted as part of the Pension Protection Act of 2006 (PPA) -- may have extended the new crediting rate to all participants with accounts (including vested participants who terminated before the amendment date). And as required by Code Section 411(d)(6), the amendment also preserved a legal minimum benefit equal to the account balance at the amendment date accumulated with interest at the old crediting rate. In many cases, the old crediting rate may not satisfy the final market-rate rules.

The market-rate rules explicitly provide that a plan doesn't fail to satisfy the market-rate requirements merely because active participants on the amendment date receive the better of their pre-amendment account balance accumulated at the old compliant interest rate and their ongoing account balance credited with interest at the new compliant rate. We have two concerns with the scope of this relief.

First, the relief appears to apply only if both the old rate and the new rate satisfy the market-rate rules at the time of the amendment. The regulation provides relief "in the case of an amendment to change a plan's interest crediting rate for periods after the applicable amendment date from one interest crediting rate (the old rate) that satisfies the requirements of paragraph (d) of this section to another interest crediting rate (the new rate) that satisfies the requirements of paragraph (d) of this section." For plans that changed interest crediting rates in the past, it is unclear whether the special rule applies if either the old rate or the new rate did not fully satisfy "the requirements of paragraph (d)" at the time of the amendment (for example, one of the rates used a nonconforming lookback period), even if the plan is amended by the end of 2015 to bring both rates into full compliance. If the rule does not apply, then the plan may be treated as crediting an above-market rate.

Second, the relief applies only with respect to participants who were actively benefiting under the plan at the time of the amendment. Thus, the relief does not apply to terminated vested employees. The preamble to the final rule provides the following explanation:

The proposed transition rules indicate that if a plan credits "a composite rate that is the greatest of two or more variable rates described in paragraph (d)(3) or (d)(4) . . . then the plan must be amended to credit interest using the lesser of the composite rate and a rate described in paragraph (d)(3)" (a third segment rate). But we have several concerns applying this proposed rule in the context of plan amendments providing 411(d)(6) protection of a prior crediting rate:

• Does the relief in proposed regulations § 1.411(b)(5)-1(e)(3)(vi)(C)(5) apply? The relief appears aimed at situations where a plan credits the greater of two rates on a year-by-year basis. It is not clear that it is also intended cover a greater-of-two-balances situation since the 411(d)(6)-protected minimum benefit is, in effect, more like a cumulative floor rate described in paragraph (d)(6)(iii), even when the underlying rate is a bond-based rate described in paragraph (d)(3) or (d)(4).

• Are the lookback rules in paragraph (d)(1) considered in determining whether the rates are described in paragraphs (d)(3) or (d)(4)? Plans have used a variety of lookback periods in the past. If either the old or the new rates had a nonconforming lookback rule at the time of the amendment, is the rate still considered to be one that is described in (d)(3) or (d)(4)? If not, then does the relief apply if the lookback periods are changed to satisfy the final rules?

• What correction applies if one of the rates isn't a variable bond-based rate described in paragraph (d)(3) or (d)(4)? For example, some plans may have changed from a fixed rate described in (d)(4) to a variable bond-based rate, or from an investment-based rate to a variable bond-based rate, or vice versa. There does not appear to be any correction for these greater-of situations.

• How is a third segment rate cap applied to a cumulative "greatest of" rate? If applying a third segment rate cap is the appropriate correction, the proposed rules are unclear how such a cap should be applied in the case of a cumulative "greatest of" calculation. One possibility is that each annual rate is separately capped at the third segment rate. A second possibility is that the plan must create and track a "maximum" balance. The maximum balance at the start of the 2016 plan year would equal the greatest of the cash balance account or the protected minimum balances at the end of the 2015 plan year; it would be credited with interest at the third segment rate for 2016 and later years. At the annuity starting date, the participants benefit would equal the greatest of the cash balance account and the protected minimum balances, but not more than the maximum balance. We can envision other, more complicated possibilities.

Solely for plan amendments changing interest crediting rates that were adopted and effective before the final regulations were published on September 19, 2014, the final transition rules should provide:

• If the old and the new crediting rates (considered individually) don't already comply with § 1.411(b)(5)-1(d), the plan must be amended to bring each rate into compliance, following the transition rule that would apply if that rate were the plan's only crediting rate.

• If both the old and new interest crediting rates (as amended pursuant to the first bullet above) are corporate-bond or safe-harbor rates described in paragraph (d)(3) or (d)(4) (not limited to only "variable" rates described in (d)(3) and (d)(4)), the plan is not treated as crediting an above-market rate with respect to any individual who was a participant on the original amendment date, regardless of whether the participant was benefiting under the plan (within the meaning of § 1.410(b)-3(a)) on that date. Because the greater of the old and the new rate is determined only on a cumulative basis at the annuity starting date -- not year-by-year -- and both the old and the new rates are either fixed," bond-based, or CPI-based rates with no more than the maximum permissible margin, the opportunity to credit materially above-market rates is minimal and does not justify cutting back participants' benefits. And the time and effort that would be required for these plans to implement and communicate further crediting rate changes for some or all participants (or to track yet another account balance) to totally eliminate the remote possibility that some participant might receive an above-market interest credit is not justified. If IRS does not agree with our proposed correction, the final rules must provide clear guidance on the appropriate correction, describing exactly how to apply a third-segment-rate cap to a cumulative "greatest of" calculation performed only at the annuity starting date.

• If either the old or new interest crediting rates (as amended pursuant to the first bullet above) is not a corporate-bond or safe-harbor rate described in § 1.411(b)(5)-1(d)(3) or -1(d)(4) (for example, the old rate is a safe-harbor rate but the new rate is an investment-based rate):

• • The plan is not treated as crediting an above-market rate with respect to any participant who was benefiting under the plan (within the meaning of § 1.410(b)-3(a)) on the original amendment date.

  • The plan must apply a "cumulative third segment rate cap" to any participant who was not benefiting under the plan (within the meaning of § 1.410(b)-3(a)) on the original amendment date. To apply the cap, the plan would track a maximum account balance after 2015, which is applied at the annuity starting date. The maximum balance at the start of the 2016 plan year would equal the greatest of the cash balance account or the protected minimum balances at the end of the 2015 plan year; it would be credited with interest at the third segment rate for 2016 and later years. At the annuity starting date, the participants benefit would equal the greatest of the cash balance account and the protected minimum balances, but not more than the maximum balance.

To satisfy the anti-backloading requirements of Code Section 411(b)(1), some cash balance plans provide for a rolling cumulative floor rate determined over a fixed, multi-year period. These designs were expressly approved by IRS during the determination letter review process following the IRS moratorium on cash balance plan determination letters.

For example, a calendar-year cash balance plan with age-graded cash balance credits using 5-year age bands might provide that the interest crediting rate for a plan year is the greater of (1) the 30-year Treasury Constant Maturity rate for November preceding the plan year or (2) the rate that, when compounded with the five prior years' crediting rates, produces a total compound interest credit for the six-year period of 25%. The table on the next page shows the prior November 30-year Treasury rates for the 2009-2014 plan years. The rolling cumulative floor was not triggered before 2014 because the November 30-year. Treasury rate, compounded over the rolling six-year period, has been at least 25% in each preceding plan year Therefore, the actual crediting rates for 2009-2013 equal the prior November rates shown in the table.

 Plan year                    30-Year Treasury rate for prior November

The market-rate rules allow for an annual floor of 4% in combination with a corporate bond rate described in § 1.411(b)(5)-1(d)(3) or -1(d)(4)(iv), or an annual floor of 5% combined with a safe-harbor rate described in § 1.411(b)(5)-1(d)(4)(ii) or (iii). They also allow for a cumulative floor of 3% in combination with any rate described in § 1.411(b)(5)-1(d)(3), (4), or (5), that is applied over the "guarantee period." But the rules are unclear whether the guarantee period can be a rolling fixed period, and if so, what constraints may apply to that period. (A fixed guarantee period of one year or less is apparently prohibited, since this would conflict with the provisions of § 1.411(b)(5)-1(d)(6)(ii).) Furthermore, the final rules for annual and cumulative floors are inconsistent when combined with bond-based rates described in paragraphs (d)(3) and (d)(4). If a plan can have an annual floor of 4% or 5% in combination with a bond-based rate, there is no reason to limit a fixed cumulative floor rate to 3%, given that a cumulative floor will produce the same or lower account balance than an annual floor using the same fixed rate applied over the same period. Finally, it is unclear whether, and if so how, such plans should apply the correction for a "bond-based rate with fixed minimum rate exceeding maximum permitted fixed minimum rate. Must the rolling cumulative floor be reduced to 3%? For example, suppose a plan credits the 30-year Treasury rate subject to a rolling six-year cumulative floor of 26.5% (4% compounded for six years). Must the plan reduce the rolling cumulative floor to 19.4% (3% compounded for six years), even though the plan could have provided an annual floor of 4%?

Proposed solution

The final rules should explicitly permit rolling cumulative floor rates determined over a fixed, multi-year period in combination with corporate-bond or safe-harbor rates described in § 1.411(b)(5)-1(d)(3) or (4), provided the cumulative floor does not exceed the maximum permissible annual floor rate compounded over the fixed period. In the example above, a 30-year Treasury rate may be combined with an annual floor rate up to 5%. A rolling cumulative floor of 25% determined over a six-year period should be permissible since it is less than the 5% maximum permissible annual floor rate compounded over the fixed six-year period (1.05⁶ - 1 = 34%).

Plans with rolling cumulative floor rates in excess of the maximum permissible rate should have anti-cutback relief for plan amendments reducing the cumulative floor to the maximum permissible annual floor rate compounded over the rolling period. Requiring such plans to reduce the cumulative floor further (for example, to 3% compounded over the rolling period) will unnecessarily reduce participant benefits.

The final rules should also provide anti-cutback relief for any plan amendment replacing a rolling cumulative floor with an equivalent annual floor. In the example above, a plan amendment replacing the rolling six-year cumulative floor with an annual floor of 3.79% (1.25^1/6 = 1.0379), should be permissible. The annual floor will provide the same or better cumulative interest credit over the applicable period, so the potential adverse impact on participants is minimal.

Actual return on a subset versus total plan assets

The final market-rate rules added a new permissible interest crediting rate: the return on a specified subset of plan assets. Because this option was not previously available, cash balance, variable annuity, or other hybrid plans that credit interest or adjust benefits based on actual asset returns have, to date, used the return on total plan assets. Sponsors of such plans may now wish to move to crediting the return on a specified subset of plan assets to facilitate better matching of plan assets and liabilities, especially for plans that include a mix of traditional fixed annuity benefits and hybrid benefits.

Looking ahead, we can also foresee circumstances in which a plan that ties interest credits or benefit adjustments to the actual return on a subset of plan assets might want to switch to instead use the actual return on total plan assets. For example, a cash balance plan that also includes heritage fixed annuity benefits might initially want to tie the cash balance crediting rate to a specified subset of assets. Over time, as heritage benefits are paid out or annuitized, the subset may become the bulk of plan assets, so there is little difference between returns on the subset and on total plan assets, making the expense of maintaining the subset so its market value remains approximately equal to the associated benefit liabilities disproportionate.

Unless the specified segment and the residual assets are invested identically at all times (in which case, there would be no reason to tie the crediting rate to the subset), there will undoubtedly be some periods when the return on total assets exceeds the return on the subset and vice versa, It is unclear whether this means a plan amendment changing the interest crediting rate from the return on all assets to the return on a subset or vice versa triggers anti-cutback protection under § 1.411(b)(5)-1(e)(3)(i). Arguably it should not, since this change is no different from changing the investment mix of plan assets or the subset used to set the interest crediting rate, which presumably does not trigger 411(d)(6) protection.

Proposed solution

The final rules should confirm that plans do not trigger 411(d)(6) cutback protections merely because they change the interest crediting rate from the return on total plan assets to the return on a specified subset of plan assets, or vice versa.

If the service instead concludes such a change triggers 411(d)(6) protection, at minimum, the final rules should provide anti-cutback relief for plan amendments changing the interest crediting rate from the return on total plan assets to the return on a specified subset of plan assets that are adopted and effective no later than one year after the market-rate rules take effect. The service should also provide permanent anti-cutback relief for plan amendments changing the interest crediting rate from the return on a specified subset of plan assets to the return on total plan assets if, on the valuation date for the plan year in which the amendment is adopted, the liabilities for benefits that are adjusted by reference to the rate of return on the assets within the subset are at least 70% of the plan's total benefit liabilities.

Rounding of interest crediting rates

Some cash balance plans round their interest crediting rates to the nearest multiple of 10 or 25 basis points to simplify participant communication. The market-rate rules are silent on rounding, leaving it unclear whether such rounding is permissible. This is also a consideration for plans crediting the actual return on all or a subset of plan assets: How many decimal places must the used in the rate of return calculation?

Proposed solution

IRS should clarify it is permissible to round to the nearest multiple of 10 or 25 basis points because, over time, the rate will be rounded down as often as it is rounded up and therefore cumulative interest credits are not expected to be above market-rate.

New 'lump sum-based benefit formula' definition

The market-rate rules changed the definition of "lump sum-based benefit formula" without providing any opportunity for comment on the new definition. Specifically, the final rules provide:

• Plans that have continued to perform lump sum whipsaw calculations, rather than eliminating these calculations during the PPA amendment period, (which expired at the end of the 2009 plan year). These plans do not meet the new definition of a lump sum-based benefit formula since there will be times when, depending on the plan's interest crediting rate and 417(e) segment rates, the whipsaw lump sum will exceed the account balance.

• Plans that use fixed annuity conversion factors (such as a factor of 120 to convert the account balance to a monthly single-life annuity at age 65) or fixed annuity conversion assumptions (such as 6% interest and 417(e) mortality). These plans do not meet the new definition of a lump sum-based benefit formula because, under certain capital market conditions, the plan's annuity conversion basis might not be considered "actuarially equivalent (determined using reasonable actuarial assumptions)."

The final regulations also include a special age discrimination rule for plans with indexed benefits, defined as plans that provide "for the periodic adjustment of the participant's accrued benefit . . . by means of the application of a recognized index or methodology. An indexing rate that does not exceed a market rate of return, as defined in paragraph (d) of this section, is deemed to be a recognized index or methodology for purposes of the preceding sentence." It is unclear whether a cash balance plan or PEP that performs whipsaw calculations or that uses fixed annuity conversion factors meets this rule, since the plan indexes the account balance or PEP accumulation -- not the accrued benefit expressed as a lifetime annuity starting at normal retirement age. Cash balance or PEP formulas using fixed conversion factors generally could be restated in a fashion that would meet this rule (that is, define the accrued benefit as the current account balance divided by the fixed annuity factor at normal retirement age, which is then indexed by applying the interest crediting rate). But it is unclear whether this might work for plans that retained whipsaw, because the immediate annuity factor is typically a variable factor (such as one based on 417(e) rates).

Assuming these plans can get past the age-discrimination problem, they face a second concern: annuity whipsaw. Plans that don't have lump sum-based benefit formulas (including indexed plans) must demonstrate that every optional payment form is at least the actuarial equivalent of the accrued lifetime annuity benefit starting at normal retirement age. Few cash balance plans or PEPs currently test the value of non-417(e) forms against the value of the accrued benefit starting at normal retirement age, and they will need to overhaul their administration systems to do so.

Proposed solution

IRS needs to provide explicit guidance on how plans that retained lump sum whipsaw calculations or that use fixed annuity conversion factors should be tested for age discrimination and what additional steps may be required for these plans to fully comply with the final rules. For example, IRS could add an example to the regulations confirming that such a plan satisfies the age discrimination rule for indexed plans. Clarity is critical: one of the key goals of the Pension Protection Act of 2006 was to clarify the age discrimination status of hybrid plans; but the final regulations have opened up a new area of uncertainty for an entire category of hybrid plans.

In addition, IRS needs to provide a pathway for plans currently using fixed annuity conversion factors to become lump sum-based benefit formulas. Plans that are amended to eliminate whipsaw calculations prospectively (with 411(d)(6) protection of whipsaw lump sums for benefits accrued before the effective date) can fit within the new definition because it includes an explicit exception "to the extent the single-sum payment is greater to satisfy the requirements of section 411(d)(6)." But the new definition does not provide a similar exception that would allow plans with fixed annuity conversion factors to come under the new definition by adopting amendments prospectively changing to reasonable actuarial equivalent annuity conversion factors (with 411(d)(6) protection of the fixed factors for benefits accrued before the effective date). Thus, at a minimum, IRS should include a comparable rule disregarding 411(d)(6) protected minimum annuities from the definition of lump-sum based formulas.

If you have any questions or need further information, please contact Paul Strella at (202) 263-3912 or Heidi Rackley at (206) 214-3662.