Mellon Targets Problems in Proposed Regs on Protected Benefits

To: Kinard Pamela R; Marshall Linda S

Mellon's Human Resources and Investor Solutions (Mellon) is pleased to submit these comments on regulations proposed on March 23, 2004 concerning Section 411(d)(6) Protected Benefits (the proposed regulations).

Mellon is a leading global employee benefits and human resources consulting firm that provides consulting, actuarial and administrative assistance to many employers whose defined benefit plans would be impacted by regulations under Section 411(d)(6) of the Code.

In our September 30, 2002 response to IRS Notice 2002-46, we wrote as follows:

We support wholeheartedly the Service's objective of reducing employers' burdens in administering qualified plans, particularly where a plan is required to offer many optional forms of benefit that may be of little value, are redundant or are rarely used.

Complexity is ultimately a burden on plan participants because sponsors are reluctant to take on obligations where the determination of the obligation is difficult and expensive. Instead of integrating employees generously and fairly into a continuing plan of benefits, employers become inclined to terminate all past arrangements and bring acquired employees into their plans only as new employees.

Administrative complexity is readily apparent in the M&A context, but it can occur elsewhere. Past changes in benefits philosophy may have resulted in a proliferation of optional forms.

To encourage the formation and continuation of defined benefit plans, we believe it is important to allow some flexibility for defined benefit plan sponsors to eliminate or change options.

Complexity is not merely, or even primarily, a computer programming problem. Our administrative group has programmed many complex benefit designs and we are confident that we can write computer programs to calculate any pension benefit that comes up in the future. A complex plan is more difficult for employees to navigate, sometimes to the point of discouraging interest in the plan.

A plan with 15 retirement options, for example, provides a challenge to most employees that a plan with three options does not. When faced with too many choices, most people find making any choice to be extremely difficult. And, of course, each additional choice must be communicated accurately and completely and plan administrators must be familiar with each option's nuances.

We are pleased to see that the proposed regulations address our concerns about complexity, and even include some of our specific suggestions. In our comments below, we address areas that remain complex or obscure or that inhibit the formation and continuation of defined benefit plans.

Final regulations should allow for routine updating of actuarial assumptions:

No relief is offered, under the proposed regulations, for plan sponsors that wish to update the actuarial assumptions used to calculate optional forms of benefit. Note that the recently issued regulations on disclosure of optional values will force many plan sponsors to update their assumptions if they are to claim that all their benefit options are actuarially equivalent. If plans are to remain current, a simple mechanism is needed for updating assumptions without creating layers of benefit subject to indefinite protection under Section 411(d)(6). The regulations under Section 417(e) offer a precedent for such a mechanism, and we would be pleased to work with you in developing rules in this area.

Final regulations should liberalize the de minimis rule:

In certain cases, under the proposed regulations, a form of benefit can be eliminated if, among other requirements, the present value of the eliminated form does not exceed the present value of the retained form by more than a de minimis amount. For this purpose, the proposed regulations define the de minimis amount as being no greater than the greater of 2% of the value of the eliminated retirement-type subsidy or 1% of prior year compensation. The 2% rule is so restrictive as to be almost useless. The rule should refer to 2% of the value of the eliminated retirement benefit rather than the eliminated retirement-type subsidy. In the case of terminated vested participants, the 1% of prior-year compensation limit is useless because there is usually no prior year compensation. Instead of referring to prior-year compensation, the final regulations should refer to annualized compensation in the last year for which compensation was paid.

Final regulations should allow for the elimination of joint and survivor annuity benefits with a continuation percentage of less than 50%. The proposed regulations, under the 90-day rule, would not permit a plan to drop all of its contingent annuity benefits with continuation percentages of less than 50%. These benefit options are rarely used, and we see no reason why they should be required to be maintained indefinitely. Furthermore, the proposed regulations would allow the substitution of a 49% continuation percentage for any and all continuation percentages of less than 50%. It would be simpler to require the continuation of a 50% joint and contingent benefit in lieu of all lesser continuation percentages.

Final regulations should allow for the elimination of lump sum benefits after a merger or acquisition after a reasonable transition period. Employers, and society at large, are divided on whether defined benefit plans should pay lump sum benefits (with the exception of de minimis cash outs). An acquiring company that does not pay lump sums has a number of unsatisfactory choices if it acquires a company whose plan does pay lump sums. One choice is, of course, to freeze benefits under the old plan, and bring the acquired employees into its plan as new participants. This is often a bad choice for the acquired employees, especially in a final pay plan. Acquired employees are usually better off if they come into the acquiring Company's plan with credit for their past service with the acquired organization. To encourage this result, we believe it is important for final regulations to allow the lump sum benefit to be phased out over a period no greater than four years following a plan merger where such past service is granted, even if the lump sum applied with respect to more than 25% of the participant's accrued benefit under the prior plan. Although a transition period as long as four years discourages the continuation of defined benefit plans, we believe that, in this instance, employee expectations require a transition period this long.

Final regulations should provide a transition period to eliminate a contingent event benefit. The preamble to the proposed regulations would allow a plan to be amended, before the regulations are finalized, to eliminate contingent event benefits that would otherwise be considered accrued benefits. This is not a sufficient period in many situations, especially if contingent event benefits were negotiated as part of a collective bargaining agreement. We suggest that final regulations stipulate, in the case of contingent event benefits that are in a plan as a result of collective bargaining, that they may be removed by amendment at any time up to 90 days after the end of the bargaining agreement in effect on the date the regulations are published in the Federal Register, but in no event more than three years after such date. In the case of a contingent event benefit that is not the result of collective bargaining, final regulations should allow it to be removed by amendment at any time up to 90 days after the date final regulations are published in the Federal Register.

The proposed regulations are too restrictive in their definition of what constitutes significant burdens or complexities for a plan. ERISA and the Code permit the elimination, under Treasury regulations, of early retirement benefits, retirement-type subsidies, and optional forms of benefit under a plan which create significant burdens or complexities for the plan and its participants, but only if the elimination does not adversely affect the rights of any participant in a more than de minimis manner. It is common for plans to be amended to add benefits that seem like a good idea at the time but turn out to be burdensome and/or rarely used (e.g., a social security leveling option, joint and survivor annuities with pop-up features). Under the proposed guidance, a merger or acquisition might create a presumption of a significant burden sufficient to allow elimination of a benefit. However, emerging experience of a single employer or a change in company management or a simple mistake of judgment would probably not be sufficient to allow for an option's elimination. Final regulations should allow a more expansive standard of what constitutes a significant burden.

Final regulations should not prescribe a 75% joint and contingent benefit as a core benefit. Current regulations allow for the elimination of all qualified joint and survivor benefits provided that the QJSA with the highest continuation percentage and the QJSA with the lowest continuation percentage are continued. Most common practice has been to offer either a 50% continuation or both 50% and 100% continuations. Plans that offer 75% and 66-2/3% continuations have become rare over the years. Proposed regulations would require core benefits to include a 75% joint and survivor benefit in lieu of all other joint and survivor benefits. Nowhere in ERISA or the Code is there any reference to a 75% continuation benefit as being preferable, let alone required in a qualified plan. We know of no reason for Treasury, by regulation, to encourage the offering of a benefit option that is not commonly offered and that is nowhere required by law. We suggest that final regulations define core benefits to either require the 50% continuation or continue the pattern of current regulations and require the continuation of a highest and lowest continuation percentage.

Final regulations should clarify that the simultaneous amendment rule applies retroactively as well as prospectively:

Under current law, when determining whether a participant's accrued benefit has decreased, all amendments with the same applicable amendment date are treated as one amendment. However, there has been litigation on this issue and the courts have not applied the simultaneous amendment rule uniformly. It is not clear from the proposed regulations whether Treasury means to say that the simultaneous amendment rule is intended to apply prospectively only or whether Treasury is affirming that the simultaneous amendment rule applied before the issuance of final regulations. Plan sponsors have relied on the simultaneous amendment rule for many years. A Treasury statement that the rule applied only prospectively would subject sponsors to an unwarranted litigation risk and further discourage plan sponsors from maintaining defined benefit plans. Final regulations should clarify that Treasury is reaffirming its long standing position on the simultaneous amendment rule.

Final regulations should address issues raised under Section 411(d)(6) by indexed annuities:

A few plans index their annuity payments either through automatic COLA provisions or as variable annuities. Under the proposed 90-day rule, indexed annuities appear to be outside any of the six families and, therefore, not subject to complete elimination. Presumably, an indexed annuity could be eliminated after a merger or acquisition under the burdensome rule, but this may be insufficient relief in some cases. One problem is that the new minimum distribution regulations under Section 401(a)(9) prescribe a minimum assumed investment return for variable annuities, which may require the modification or elimination of an optional form. Final regulations should allow the elimination of a form that can no longer be legally provided. Second, a particular index may no longer be available (e.g., the yield rate on newly issued 30-year Treasury bonds) and a substitute must be found. It would be helpful for final regulations to stipulate conditions under which there would be no Section 411(d)(6) violation when one index is substituted for another. This issue is technically complicated and we would be glad to provide our expertise if needed. Third, if after a merger or acquisition, the acquirer wishes to eliminate an indexed annuity option as burdensome, it is by no means obvious how to value the indexed benefit under the de minimis rule. It would be helpful if final regulations provided guidance in this area.

Final regulations should allow for the elimination of rarely used optional forms:

Treasury considered but rejected our proposal to allow the elimination of rarely used optional forms because it could not find a way of determining when an option was rarely used. We hope Treasury reconsiders this decision. Rarely used forms create a continuing burden, even if participants understand them, because administrators may be unfamiliar with the nuances of the form.

An actual case history illustrates the problem. A variable annuity feature was added to a plan in 1969. Under the feature, a retiring participant could elect to have 25%, 50% or 100% of his retirement benefit paid as a variable annuity. The plan defined the assumed investment return as either 0% or 3% at the election of the participant, and the retirement annuity could be invested in a number of funds, again at the choice of the participant. After some initial interest, the variable annuity provision fell into disuse. A retiring senior officer in 2000 researched the plan provisions with unusual thoroughness and demanded payment of a portion of his benefit as a variable annuity. Some of the funds no longer existed, and there were no procedures to handle split benefits or Section 415 issues. The request created technical problems that took months to resolve. A special computer system had to be established merely to handle this one person's benefit. One method of permitting the elimination of rarely used forms, without explicitly defining rarely used, would be to state that elimination of a rarely used form, under either the 90 day or 4-year rule, would be permitted if its maintenance constituted a significant burden, based on all the relevant facts circumstances, as under the de minimis rule.

Final regulations should liberalize the expected transition period as an alternative to the de minimis rule:

As an alternative to the de minimis test, the proposed regulations offer an expected transition rule that provides for a wear-away of subsidized, optional forms of distribution. Participants continue to accrue benefits under the eliminated form until a delayed effective date. We agree with the concept of a delayed effective date, since some mechanism is needed to phase out forms of benefit whose value is greater than the retained benefits by more than a de minimis amount. However, the proposed rule appears to be prohibitively expensive because it requires that the expected transition be determined by disregarding compensation increases and by creating a different delayed effective date for every participant. Ignoring compensation increases defies economic reality. Doing a separate calculation for each individual is problematical for individuals with atypical employment patterns, such as employees on phased retirement or extended leave. Final regulations should allow for the calculation of a single delayed effective date for the plan based on a reasonable sample of employees and a reasonable assumption about future salary growth.

Treasury should issue regulations to address the Supreme Court's decision in Central Laborers Pension Fund v. Heinz.

The proposed regulations reserve on the interaction of the vesting and anti-cutback rules pending resolution of the Heinz case, which was decided by the Supreme Court last month. In a holding that was contrary to the IRS long-standing informal position, the court stated that an amendment that broadened the definition of disqualifying employment for the purpose of suspending benefits was a prohibited cutback. The Court went on to invite Treasury to issue regulations that would enlarge the scope of disqualifying employment. Employers need the flexibility to limit the circumstances under which employees can simultaneously receive pay and pension benefits, and we urge Treasury to issue regulations that affirm the IRS historic position.

We thank you for this opportunity to comment. If you have any questions concerning these comments, you can contact me at (212) 330- 1200, or by mailto:rumack.f.