IRS Notice 2016-67 Provides Guidance on Application of Market Rate of Return Limitation Rules to Pension Equity Plans | Practical Law

IRS Notice 2016-67 Provides Guidance on Application of Market Rate of Return Limitation Rules to Pension Equity Plans | Practical Law

The Internal Revenue Service (IRS) released Notice 2016-67, which discusses the applicability of the market rate of return limitation rules of Code Section 411(b)(5)(B)(i) to implicit interest pension equity plans that apply a deferred annuity factor to the participant's accumulated benefit when determining deferred benefits.

IRS Notice 2016-67 Provides Guidance on Application of Market Rate of Return Limitation Rules to Pension Equity Plans

by Practical Law Employee Benefits & Executive Compensation
Published on 08 Nov 2016 • USA (National/Federal)
The Internal Revenue Service (IRS) released Notice 2016-67, which discusses the applicability of the market rate of return limitation rules of Code Section 411(b)(5)(B)(i) to implicit interest pension equity plans that apply a deferred annuity factor to the participant's accumulated benefit when determining deferred benefits.
On November 4, 2016, the IRS issued IRS Notice 2016-67, which:
  • Discusses the applicability of the market rate of return limitation rules of Code Section 411(b)(5)(B)(i) to implicit interest pension equity plans (PEPs), which apply a deferred annuity factor to the participant's accumulated benefit when determining deferred benefits.
  • Requests comments on whether the IRS should issue proposed regulations that would subject implicit interest PEPs to the market rate of return limitation.

Pension Equity Plans and the Market Rate of Return Limitation Rules

A PEP is a defined benefit plan that expresses a participant's accumulated benefit as the current value of an accumulated percentage of the participant's final average compensation, highest average compensation, or highest average compensation during a limited period of years. PEPs provide a single-sum distribution equal to the accumulated benefit (the current value of an accumulated percentage of the participant's average compensation) at the time principal credits cease.
Under Code Section 411(b)(1)(H), defined benefit plans lose their tax-qualified status if the attainment of any age causes an employee's benefit accrual to cease or reduces an employee's rate of benefit accrual. There are special rules in Code Section 411(b)(5) for PEPs, cash balance plans, and other plans that have a similar effect as a cash balance plan or PEP (for more information on cash balance plans, see Practice Note, Cash Balance Plans). PEPs and cash balance plans are also referred to as hybrid retirement plans.

Age Discrimination Requirements

A defined benefit plan fails to meet the age discrimination requirements of Code Section 411(b)(5)(B) if the plan provides any interest credit (or equivalent amount) for any plan year at a rate greater than a market rate of return.
An interest credit is one of the following adjustments to a participant's accumulated benefit under a statutory benefit formula for hybrid retirement plans, to the extent not conditioned on current service and not made on account of imputed service:
  • Any increase or decrease for a period, under the terms of the plan at the beginning of the period, that is calculated by applying a rate of interest or rate of return (including a rate of increase or decrease under an index) to the participant's accumulated benefit (or portion thereof) as of the beginning of the period.
  • Any other increase for a period, under the terms of the plan at the beginning of the period.
(26 C.F.R. § 1.411(b)(5)-1(d)(1)(ii)(A).)
A principal credit is any increase to a participant's accumulated benefit under a statutory formula for hybrid retirement plans that is not an interest credit (26 C.F.R. § 1.411(b)(5)-1(d)(1)(ii)(D)).

Background

The Pension Protection Act of 2006 (PPA) imposed an age discrimination safe harbor requiring that interest crediting rates cannot be greater than a market rate of return (see Practice Note, Cash Balance Plans: Post-PPA: Age Discrimination Safe Harbor).
In 2010 and 2014, the IRS issued two sets of final regulations on hybrid plans (the final hybrid plan regulations) that implemented the requirements of the PPA (for more information on those regulations, see Legal Update, IRS Issues Final Regulations Providing Guidance on Hybrid Retirement Plans and Proposed Regulations Providing Anti-Cutback Relief).
The final hybrid plan regulations provide a list of interest crediting rates and combinations of rates that do not exceed a market rate of return, as required by Code Section 411(b)(5)(B)(i). The provisions that provide for a list of rates are set out at 26 CFR Sections 1.411(b)(5)-1(d)(1)(iii), (d)(1)(vi), and (d)(6)(i). The regulations also delayed the applicability of date of certain portions of the hybrid plan final regulations from January 1, 2016 to January 1, 2017 (including the interest crediting rates that satisfy the requirement of Code Section 411(b)(5)(B)(i) that a plan not provide an effective date of return in excess of a market rate of return).

Explicit Interest PEPs and Implicit Interest PEPs

As discussed in Notice 2016-67, for annuity starting dates after principal credits cease, PEPs often provide for an increase in the amount of benefits that are payable to reflect the time value of money. This increase can come in two forms, through a PEP that:
  • Explicitly credits interest on the accumulated benefit after principal benefits cease (an explicit interest PEP).
  • Applies a deferred annuity factor to the participant's accumulated benefit as of the date principal credits cease (an implicit interest PEP). Preretirement interest is implicitly reflected in the deferred annuity factor.

Notice 2016-67

Uncertainty Regarding Application of Market Rate of Return Rules

Certain plan sponsors expressed uncertainty as to whether the market rate of return limitation rules under 26 C.F.R. Section 1.411(b)(5)-1(d) of the final hybrid plan regulations apply to implicit interest PEPs. As a result, some plan sponsors of implicit interest PEPs might have believed that the preretirement interest that is implicit in a deferred annuity factor was subject to the market rate of return limitation rules under 26 C.F.R. Section 1.411(b)(5)-1(d). Furthermore, some plan sponsors might have already adopted plan amendments to reduce that interest in accordance with the rules under the transition regulations that apply to amendments reducing interest crediting rates that exceed a market rate of return.

Application of Market Rate of Return Limitation Rules

IRS Notice 2016-67 explains that for an explicit interest PEP, the interest credits that are used to adjust the accumulated benefit to determine the benefit payable at annuity starting dates are subject to the market rate of return limitation rules of Code Section 411(b)(5)(B)(i) and 26 C.F.R. Section 1.411(b)(5)-1(d).
An explicit interest PEP that is amended to bring the interest crediting rate into compliance with the market rate of return limitation rules must be made before January 1, 2017 (the applicable deadline in 26 C.F.R. Section 1.411(b)(5)-1(e)(3)(vi)(B)(3) of the transition regulations) for the amendments to be eligible for the exception in Code Section 411(d)(6) provided in the transition regulations.
For an implicit interest PEP, the preretirement interest that is implicit in applying a deferred annuity factor to the accumulated benefit is not included in the definition of an interest credit under the market rate of return limitation rules (specifically, under 26 C.F.R. Section 1.411(b)(5)-1(d)(1)(ii)(A)); the accumulated benefit remains a constant percentage of average compensation and is not adjusted with interest credits after principal credits cease. Therefore, no amendment is required to the deferred annuity factors under an implicit interest PEP in order to reduce the preretirement interest that is implicit in those factors to a rate that does not exceed a market rate of return. The exception from Section 411(d)(6) under the transition regulations does not apply to such an amendment.

Possible Future Amendments

In Notice 2016-67, the IRS requests comments on whether it should propose amendments to the final hybrid plan regulations that would subject implicit preretirement interest to the market rate of return limitation. The IRS instructs potential commenters that comments should take into account:
  • The statutory intent of Code Section 411(b)(5) to subject interest credits and equivalent amounts to a market rate of return limitation.
  • The difference between interest credits and the interest that is implicit in deferred annuity factors.
If the IRS ultimately adopts final regulations to subject implicit preretirement interest to the market rate of return limitation, it expects that:
  • Plan sponsors will be given an adequate period of time to amend plans to comply with the rule.
  • The final rule will not apply earlier than for plan years that begin on or after January 1, 2018.
  • The exception to Code Section 411(d)(6) provided in the transition regulations will be expanded to cover required changes in the deferred annuity factor made during the period covered by the existing transition regulations and after that period ends but prior to the applicability date of the new final rule. Plan sponsors that have already reduced the implicit interest rate in a PEP to a market rate of return would not have to take further action. However, if the IRS does not adopt a final rule, any amendment that has already been adopted to change a plan's deferred annuity factors would not be eligible for the exception from Code Section 411(d)(6). In such a case, the plan would have to be corrected to the extent that the prior amendment violates Code 411(d)(6) (the IRS would provide guidance relating to permissible corrections).
Comments are due on or before February 21, 2017. The Notice provides instructions for commenters.

Practical Implications

Sponsors of pension equity plans that apply a deferred annuity factor to the participant's accumulated benefit to determine deferred benefits (an implicit interest PEP) should carefully review Notice 2016-67. The Notice clarifies that sponsors of implicit interest PEPs need not amend their plans to reduce the preretirement interest implicit in the deferred annuity factors to a rate that does not exceed a market rate of return. Sponsors of PEPs should also be aware of the comment period and possible future regulatory activity in this area.