Hybrid Plan Rules Allow Sponsors to Choose Risk Level

The Internal Revenue Service (IRS) has issued final regulations for hybrid retirement plans. According to Jim McHale, a principal in PwC’s retirement practice, based in New York City, the regulations clarify the lump-sum based formula concept and define what kinds of plans are subject to the regulations—cash balance plans, variable annuity plans and pension equity plans. Richard C. Shea, chair of the Employee Benefits & Executive Compensation practice at Covington & Burling LLP, adds that there’s a provision in the statute which says the Treasury can treat plans with similar formulas to cash balance and pension equity plans as hybrid plans. “This may be important to people trying to market different plan designs,” he tells PLANSPONSOR.

But, the main thing the final regulations do is clarify what is meant by “market rate of return” in the hybrid plan statute, which says interest credits for any plan year may not exceed a market rate of return. According to Shea, the simplest thing plan sponsors can do is a fixed interest credit of up to 6%. This was increased from the 5% stated in regulations issued in 2010.

The next simplest thing is to use one of the crediting rates that was listed in IRS Notice 96-8, which offered a list of government bond yields, such as the rate on 30-year Treasuries, and allowed the addition of a certain number of basis points—what the Treasury calls government bonds with margins. Notice 96-8 also allowed the use of rates published by the Pension Benefit Guaranty Corporation (PBGC) for calculating minimum funding requirements for defined benefit plans, as well as consumer price index (CPI)-based rates for certain periods defined in the plan. The final regulations keep this list mostly the same, Shea says.

However, according to a PwC insights article, plan sponsors can use each of the three segment rates used for the minimum funding requirements for defined benefit plans as a permissible interest crediting rate, or the rates adjusted by the MAP-21 and HATFA legislation, which modify the segment rates to fall within a range of the average rates over a 25-year period.

Where the regulations get more complicated, Shea says, is in allowing the use of registered investment companies’ mutual funds or exchange-traded funds (ETFs), such as an S&P 500 or balanced fund. The rules say plan sponsors cannot use industry or sector funds or funds that have leverage in them, and the mutual fund or ETF has to be reasonably expected not to be more volatile than a broad U.S. equity, or similar international equity, market.

Also, just as in the 2010 regulations, hybrid plan sponsors are allowed to credit interest based on the actual return on plan assets. But, while in 2010 the interest rate was required to be based on aggregate plan assets, the final regulations allow plans to credit interest based on the return on a subset of plan assets. Shea explains that if the return on aggregate plan assets was used and the plan invested aggressively, it could be bad for older employees; if the plan invested conservatively, it could be bad for younger employees. Plan sponsors told the Treasury they should be able to segregate and have different asset pools for different participant demographics. The final regulations allow that, but Treasury avoided specifically saying plan sponsors could segregate by age—to avoid anything age discriminatory, Shea speculates. The final regulations mention segregating asset pools by years of service and a couple of other factors.

McHale tells PLANSPONSOR that if plan assets have negative returns, the plans have capital preservation protection, so negative returns cannot be applied to the point that a participant’s balance falls below the aggregate amount of credits to the account. In addition, all DB plans are subject to backloading rules which are designed to keep employers from favoring longer service employees by having accruals go back to the beginning of their career. In a hybrid plan, when plan sponsors test for backloading, they have to do a projection and conversion of the benefit to an annuity. The final regulations allow the use of a 0% return in testing for backloading when the prior year’s return was negative.

“The most interesting part of the regulations to me is [registered investment company funds and return on plan assets] are the only two actual market rates of return in this definition of ‘market rate of return,’” Shea notes. “You can’t go out into the market and get the government bond rates listed” in the final regulations.

“In my view these rules allow employers to dial up or down the risk they want to take in offering employees a pension plan and avoid or reduce some of the risk they would have with traditional defined benefit plans without putting all the risk on employees,” McHale says. “Plan sponsors can now design a plan where liabilities and assets move in tandem. They can completely guarantee returns or have minimums, while participants have the safety net of a capital preservation guarantee and the ability to take an annuity at retirement.” He adds that plan sponsors can decide what is the best of both worlds to them on a continuum of choices.

Shea agrees, and explains, “If I offer a conventional cash balance plan with a fixed interest rate or government bond yield, those behave like traditional plans; the employer is on the hook for funding that, and it takes on the risk of making sure the assets are constantly appreciating. But using rates of return on plan assets or a subset plan assets, or using a mutual fund or ETF, results in less risk for the plan sponsor. Risk is shared with employees.” He adds that there are also situations in which plan sponsors put a floor on returns or subsidize with disability benefits when returns go down, so there’s a range of risk that sponsors can take on. “This is important because a lot of employers are very nervous about offering DB plans because of market and interest rate volatility. Now they have workable rules for dampening that volatility.”

The final regulations go into effect in 2016, so sponsors of existing plans should look to see if they are in compliance with the new interest crediting regulations, McHale says. Plans with an interest crediting rate that is not allowed have until 2016 to be modified. He adds that the regulations allow plans to move to a new formula without having to change past, and without violating anti-cutback rules.

More information about hybrid plans and the final regulations are in PwC’s Insights article.