“Guidance on defined benefit plans is important because under these plans the employer bears the investment risk which results in retirement security not available under a defined contribution plan,” according to stated Treasury Assistant Secretary for Tax Policy Pam Olson.

Age Neutral

Under the proposed rules, the plan must be age-neutral before, after, and during the process of the conversion.   A  Treasury Department press release  explains that means that each employee following a conversion must start with a cash balance account calculated on an age-neutral basis.   “Assuming that is the case, a “wear-away” period, during which cash balance benefits catch up with benefits under the traditional plan would not run afoul of the proposed rules”, according to the release.   The proposed rules include different acceptable approaches for applying benefit accruals under various plan types.

In a cash-balance plan, the employer establishes a hypothetical account for each worker and credits a percentage of pay to it every year. Under that approach, older workers can – and do – end up with less benefit under a cash balance plan than a traditional plan.   However, in a real sense, traditional pension plans also “discriminate” based on age – just in favor of older workers. Benefits in a cash balance plan generally accumulate evenly throughout a career.

Consequently, workers with 20 years to accumulate benefits will fare better than those with just 5….just like participation in a 401(k) plan (for more on how this works, see  What to Watch Out For ).

Not Inherently Age Discriminatory

Contrary to cash balance critic’s stance, the new regulations also conclude that cash-balance plans are not inherently age-discriminatory – so long as pay credits earned by older workers are the same as or better than those earned by younger workers.

In past conversions, some companies have calculated benefits earned by workers under the old plan, and if they were higher than the worker would have earned under the new plan, the worker earned no new benefits until the new formula caught up, the so-called “wear-away.”   However, the new rules would require employers to preserve the present value of any benefits earned under the old plan and require the crediting of interest in a way that would make this temporary “pause” in earning benefits less likely, though not impossible, according to a report in the Washington Post, citing Treasury officials.

Muster Map

In order to pass muster, a converted plan that otherwise would be treated as an eligible cash balance plan must satisfy one of two alternative rules. Under the first option, the converted plan must determine each participant’s benefit as not less than the sum of the participant’s benefits accrued under the traditional defined benefit plan and the cash balance account – an approach that would result in no wear-away period for benefits accrued under the traditional defined benefit plan, according to the proposal.

Alternatively, The IRS says the converted plan must establish each participant’s opening account balance as an amount not less than the actuarial present value of the participant’s prior accrued benefit, using reasonable actuarial assumptions.   The proposed rules note that an interest rate assumption would not be considered reasonable if it increases, directly or indirectly, because of the participant’s attainment of any age.   Now, while this alternative does not preclude the possibility of a wear-away period for some or all the participants in the plan, the IRS says it ensures that the opening account balance of each participant reflects the actuarial value of the prior accrued benefit, determined by using reasonable assumptions.

Any excess in the opening account balance over the present value of a participant’s previously accrued benefit is included as part of the participant’s rate of benefit accrual for the plan year, and thus is tested under section 411(b)(1)(H) along with other pay credits for the year, according to the rules.

Effectively, this second alternative provides that a converted plan will not fail to satisfy section 411(b)(1)(H) if:

• the benefit formula before the conversion satisfies section 411(b)(1)(H),
• the opening account balance is based on actuarial assumptions that are reasonable, and
• the benefit formula after the conversion — including any excess in the opening account balance over the present value of a participant’s previously accrued benefit — satisfies section 411(b)(1)(H).

Whipsaw Note

However, while offering some guidance on the age-based issues of cash balance programs, the proposed rules do not address another critical issue, the so-called  “whipsaw” effect , which causes fluctuations in participants’ benefits as a result of interest rate swings.  

Before these proposed regulations are adopted as final regulations, consideration will be given to written comments (preferably a signed original and eight (8) copies) that are submitted timely to the IRS. Alternatively, taxpayers may submit comments electronically to the IRS Internet site at www.irs.gov/regs 

There will be a 90-day comment period and an IRS hearing on the proposals – scheduled for April 10, 2003, at 10 a.m. in room 4718 of the Internal Revenue Building, 1111 Constitution Avenue NW., Washington, DC.