Hybrid Pension Plans: Tiptoe Through the Tulips

It is time again for firms to consider hybrid plans, such as cash balance plans. However, firms may want to move slowly ' tiptoe through the tulips so to speak (for those old enough to remember Tiny Tim). In October 2010, the Department of the Treasury (Treasury) issued very helpful guidance, but many of the most important issues remain either unanswered or answered only by proposed regulations.

What Was

There was a time when hybrid pension plans, such as cash balance plans, were viewed as the answer to the retirement puzzle. Hybrid plans are defined benefit pension plans that look like defined contribution plans. Firms could explain them to participants in terms of their lump-sum amounts, a concept easily understood and appreciated by employees. As defined benefit plans, they provided the same higher benefit and deduction limits plus PBGC guarantees as traditional final average pay plans, but without the volatility and legacy costs of such plans.

Then the questions began to arise. Did the design satisfy the rules for defined benefit plans? Was the participant entitled to a lump-sum payment greater than the nominal account balance (the “whipsaw” problem)? Was the plan age-discriminatory because younger workers received interest credits for a longer period of time? Did the plan violate age discrimination in converting from a traditional plan to a hybrid plan (the “wear-away” problem)? Did the plan satisfy the accrual rules (i.e., was it improperly backloaded)?

With the questions came employee complaints and litigation. And hybrid plans instead of being a solution became a problem ' sometimes a costly one. Legislative and regulatory attempts to address the issues became tangled with pending litigation and political pressures.

What Is

Finally, in 2006, over 20 years after the first hybrid plan was put in place, the Pension Protection Act of 2006 (PPA) prescribed the rules governing hybrid plans going forward. With respect to the “mess” that went on before, PPA's compromise was to leave it for someone else ' the courts ' to clean up. PPA very specifically says that there should be “no inference” from what PPA allows or requires going forward as to what the prior rules were. PPA also provided in Section 1107 that any changes made to current plans before the end of the 2009 plan year pursuant to the PPA or the implementing regulations would not be subject to the anti-cutback restrictions of Internal Revenue Code (Code) Section 411(d)(6). In essence, sponsors could redesign their hybrid plans as they wished.

In 2007, the Treasury issued proposed regulations. It used the preamble to those proposed regulations to raise numerous questions and possible solutions (2007 questions), mostly with respect to what is a “market rate of return.” At the end of 2009, the Internal Revenue Service (IRS), in response to the end of the PPA Section 1107 period, issued guidance that delayed until the end of the 2010 plan year the deadline for hybrid plans to be amended to address market rate of return and certain other issues. The relief also provided that the amendments, when made, would not be treated as violating the anti-cutback restrictions but only “to the extent they were necessary” to satisfy the statute and the regulations. In essence, sponsors were limited to the minimum necessary changes necessary to comply.

Last October, Treasury issued final regulations (“2010 final regulations”) with respect to items in the 2007 proposed regulations; issued proposed regulations (“2010 proposed regulations”) with respect to the 2007 questions; and used the preamble to the 2010 proposed regulations to ask more questions (“2010 questions”), again mostly about the “market rate of return.” In December, the IRS provided new relief delaying the need to amend until the end of the 2011 plan year with the same “to the extent necessary” anti-cutback relief.

What Will Be

Sometime, probably late in the summer or early in the fall, Treasury will issue final regulations with respect to the 2010 proposed regulations and with respect to as many of the 2010 questions as they feel they can address within the constraints of the administrative process. That guidance hopefully will answer the key open questions, especially with respect to market rate of return. The effective date of those regulations remains a major question that cannot be answered. It does not seem likely that Treasury can get final regulations out before July. The comment period on the proposed regulations closed on Jan. 12, and a hearing on the proposed regulations was scheduled for late January. The issues are difficult and controversial, and employer groups have asked for Treasury to provide an effective date that is no earlier than 12 months after the final regulations are issued to provide sufficient time for analysis and redesign. Because regulations are generally tied to the first day of the plan year, if Treasury grants the request, plan redesign would be first required for the 2013 plan year.

However, Treasury might well feel that making the regulations effective for the 2012 plan year provides sufficient time for plan redesign. The IRS amendment extension, which was developed in conjunction with Treasury, only provided relief until the end of the 2011 plan year. Also, the IRS is requiring that submissions for determination letters in new Cycle A (which runs from Feb. 1, 2011 to Jan. 31, 2012) include hybrid plan amendments.

What to Do

Not to be flip, but the best answer is to call your attorney or consultant, or both. The next step is very plan-specific. It depends on the current plan design and what you want to accomplish with the hybrid plan. Addressed below are some of the reasons you, in consultation with your advisers, may want to wait a little longer before amending the plan.

Market Rate of Return

The Code requires that the plan's “interest crediting rate” be a “market rate of return.” The Treasury has proposed an exclusive list of permissible market rates of return. This list is not just a safe harbor. If your plan's interest crediting rate does not satisfy the list in any respect, the plan will not be qualified and will violate ERISA. Those commenting on the proposed regulation have challenged both the Treasury's authority to prescribe an exclusive list and the policy behind not leaving a “market” rate to be determined by the market. Behind the rhetoric is a wish by plan designers to be able to use higher interest crediting rates, which provide more design flexibility.

If your plan already satisfies the proposed exclusive list (e.g., does not use a fixed crediting rate higher than 5% or does not use a variable rate with a floor higher than 4%), you generally do not have a current problem. (I say “generally” because the interest rate must meet several other conditions as well). Of course, that does not mean you might not want to redesign when the Treasury finally answers what the full range of possibilities are.

Correction of Market Rate of Return

If your plan's market rate of return is outside the exclusive list, the Treasury has made clear that you will be able to correct only “to the extent necessary.” But in its 2010 questions, it has asked for comments on what should be allowed as the “extent necessary.” Assume your plan's interest crediting rate is a variable rate with a fixed floor of 5%. The Treasury's exclusive list currently includes as a permissible market rate a variable rate with a fixed floor of 4%. It also includes a fixed interest crediting rate of 5%. What is the “extent necessary” correction ' drop the fixed floor associated with the variable rate to 4%? Drop the variable rate and keep the fixed rate at 5%? The Treasury will not answer that question until the final regulations are issued. It is also possible that in the final regulations Treasury will raise the permissible floor (with a variable rate) from 4%, raise the permissible flat rate above 5%, or allow a shift to any maximum rate regardless of what rate existed before.

Participant Direction

Some plan sponsors provide participants with flexibility to pick their own interest crediting rate, frequently tied to the choices the participants have in a parallel self-directed 401(k) plan. The Treasury's 2010 questions ask for comments on whether this should be allowed and, if so, with what constraints. As in a 401(k) plan, this design allows each participant to determine his or her own risk tolerance. Until the Treasury issues the final regulations, we will not know whether such a design is permissible and, if so, under what constraints (e.g., not allowing employee stock or brokerage accounts).

Subsidies

PPA allows most hybrid plans to pay out the nominal account balance as the lump sum, thereby finally eliminating the whipsaw issue that caused so much litigation (which sponsors mostly lost). In comments on the 2007 proposed regulations, sponsors asked for guidance on whether alternative forms of benefit payments such as five years of payments or joint and survivor annuities could be based on the nominal account balance rather than the single life annuity at normal retirement age.

The 2010 proposed regulations allow such calculations as long as reasonable actuarial assumptions are used. However, that flexibility does not appear to be available if the plan wants to offer a subsidized early retirement annuity or a subsidized joint and survivor annuity. Such a constraint would limit plan design options and increase administrative cost. We will not know until final regulations are issued whether the Treasury will modify its position.

Conclusion

Because the Treasury has not yet issued final regulations on many key design issues ' and those discussed above are only a few of the more major ones ' it is hard to make final design decisions. Complicating the matter is that we do not know whether design changes will be needed for 2012 or for 2013.

While it may be too early to redesign, it is important that you discuss your individual situation with your advisers because each situation is unique ' just like the tulips.

Stuart A. Sirkin is a Principal, National Technical Resources, for Buck Consultants. He spent over 30 years addressing pension issues for the Labor Department, the IRS, and the PBGC, and was on the staff of the Senate Finance Committee during the enactment of PPA. Mr. Sirkin is a charter member of the American College of Employee Benefit Counsels, and co-chair of the Defined Benefit Subcommittee of the ABA Tax Section's Employee Benefits Committee.

It is time again for firms to consider hybrid plans, such as cash balance plans. However, firms may want to move slowly ' tiptoe through the tulips so to speak (for those old enough to remember Tiny Tim). In October 2010, the Department of the Treasury (Treasury) issued very helpful guidance, but many of the most important issues remain either unanswered or answered only by proposed regulations.

What Was

There was a time when hybrid pension plans, such as cash balance plans, were viewed as the answer to the retirement puzzle. Hybrid plans are defined benefit pension plans that look like defined contribution plans. Firms could explain them to participants in terms of their lump-sum amounts, a concept easily understood and appreciated by employees. As defined benefit plans, they provided the same higher benefit and deduction limits plus PBGC guarantees as traditional final average pay plans, but without the volatility and legacy costs of such plans.

Then the questions began to arise. Did the design satisfy the rules for defined benefit plans? Was the participant entitled to a lump-sum payment greater than the nominal account balance (the “whipsaw” problem)? Was the plan age-discriminatory because younger workers received interest credits for a longer period of time? Did the plan violate age discrimination in converting from a traditional plan to a hybrid plan (the “wear-away” problem)? Did the plan satisfy the accrual rules (i.e., was it improperly backloaded)?

With the questions came employee complaints and litigation. And hybrid plans instead of being a solution became a problem ' sometimes a costly one. Legislative and regulatory attempts to address the issues became tangled with pending litigation and political pressures.

What Is

Finally, in 2006, over 20 years after the first hybrid plan was put in place, the Pension Protection Act of 2006 (PPA) prescribed the rules governing hybrid plans going forward. With respect to the “mess” that went on before, PPA's compromise was to leave it for someone else ' the courts ' to clean up. PPA very specifically says that there should be “no inference” from what PPA allows or requires going forward as to what the prior rules were. PPA also provided in Section 1107 that any changes made to current plans before the end of the 2009 plan year pursuant to the PPA or the implementing regulations would not be subject to the anti-cutback restrictions of Internal Revenue Code (Code) Section 411(d)(6). In essence, sponsors could redesign their hybrid plans as they wished.

In 2007, the Treasury issued proposed regulations. It used the preamble to those proposed regulations to raise numerous questions and possible solutions (2007 questions), mostly with respect to what is a “market rate of return.” At the end of 2009, the Internal Revenue Service (IRS), in response to the end of the PPA Section 1107 period, issued guidance that delayed until the end of the 2010 plan year the deadline for hybrid plans to be amended to address market rate of return and certain other issues. The relief also provided that the amendments, when made, would not be treated as violating the anti-cutback restrictions but only “to the extent they were necessary” to satisfy the statute and the regulations. In essence, sponsors were limited to the minimum necessary changes necessary to comply.

Last October, Treasury issued final regulations (“2010 final regulations”) with respect to items in the 2007 proposed regulations; issued proposed regulations (“2010 proposed regulations”) with respect to the 2007 questions; and used the preamble to the 2010 proposed regulations to ask more questions (“2010 questions”), again mostly about the “market rate of return.” In December, the IRS provided new relief delaying the need to amend until the end of the 2011 plan year with the same “to the extent necessary” anti-cutback relief.

What Will Be

Sometime, probably late in the summer or early in the fall, Treasury will issue final regulations with respect to the 2010 proposed regulations and with respect to as many of the 2010 questions as they feel they can address within the constraints of the administrative process. That guidance hopefully will answer the key open questions, especially with respect to market rate of return. The effective date of those regulations remains a major question that cannot be answered. It does not seem likely that Treasury can get final regulations out before July. The comment period on the proposed regulations closed on Jan. 12, and a hearing on the proposed regulations was scheduled for late January. The issues are difficult and controversial, and employer groups have asked for Treasury to provide an effective date that is no earlier than 12 months after the final regulations are issued to provide sufficient time for analysis and redesign. Because regulations are generally tied to the first day of the plan year, if Treasury grants the request, plan redesign would be first required for the 2013 plan year.

However, Treasury might well feel that making the regulations effective for the 2012 plan year provides sufficient time for plan redesign. The IRS amendment extension, which was developed in conjunction with Treasury, only provided relief until the end of the 2011 plan year. Also, the IRS is requiring that submissions for determination letters in new Cycle A (which runs from Feb. 1, 2011 to Jan. 31, 2012) include hybrid plan amendments.

What to Do

Not to be flip, but the best answer is to call your attorney or consultant, or both. The next step is very plan-specific. It depends on the current plan design and what you want to accomplish with the hybrid plan. Addressed below are some of the reasons you, in consultation with your advisers, may want to wait a little longer before amending the plan.

Market Rate of Return

The Code requires that the plan's “interest crediting rate” be a “market rate of return.” The Treasury has proposed an exclusive list of permissible market rates of return. This list is not just a safe harbor. If your plan's interest crediting rate does not satisfy the list in any respect, the plan will not be qualified and will violate ERISA. Those commenting on the proposed regulation have challenged both the Treasury's authority to prescribe an exclusive list and the policy behind not leaving a “market” rate to be determined by the market. Behind the rhetoric is a wish by plan designers to be able to use higher interest crediting rates, which provide more design flexibility.

If your plan already satisfies the proposed exclusive list (e.g., does not use a fixed crediting rate higher than 5% or does not use a variable rate with a floor higher than 4%), you generally do not have a current problem. (I say “generally” because the interest rate must meet several other conditions as well). Of course, that does not mean you might not want to redesign when the Treasury finally answers what the full range of possibilities are.

Correction of Market Rate of Return

If your plan's market rate of return is outside the exclusive list, the Treasury has made clear that you will be able to correct only “to the extent necessary.” But in its 2010 questions, it has asked for comments on what should be allowed as the “extent necessary.” Assume your plan's interest crediting rate is a variable rate with a fixed floor of 5%. The Treasury's exclusive list currently includes as a permissible market rate a variable rate with a fixed floor of 4%. It also includes a fixed interest crediting rate of 5%. What is the “extent necessary” correction ' drop the fixed floor associated with the variable rate to 4%? Drop the variable rate and keep the fixed rate at 5%? The Treasury will not answer that question until the final regulations are issued. It is also possible that in the final regulations Treasury will raise the permissible floor (with a variable rate) from 4%, raise the permissible flat rate above 5%, or allow a shift to any maximum rate regardless of what rate existed before.

Participant Direction

Some plan sponsors provide participants with flexibility to pick their own interest crediting rate, frequently tied to the choices the participants have in a parallel self-directed 401(k) plan. The Treasury's 2010 questions ask for comments on whether this should be allowed and, if so, with what constraints. As in a 401(k) plan, this design allows each participant to determine his or her own risk tolerance. Until the Treasury issues the final regulations, we will not know whether such a design is permissible and, if so, under what constraints (e.g., not allowing employee stock or brokerage accounts).

Subsidies

PPA allows most hybrid plans to pay out the nominal account balance as the lump sum, thereby finally eliminating the whipsaw issue that caused so much litigation (which sponsors mostly lost). In comments on the 2007 proposed regulations, sponsors asked for guidance on whether alternative forms of benefit payments such as five years of payments or joint and survivor annuities could be based on the nominal account balance rather than the single life annuity at normal retirement age.

The 2010 proposed regulations allow such calculations as long as reasonable actuarial assumptions are used. However, that flexibility does not appear to be available if the plan wants to offer a subsidized early retirement annuity or a subsidized joint and survivor annuity. Such a constraint would limit plan design options and increase administrative cost. We will not know until final regulations are issued whether the Treasury will modify its position.

Conclusion

Because the Treasury has not yet issued final regulations on many key design issues ' and those discussed above are only a few of the more major ones ' it is hard to make final design decisions. Complicating the matter is that we do not know whether design changes will be needed for 2012 or for 2013.

While it may be too early to redesign, it is important that you discuss your individual situation with your advisers because each situation is unique ' just like the tulips.

Stuart A. Sirkin is a Principal, National Technical Resources, for Buck Consultants. He spent over 30 years addressing pension issues for the Labor Department, the IRS, and the PBGC, and was on the staff of the Senate Finance Committee during the enactment of PPA. Mr. Sirkin is a charter member of the American College of Employee Benefit Counsels, and co-chair of the Defined Benefit Subcommittee of the ABA Tax Section's Employee Benefits Committee.