Frozen plan update

May 27, 2016

In January 2016, IRS published a proposed regulation addressing the issue of the application of Tax Code nondiscrimination rules to frozen DB plans. In April 2016, IRS announced its intention to withdraw certain provisions from that proposal.

In this article we discuss the provisions of IRS proposal applicable to frozen plans and some issues under it that have been identified as problematic. In this article our aim is to provide a reasonably thorough treatment of the issue (although some simplification is inevitable). The material is, unfortunately, very dense; but for sponsors of frozen DB plans (and of plans with closed groups), the issue discussed is of some significance.

We begin with background on the issue.

The frozen plan/closed group issue

While it often comes up in connection with plan freezes, it’s probably more accurate to describe this as the ‘closed group’ issue. Consider several fact situations:

A sponsor amends its DB plan to exclude all new employees; ‘old’ participants (those employed at the time of the amendment) continue to participate in the DB plan. This is sometimes called a ‘soft freeze.’

A sponsor amends its DB plan to terminate all future accruals for all participants (a “hard freeze”) and establishes a new defined contribution plan under which additional ‘make whole’ contributions are made for former participants in the DB plan.

Company A, sponsor of Plan A, merges with Company B, sponsor of Plan B; ‘old’ Company B employees continue to participate in Plan B, but all new employees participate in Plan A.

A sponsor converts its traditional DB plan to a cash balance plan; ‘old’ participants (those employed at the time of the conversion) continue to accrue benefits under the ‘old’ formula.

A sponsor amends its DB plan accrual formula, effectively reducing future accruals; ‘old’ participants (those employed at the time of the amendment) continue to accrue benefits under the ‘old’ formula.

There are, obviously, many variations here. For instance, in connection with a ‘soft freeze,’ the sponsor may (or may not) establish a new DC plan in which new employees participate. In connection with a cash balance plan conversion, only some ‘old’ participants (those meeting certain age and service criteria) may get the ‘old’ formula, or instead of getting the ‘old’ formula they may get additional credits under the new cash balance formula. Plan amendments may not directly affect the benefit formula but only change a ‘right or feature,’ such as a subsidized early retirement benefit or subsidized payment option.

In each of these cases, a closed group of ‘old’ (that is, pre-freeze/amendment/conversion) participants is created that is getting a different benefit (or a different ‘right or feature’) than those not in the group (typically new employees). Over time this ‘old’ group with better benefits may generate a problem under Tax Code nondiscrimination rules.

Tax Code nondiscrimination rules

The Tax Code and related regulations contain elaborate rules generally intended to prevent plans from discriminating in favor of “highly compensated employees” (HCEs). A closed group may create a problem under those rules in the situations described above because, over time, the number of HCEs in it will, relative to the number of non-highly compensated employees (NHCEs), increase: some NHCEs will, after a pay raise or a promotion, become HCEs; others will terminate (there is generally more turnover among NHCEs than HCEs).

The simplest version of this problem occurs in connection with the first example, a straightforward ‘soft freeze.’ The plan is amended to exclude all new employees. At the time of the amendment, the group covered by the plan is nondiscriminatory – that is, more or less, the proportion of HCEs covered by the plan does not impermissibly exceed the proportion of NHCEs covered. (The rules here are extremely technical; we are going to speak in terms of generalities rather than get into the details of each nondiscrimination test.) Because of pay increases, promotions and terminations, over time the ratio of HCEs to NHCEs in the closed group of ‘old’ participants increases, and at some point that group becomes 'discriminatory.’

Another version of this problem arises when, in connection with a plan amendment or freeze, the sponsor establishes a new plan with the intention of testing the two plans together (on a ‘combined basis’) under the nondiscrimination rules. At some point, because of pay increases, promotions and terminations, (again, under very complicated rules) combined testing will not be allowed because of the increased ratio of HCEs to NHCEs in the “old” plan or other applicable rules.

Similar rules apply where what is being preserved for the closed group is a ‘benefit, right or feature,’ such as a subsidized early retirement benefit or subsidized payment option, resulting in a similar problem for the closed group.

Again, there are a number of variations on each of these issues.

Combined testing/cross-testing – threshold requirement

Where new employees (those frozen out of the DB plan) are covered under an ongoing DC plan, one way to deal with this problem is (as discussed above) to apply the Tax Code nondiscrimination test to both the (frozen) DB plan and the DC plan on a combined basis. Usually this only works if, for purposes of the test, you convert DC contributions to DB benefits (e.g., you project a DC contribution made for a 30 year old to age 65). This is called testing on a ‘benefits basis.'

Current rules allow sponsors to do combined testing on a benefits basis only if the plan(s) meet a threshold requirement, passing one of three tests:

  1. The ‘defined benefit in character’ test.
  2. The ‘broadly available separate plans’ test.
  3. The ‘minimum aggregate allocation gateway’ test.

While (1) and (2) are generally easier for a frozen DB plan to pass than a standalone test, eventually the same problem (identified above) emerges – the grandfathered group becomes discriminatory. Test (3) – the minimum aggregate allocation gateway – is viewed by many sponsors as a non-viable solution. The minimum allocation is often prohibitively expensive, and (for instance) matching contributions in the DC plan generally cannot be taken into account (although the IRS proposal provides some relief with respect to that rule).

Temporary relief

In December 2013, in Notice 2014-5, IRS provided temporary relief for closed/frozen plans. The Notice provides, generally, that (i) if the plan was frozen before December 13, 2013, and (ii) if the DB plan is able to pass nondiscrimination testing for 2013 on a standalone basis or on a combined/benefits basis under threshold test (1) or (2) above then (iii) for the 2014 and 2015 plan years the plan may continue to test on a benefits basis even if it does not pass the threshold test for those years (because of the erosion of the nondiscriminatory character of the closed group). In 2015 this relief was extended to 2016 plan years.

The proposed regulation

The (January 2016) proposed regulation is intended to provide permanent relief for the frozen plan/closed group problem. Summarizing (and leaving out a lot of nuances), under the proposal:

DB plans: A DB plan may provide a grandfathered benefit to a closed group that becomes discriminatory over time if: (1) it was in effect for 5 years before the closure date; (2) its benefit formula/coverage wasn’t significantly changed during the period that begins 5 years before the closure date and ends on the last day of the (current) plan year; and (3) for 5 years after the closure date the plan satisfies the regular nondiscrimination rules. Certain amendments are disregarded for purposes of this rule, e.g., if they don’t increase benefits/coverage and are nondiscriminatory or they extend coverage to an acquired group.

DC plans: A DC plan may provide a ‘defined benefit replacement allocation’ (DBRA) if: (1) it is provided only to a grandfathered group of employees with respect to a closed DB plan; (2) the allocation is reasonably expected to replace benefit accruals under the closed DB plan; (3) the closed DB plan (i) had an age- or service-based benefit formula that generated equivalent normal allocation rates that increased from year to year, (ii) generally satisfied the minimum coverage and nondiscrimination requirements for the plan year preceding the closure date, and (iii) was in effect for the 5-year period ending on the closure date and its benefit formula/coverage wasn’t significantly changed during that period; and (4) for each plan year that begins before the fifth anniversary of the closure date, the grandfathered group satisfies the regular nondiscrimination rules. Again, certain amendments are disregarded for purposes of this rule.

Benefits, rights and features: A benefit, right, or feature under a DB or DC plan may be provided only to a grandfathered group of employees under a closed DB plan if the availability of the benefit, right, or feature isn’t amended after the closure date and:

With respect to a DB plan benefit, right, or feature: (1) the DB plan is the closed DB plan; (2) the benefit, right, or feature wasn’t amended within the 5-year period ending on the closure date; and (3) the closure amendment provided for a ‘significant change’ in the benefit formula (e.g., a cash balance conversion).

With respect to a DC plan benefit, right, or feature: (1) the benefit, right, or feature is a right to a rate of matching contributions provided under the DC plan; (2) that rate is reasonably designed to replace some or all of the benefit accruals under the closed DB plan; (3) the closed DB plan had an age- or service-based benefit formula that generated equivalent normal allocation rates that increased from year to year; and (4) the matching contribution rate is provided in a consistent manner.

Again, certain amendments are disregarded for purposes of this rule.

Other changes to nondiscrimination testing rules

In addition to the proposals discussed above, the proposal includes certain other changes to the nondiscrimination testing rules not limited to the frozen plan issue:

The rules under which any DB/DC plan can satisfy the nondiscrimination in amount requirement on the basis of benefits would be eased, by allowing (subject to limitations) the use of certain average equivalent allocation rates for purposes of satisfying the minimum aggregate allocation gateway test.

The average of actual NHCE matching contributions may to a limited extent (up to 3 percent of compensation) be used under the minimum aggregate allocation gateway test.

Under a new alternative to the minimum aggregate allocation gateway test, a DB/DC plan may be tested on a benefits basis (without, e.g., having to satisfy the minimum aggregate allocation gateway) if it satisfies the nondiscrimination in amount requirement using an interest rate of 6% (rather than the current standard interest rate of between 7.5% and 8.5%.)

Effective date, reliance

The new rule would generally be effective for plan years after publication of a final regulation. For plan years beginning on or after January 1, 2014 and prior to the regulation’s effective date, sponsors (and plans) may rely on the proposal, other than those provisions described above under the subheading “Other changes to nondiscrimination testing rules.”

Issues raised with respect to the IRS proposal

Issues raised by those commenting on the IRS frozen plan/closed group proposal include:

The proposal does not adequately address situations presented by corporate transactions – mergers, acquisitions, sales and spinoffs. For example, a pre-closure acquisition/plan merger would violate the ‘no pre-closure amendment’ rule, and an acquisition during the post-closure 5-year period might trigger a nondiscrimination issue.

The exception for nondiscriminatory amendments is unnecessarily restrictive and would not allow certain amendments that would generally be considered nondiscriminatory.

With respect to grandfathered benefits, rights and features, some have asked for clarification of what a ‘significant change’ in the benefit formula means. Others have suggested the elimination of this requirement. One critical issue: apparently, a ‘significant change’ would not include a ‘soft freeze’ (closing the plan to new entrants).

Relief still needed for minimum participation requirement

One related matter (not strictly a nondiscrimination issue) is that the creation of a closed group may raise an issue under Tax Code section 401(a)(26), the Tax Code minimum participant requirement. Tax Code section 401(a)(26) requires that, generally (and subject to several exceptions), a plan must benefit at least 50 employees or (if less) 40% of all employees. Obviously, attrition will over time reduce the number of employees in the closed group, at some point below 50. The proposal does not address this issue.

* * *

These are, obviously, very technical issues, and IRS’s proposal (and the issues it presents) is dense and at times difficult to follow. Nevertheless, for sponsors of frozen plans, and plans with a closed group, the consequences are significant.

The IRS proposal provides some useful relief, but it may leave out a lot of plans. The most obvious Plan B – if a plan cannot fit within the relief IRS is proposing – is to freeze all accruals with respect to the closed group.

As 2017 approaches, and relief under Notice 2014-15 expires, effected sponsors may want to review the application of the proposal to their plan(s) and whether an alternative should be considered.

October Three Consulting, LLC is a full service actuarial, consulting and technology firm that is a leading force behind the reemergence of defined benefit plans across the country. A primary focus of the consultants at October Three is the design and administration of comprehensive retirement benefits to employees that minimize the financial risks and volatility concerns employers face.

Through effective plan design strategies October Three believes successful financial outcomes are achievable for employers and employees alike. A critical element of those strategies is the ReDB® plan design. The ReDefined Benefit Plan® represents an entirely new, design-based approach to retirement and to the management of both the employer’s and the employee’s financial risk, focusing on maximizing financial efficiency and employee value.

For more information:

233 South Wacker Drive, Suite 8350
Chicago, IL 60606-7147
info@octoberthree.com
Phone: 312-878-2440
Fax: 866-945-9676
Contact Us

 

Share this with your Colleagues:

Latest News:

  • November 2017 Pension Finance Update - Read More
  • Current outlook – November 2017 - Read More
  • Latest SOA analysis shows year-over-year increase in mortality - Read More
  • October 2017 Pension Finance Update - Read More
  • Current pension outlook – October 2017 - Read More
  • Cash Balance Plan Design - Read More
  • ReDefined Benefit Plan™ - Read More