Treasury/IRS highlight ‘closed plan’ DB issues in Priority Guidance Plan

On August 9, 2013, the Department of the Treasury and the Internal Revenue Service released the 2013-2014 Priority Guidance Plan – generally setting priorities for the allocation of the resources for the period July 2013-June 2014. The first item under the subheading Employee Benefits/Retirement Benefits was “Guidance on frozen defined benefit plans and related matters.”

In this article we review the ‘frozen DB plan’ issues and proposed solutions.

The closed group

While it often comes up in connection with plan freezes, it’s probably more accurate to describe this as the ‘closed group problem.’ 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’ or a ‘closed’, rather than ‘frozen’ plan.

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 up’ 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 ‘closed’ plan, 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 ‘benefit, 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 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 often more turnover among NHCEs than HCEs).

The simplest version of this problem occurs in connection with the first example, a straightforward ‘closed’ plan. The plan is amended to exclude all new employees. At the time of the amendment, the group covered by the plan is nondiscriminatory – this is true by definition in the case of an amendment that allows all current participants to continue to accrue benefits under the ‘old’ plan; otherwise the ongoing plan would have a nondiscrimination problem even before closing the plan to new entrants. Because of pay increases, promotions and terminations, over time the ratio of HCEs to NHCEs in the closed group of ‘old’ participants is likely to increase, and at some point the closed group may become ‘discriminatory.’

Another version of this problem arises when, in connection with a plan amendment closing the plan to new entrants, the sponsor establishes a ‘new’ DC plan for new employees with the intention of testing the two plans together 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 the closed plan has too few NHCEs.

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.

Minimum participation requirements

Employers that close plans to new entrants may, in some cases, avoid nondiscrimination issues indefinitely. Ultimately, however, all such amendments will become problematic under Tax Code section 401(a)(26), the Tax Code minimum participant requirement. This provision 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.

These are, generally, the issues that have been raised with respect to ‘closed groups,’ some or all of which Treasury/IRS may address in its “Guidance on frozen defined benefit plans and related matters.”

Possible solutions

If IRS does nothing – if current rules do not change – then a sponsor facing a ‘closed group problem’ still has some options. The sponsor can freeze benefits for one or more HCEs in the closed group, thereby reducing the (relative) number of HCEs to NHCEs. It can freeze the plan entirely. Or it may improve benefits for NHCEs not in the closed group in a way that will allow the ‘old’ plan to pass the nondiscrimination test.

For some time, sponsor organizations and some policymakers have been advocating a legislative or regulatory ‘fix’ to the ‘closed group problem.’ Generally, these proposals involve allowing the closed group to continue to pass the nondiscrimination test if it passed the test at the date of the initial event which, of course, it would have had to in order to comply under current law. Recent legislation introduced by Congressman Neal (D-MA) included a provision taking this approach.

There is concern at IRS, however, that such a rule could be abused. For instance, a sponsor could establish a rich DB plan and then close it to new entrants, allowing it to continue for an increasingly discriminatory group of employees.

Treasury/IRS Priority Guidance Plan

It’s our understanding that, in meetings with sponsor representatives, IRS has indicated that it is open to some sort of accommodation of the nondiscrimination rules to the closed group problem, provided the abuse issue can be addressed. Given Congressional gridlock (and thus the unlikelihood of a legislative solution), it’s generally thought the best chance to fix this problem would be action by the IRS. There was concern, however, that other issues (including, e.g., Affordable Care Act issues) would delay agency action.

We will continue to follow this issue.