Among the many significant changes affecting retirement plans in the Pension Protection Act of 2006, the Act provides welcome relief for sponsors of new cash balance plans (as well as certain cash balance plan conversions). The provisions are generally effective prospectively, and they impose certain requirements on plan design.
A cash balance plan is a type of defined benefit plan, referred to as a type of "hybrid" plan under the Act, in which benefits are determined by reference to a hypothetical account balance. The employee's account balance consists of hypothetical annual allocations (commonly called pay credits) and hypothetical earnings (commonly called interest credits). Because of the nature of allocations under a cash balance plan, a pay credit received by a younger participant will generally provide a larger annuity benefit at normal retirement age than that provided for an older participant. As a result, there has been considerable controversy and litigation in recent years regarding whether cash balance plans discriminate based on age.
As a defined benefit plan, a cash balance plan is required to provide benefits in the form of a life annuity beginning at a participant's normal retirement age. If the plan permits benefits to be paid in other forms, such as a lump sum, the minimum present value rules require that the alternative form of benefit not be less than the present value of the life annuity provided under the plan, determined using certain statutorily prescribed interest and mortality assumptions. In 1996, the Internal Revenue Service (IRS) issued proposed guidance on the application of the minimum present value rules to lump-sum distributions. The guidance addresses the interest rate "whipsaw" effect that occurs if the plan uses a higher interest credit rate than the statutory discount rate used to calculate the lump-sum distribution, resulting in a required lump-sum distribution that is greater than the hypothetical account balance. However, the IRS guidance has never been finalized, and the courts have not been uniformly consistent in following the IRS guidance. As a result, plan sponsors have had to deal with uncertainty regarding their plans.
Under the Act, a plan is not treated as violating the age discrimination rules if a participant's accrued benefit is equal to or greater than that of any similarly situated, younger individual who is or could be a participant. For this purpose, an individual is similarly situated if the individual and the participant are (and have always been) identical in every respect (including period of service, compensation, position, date of hire, work history, and any other respect) other than age. The plan is therefore tested by comparing a younger participant's account balance to a similarly situated older participant's account balance; if the older participant's account balance equals or exceeds the younger participant's balance, the age discrimination rules are satisfied.
To satisfy the Act, a cash balance plan must satisfy the new interest credit requirements. That is, the plan must provide that the interest credit for any plan year is not greater than a market rate of return, and the rate must not reduce the aggregate amount of contributions credited to the account. Cash balance plans cannot provide credits based on actual investment returns. A plan can provide for a reasonable minimum guaranteed rate of return or for a rate of return that is equal to the greater of a fixed or variable rate of return. The IRS is expected to issue rules governing the calculation of a market rate of return and for permissible methods of crediting interest to the account (including fixed or variable interest rates). The Act eliminates the so-called "whipsaw" effect by allowing the lump-sum distribution from a hybrid plan to be equal to the hypothetical account balance. This is effective for distributions made after the date of enactment; it provides no relief for the whipsaw problem prior to that time.
If a variable interest rate is used, the plan must provide that, upon termination of the plan, the interest rate used to determine accrued benefits is equal to the average of the rates used under the plan during the prior five-year period. The Act also requires that each employee who has completed at least three years of service be fully vested in the accrued benefit derived from employer contributions. This requirement is effective for plan years beginning in 2008 or later, unless the employer elects earlier application.
If a traditional defined benefit pension plan is converted to a cash balance plan after June 29, 2005, the participant's accrued benefit must be determined in two parts: first, under the terms of the plan in effect before on or before June 29, 2005, and, then, as provided for under the Act after June 29, 2005. The Act, therefore, prohibits the reduction of pre-conversion accrued benefits (often referred to as a "wear-away") under a plan if the conversion occurs after June 29, 2005. For the amount prior to the effective date, the plan must generally credit the account for any early retirement benefit or retirement-type subsidy. However, it is important to note that no inference may be drawn (or relief provided) with respect to earlier conversions.
The Act is generally effective for periods on or after June 29, 2005. However, the provisions relating to minimum value rules for cash balance plans are only effective after the date of enactment. The interest credit and vesting requirements are applicable for plan years beginning after December 31, 2007, although a plan sponsor may elect to have them apply earlier. The provisions relating to cash balance plan conversions apply to those conversions occurring after June 29, 2005, although a plan sponsor may also elect to have the Act apply before and after such date.
Employers now have an approved method for establishing a cash balance plan. Provided the employer is willing to use the required interest crediting method and give full vesting credit after three years of service, a cash balance plan can be an attractive plan design by allowing for greater contributions and retirement savings without the same risks and expense of a traditional defined benefit plan. Also, employers that currently maintain a traditional defined benefit plan that want to convert their plan to a cash balance plan have an approved method for conversion. However, employers who converted their defined benefit plans to cash balance plans on or before June 29, 2005 will not have the same relief. Those employers may want to consider freezing or terminating their current cash balance plan and establishing a new one.