By Phil Kushin
March 17 --The chilly atmosphere for the nation's beleaguered defined benefit retirement system will get even colder if the federal government fails to find a way to help plan sponsors that have closed their plans to new hires out of a conundrum that will prompt many of them to completely freeze all employees out of the plans, business and employee benefit groups and employers said in comment letters to the Internal Revenue Service.
If the IRS doesn't change some of the tax code's nondiscrimination rules, sponsors that have closed plans, or put them under a “soft freeze,” many of these sponsors are likely to decide to cease benefit accruals for all participants to avoid running afoul of those rules, commenters said in their letters.
The commenters were responding to IRS Notice 2014-5, issued in December, which provided a temporary reprieve for closed plans from some nondiscrimination rules and offered suggestions for more permanent solutions (240 PBD, 12/16/13; 40 BPR 2857, 12/17/13). The comment deadline was Feb. 28.
The American Benefits Council said it worked with consulting firms on a survey to determine the scope of the problem and that incomplete data from just four firms suggested 650,000 participants are potentially affected by these problems.
“With full data, we suspect that the number of participants at risk by reason of this issue is well into the millions,” the Washington-based group said in its letter.
As described by the commenters, as well as the IRS in the notice, the conundrum is this: For various business reasons, many plan sponsors have sought to move from defined benefit to defined contribution plans. Many seek to continue providing the same benefits to employees already in the defined benefit plan, so they close it to new hires but continue to allow existing employees to accrue benefits. However, with no new participants flowing into the plan, higher attrition rates for nonhighly compensated employees and pay increases that turn some of them into highly compensated employees mean that eventually, the plan might very well run afoul of the tax code's nondiscrimination rules.
While plan sponsors have several options for dealing with this, the road most likely chosen will be to put a “hard freeze” on the plan, thereby preventing existing participants--more likely to be midcareer or older employees--from accruing more benefits, commenters said. This will particularly harm the older, longer-term participants because of the nature of the defined benefit system they will be moving from and of the defined contribution system that many of them will be moving into, they said.
Completely freezing a plan “is a very unfortunate result” for defined benefit plan participants “who can lose the most beneficial years of pension plan participation,” ABC said. “In fact, by losing such beneficial years, older, longer service participants could experience 'the worst of both worlds' by also not benefiting from higher” defined contribution plan allocations “earlier in their career that they would have received had the higher allocations been in effect earlier,” it said.
Towers Watson said that “forcing plan sponsors to cease” traditional defined benefit accruals for midcareer employees “will mean that such employees will typically do worse than both the participants who retired under the pre-existing traditional plan formula and new hires who might be covered by an equivalent” defined contribution formula for their entire career.
In Notice 2014-5, the IRS said that over time, the demographic forces that result in increasing proportions of highly compensated employees in a closed plan often result in the employer having to aggregate the plan with a defined contribution plan that covers new hires to meet nondiscrimination rules under tax code sections 410(b) and 401(a)(4).
“In the typical case,” the agency said, “the aggregated plans will fail the requirements” of Section 401(a)(4) “unless they are permitted to demonstrate compliance with the nondiscrimination requirements on the basis of equivalent benefits.”
To be permitted to demonstrate compliance on this basis, aggregated plans can meet any of three conditions, including being primarily defined benefit in character, consisting of broadly available separate plans or meeting the minimum aggregate allocation gateway.
But as time goes on, the IRS said, those same demographic forces cause trouble again, further increasing the proportion of highly compensated employees, meaning that eventually, the plans often are left with only one option: meeting the minimum aggregate allocation gateway.
Defined contributions plans, however, often can't meet this test, at which point plan sponsors face a choice of reducing the proportion of highly compensated employees in the closed defined benefit plan, reconfiguring contributions in the defined contribution plan so they meet the gateway or completely closing the plan.
Often, employers will choose the latter option, the IRS and the comment letters said.
Black Hills Corp., a Rapid City, S.D.-based energy company, said that might eventually be the choice it makes.
“We fear our only option to remain compliant will be to completely freeze all defined benefit plan accruals, leaving many employees with lower retirement benefits as they are caught in the DB to DC transition,” the company said.
In the notice, the IRS provided temporary regulatory relief for frozen plans, allowing them to demonstrate compliance with nondiscrimination rules on the basis of equivalent benefits through 2015 as long as they were eligible to do so in 2013, “while possible regulatory changes to the nondiscrimination rules are being considered.”
The agency put forth several ideas for such changes, offering alternative standards for whether aggregated plans could be tested on the basis of equivalent benefits, as well as modifications to rules regarding plan benefits, rights and features and the treatment of defined contribution plan matching contributions.
Commenters generally said the temporary relief was welcome. Not so for the ideas for more permanent changes.
“We are concerned that there would be relatively few plans that could satisfy the proposed requirements,” the ERISA Industry Committee said.
ERIC said that Aon Hewitt examined the impact of the IRS's ideas on closed plans and found that only 11 percent of such plans would benefit from any of the four alternative standards for being allowed to be tested on the basis of equivalent benefits, and that only 39 percent would benefit if all of the proposals were combined.
ABC said that its own survey found that these alternative standards would help some plans, but that “we would not expect any of the solutions in the Notice to prevent hundreds of thousands of participants from losing benefits by reason of the nondiscrimination rules.”
The most frequently sought changes to the nondiscrimination rules revolved around the idea that if a defined benefit plan met the requirements when it closed to new hires, it should be deemed to be in compliance going forward as long as the plan sponsor didn't change the terms of the plan in a way that would discriminate in favor of highly compensated employees.
Some commenters focused on making this change so plans could continue to be eligible to test for nondiscrimination on the basis of equivalent benefits.
The National Association of Manufacturers said that “this solution would address manufacturers' concerns that over time, their soft frozen plans may inadvertently violate the nondiscrimination rules, eliminating the likely scenario that the company would need to completely freeze the plan to avoid tripping the test.”
The IRS expressed concerns in the notice that this approach, by applying a lower nondiscrimination standard to frozen plans than to others that must be aggregated to meet nondiscrimination rules--such as those involved in mergers or acquisitions--would “provide an incentive” to completely close defined benefit plans or to be “used inappropriately to increase benefits” for highly compensated employees or reduce benefits for nonhighly compensated workers.
Towers Watson said that plan sponsors close defined benefit plans for business reasons, such as competitive conditions, risk management and financial statement volatility, “and when those decisions are made the choice is between a full freeze and grandfathering some or all current participants.”
“We do not believe that the availability of relief will affect whether plans close,” the consulting group said. “Conversely, we have seen that the inability of closed plans to satisfy nondiscrimination testing will cause closed plans to become frozen plans. As a result, we do not believe that concerns about non-closed plans should preclude granting effective relief directly to plans that are closed,” it said.
Some of the commenters said that the idea of deeming plans to be in compliance if they met nondiscrimination rules when they closed should also be applied to the benefits, rights and features (BRF) test under Treasury Regulations §1.401(a)(4)-4.
In the notice, the IRS asked for comments on the idea of modifying the rules so that if a defined benefit plan had two or more benefit formulas, one of which applied to “a closed group of participants,” the benefits, right and features of that formula wouldn't prevent the plan from complying with §1.401(a)(4)-4.
Among those pushing this concept was MeadWestvaco Corp., a Richmond, Va.-based global packaging company. The company, which has a defined benefit plan with more than 23,000 participants, including more than 4,000 active employees, said it converted its plan formula to a cash balance formula effective in 2008. However, it allowed employees who entered the plan before 2007 and were age 40 or older by the end of 2007 to choose between the new benefit formula and the one under which they had previously been accruing benefits, the company said.
“This choice was designed to preserve expectations of those closest to retirement, and was informed by a public policy in favor of protecting older workers,” according to the company, which said that 90 percent of the 3,313 employees who were offered the opportunity to remain under the old formula choose to do so.
MeadWestvaco said, however, that this aging group is putting the plan “at risk of failing” the benefits, rights and features test “in the very near future,” possibly this year. The company said that if the rules aren't changed to provide relief in this area, it would either move all employees to the cash balance formula or eliminate the pre-conversion benefits, rights and features.
“Each alternative is inconsistent with the choice previously offered, and would result in a group of employees close to retirement (everyone in the group is at least 46 years old) losing valuable benefits,” MeadWestvaco said.
ERIC said that the benefits, rights and features rules are a “significant problem” for many plans that have converted to a cash balance or other hybrid plan, particularly with respect to early retirement subsidies available to participants in the traditional defined benefit plan, as some workers in the hybrid plan might not be eligible for such subsidies. The group urged the IRS “to permit employers to manage their longer service workers effectively and exempt early retirement subsidies from the rules” for benefits, rights and features.
Groom Law Group said that regulations allow retroactive amendments to remedy BRF testing failures by permitting plans to extend the benefits, rights and features to more nonhighly compensated employees or by eliminating the BRFs, but that “these draconian solutions do not make sense here.”
“What remains, therefore, is a real risk that plan sponsors will avoid this issue altogether by implementing a hard freeze--ceasing all accruals under the traditional benefit formula--if relief is not granted. This benefits no one,” Groom said.
Groom said that allowing relief on benefits, rights and features testing would be consistent with nondiscrimination rules for plan mergers. ERIC made the same point.
The Treasury Department and the IRS “have recognized that relief from the nondiscrimination rules for BRFs is appropriate in certain circumstances, such as after a merger or acquisition,” it said. “ERIC requests the Agencies provide treatment for BRFs similar to that provided for mergers and acquisitions.”
Presently, nondiscrimination rules don't allow employer matching contributions in defined contribution plans to be counted for purposes of the minimum allocation aggregate gateway or the nondiscrimination in amount test.
In the notice, the IRS raised the idea of allowing the use of matching contributions, and commenters agreed with that idea.
The groups and companies said that, without being able to count matching contributions, defined contribution plans rarely can meet the requirements for minimum aggregate normal allocation rates under the minimum allocation aggregate gateway, which they said often require a 7.5 percent allocation rate.
That is an “above-market retirement benefit” for defined contribution plans in many industries, and providing it to all nonhighly compensated employees “is not feasible in many instances,” the American Academy of Actuaries said.
“Plan sponsors that do provide contributions of at least 7.5% often do so in the form” of a match, “to encourage employees to save,” the academy said.
The academy said matching contributions should also be allowed to be counted in satisfying other nondiscrimination in amount tests as well.
Allowing the match to be included will “provide an incentive for employers to ensure” non-highly compensated employees “receive match levels sufficient to pass the tests,” the actuaries group said. “Matching contributions have become extremely prevalent, and we believe that they are an essential tool in encouraging participants relying on account-based plans to save enough for retirement. As such, they should be included in full and treated in the same manner as non-elective contributions,” it said.
The academy and others also said employer contributions to Section 403(b) plans and employee stock ownership plans should be taken into account with regards to the average benefit percentage test, as well as for coverage and amounts testing and the cross-testing gateways.
“This change would be helpful to hospital systems, universities and other organizations that sponsor §403(b) plans as well as the many organizations that maintain ESOPs,” Towers Watson said.
Lumping the issue of matching contributions and contributions to 403(b) plans and ESOPs together, ABC said that “even if the DB/DC plan qualifies for combined testing on a benefits basis, the plan will fail the testing requirements not because benefits are discriminatory but simply because some benefits--matching, ESOP, and 403(b) contributions--cannot be taken into account. This is not fair or appropriate.”
To contact the reporter on this story: Phil Kushin in Washington at email@example.com
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The comment letters are at: American Benefits Council, http://op.bna.com/pen.nsf/r?Open=pkun-9ha8g9; Towers Watson, http://op.bna.com/pen.nsf/r?Open=pkun-9ha8dh; Black Hills Corp., http://op.bna.com/pen.nsf/r?Open=pkun-9ha8gp; ERISA Industry Committee, http://op.bna.com/pen.nsf/r?Open=pkun-9ha8cb; National Association of Manufacturers, http://op.bna.com/pen.nsf/r?Open=pkun-9ha8jg; MeadWestvaco Corp., http://op.bna.com/pen.nsf/r?Open=pkun-9ha8j5; Groom Law Group, http://op.bna.com/pen.nsf/r?Open=pkun-9ha8hm; American Academy of Actuaries, http://op.bna.com/pen.nsf/r?Open=pkun-9ha8ff.
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