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IRS Issues Guidance on Market Rate of Return Limitation Rules and PEPs

The IRS on Nov. 4 issued Notice 2016-67, which describes the applicability of the market rate of return limitation rules to a defined benefit plan that expresses a participant’s accumulated benefit as the current value of an accumulated percentage of the participant’s final average compensation, highest average compensation or highest average compensation during a limited period — often referred to as a pension equity plan (PEP).

Specifically, the notice addresses the application of the market rate of return limitation of Code Section 411(b)(5)(B)(i) and Treas. Reg. §1.411(b)(5)-1(d) to a type of PEP — often referred to as an implicit interest PEP — that applies a deferred annuity factor to the participant’s accumulated benefit in order to determine deferred benefits. The notice also requests comments on potential proposed regulations that would subject implicit interest PEPs to the market rate of return limitation.

Notice 2016-67 will be published in the Internal Revenue Bulletin of Nov. 21, IRB 2016-47.

Application of Existing Regulations

Under an explicit interest PEP, because the accumulated benefit is adjusted with interest credits to determine the benefit payable at annuity starting dates after principal credits cease, those interest credits are subject to the market rate of return limitation rules of Section 411(b)(5)(B)(i) and Treas. Reg. §1.411(b)(5)-1(d).

Thus, says the IRS, any amendments necessary to bring the interest crediting rate into compliance with the market rate of return limitation rules under the hybrid plan regulations must be made by the applicable deadline in Treas. Reg. §1.411(b)(5)-1(e)(3)(vi)(B)(3), generally before the beginning of the first plan year that begins on or after Jan. 1, 2017, in order for the amendments to be eligible for the exception from Code Section 411(d)(6).

However, under an implicit interest PEP, the preretirement interest that is implicit in applying a deferred annuity factor to the accumulated benefit is not included in the definition of an interest credit under Treas. Reg. §1.411(b)(5)-1(d)(1)(ii)(A). Thus, under the hybrid plan regulations, it is not required to amend the deferred annuity factors under an implicit interest PEP in order to reduce the preretirement interest implicit in those factors to a rate that does not exceed a market rate of return, and the exception from Code Section 411(d)(6) under the transition regulations does not apply to such an amendment.

The IRS says that due to uncertainty concerning whether the market rate of return limitation rules under Treas. Reg. §1.411(b)(5)-1(d) apply to implicit interest PEPs, some plan sponsors of implicit interest PEPs might have believed that the preretirement interest implicit in a deferred annuity factor was subject to the market rate of return limitation rules under Treas. Reg. §1.411(b)(5)-1(d). As a result, the IRS says, some plan sponsors might already have adopted plan amendments to reduce that interest in accordance with the transition regulations rules that apply to amendments reducing interest crediting rates that exceed a market rate of return.

More to Come?

The Treasury Department and the IRS are considering whether to propose amendments to the hybrid plan regulations that would subject implicit preretirement interest to the market rate of return limitation. The IRS seeks comments regarding whether it should propose such a rule. Comments should take into account the statutory intent of Code Section 411(b)(5) to subject interest credits and equivalent amounts to a market rate of return limitation, as well as the difference between interest credits and the interest implicit in deferred annuity factors.

The Treasury Department and the IRS also seek comments regarding corrections that would appropriately restore benefits that have been reduced by an amendment that was adopted to change a plan’s deferred annuity factors in order to reduce the interest implicit in those factors to a market rate of return.