Accrual Rule Refresher

For the 2017 ASPPA Annual Conference, I agreed to do the session on defined benefit topics that were not covered in other sessions. The description of the session indicated that one of the topics that I would cover was the accrual rules.

“Easy enough,” I thought, and did not give it much more thought until I was actually preparing my slides. As it turned out, there were a few issues that I was not 100% clear on. So I called Larry Deutsch, who helped me tune up my understanding on the accrual rules. I decided to write up the high points of our conversation to help any colleagues who needed a refresher — and so that I could refer to it the next time I forget!

All defined benefit plans and cash balance plans must satisfy one of the accrual rules of IRC 411(b)(1):

• The 3% rule
• The fractional rule
• The 133-1/3% rule

The purpose of the accrual rules is to prevent back-loading.

1. How do the accruals rules work when a participant is entitled to the larger or two formulae?

There are several situations when a participant might be entitled to the larger of two formulae. Examples include:

• Cash balance conversions
• Mergers and acquisitions
• Tax reform
• Cash balance with a top heavy minimum

When the accrual rule regulations were first written, they contemplated that the combined result would be subject to the accrual rules. So, it was not acceptable to demonstrate compliance with the accrual rules by demonstrating that each formula separately complied with the accrual rules. 

Then, the top heavy rules of IRC 416 were added to the law. If a defined benefit plan is subject to the top heavy rules and is providing the top heavy minimum in the defined benefit plan, it automatically has two formulae: the regular formula and the top heavy formula. When the regular formula is less than the top heavy accrual, there is an issue when the participant gets to 10 years of top heavy service. It might take several years for the regular formula to catch up to the top heavy minimum. Thus, there might be several years when the participant is not accruing any benefit at all.

Using the 133-1/3 % rule is always an issue when it is possible to accrue zero in a year and potentially any amount greater than zero in a future year. Any positive accrual is greater than 133-1/3% of zero. There would generally not be an issue with the top heavy rules if the plan satisfied the 3% accrual rule or fractional rule because those rules specify a minimum cumulative benefit. The top heavy minimum would generally have the effect of front-loading the benefit, which would be acceptable under the 3% accrual rule or the fractional rule.

Currently, the portion of the 1.411(b)-1 regulation entitled “Special rules for multiple formulas” says that it is reserved, so we have no formal guidance on how to handle the accrual rules when there are multiple formulae. Informally, the IRS has indicated to test each formula separately (in part, because without this escape cash balance plans with top heavy minimums could not comply with the accrual rules).

2. How do the accrual rules work when you set up an opening account balance in a new cash balance plan?

The general consensus is that cash balance plans can only satisfy the accrual rule using the 133-1/3% rule. This is because to use the 3% rule or a fractional rule a plan may consider at maximum a 10-year period of compensation. Career average and cash balance plans typically consider more than 10 years of compensation.

Sometimes, an opening account balance is established to increase the first-year maximum deductible contribution by creating a cushion. If a plan sets up an opening account balance and the first-year pay credit is equal to the second-year pay credit, typically there is no special issue with respect to the accrual rules.

If a plan sets up an opening account balance and sets the second-year pay credit equal to the sum of the opening account balance and the first-year pay credit, an interesting issue is raised with respect to the 133-1/3% rule. The second-year accrual cannot exceed the first-year accrual by more than 33-1/3%, but what is the first-year accrual?

For different purposes, the IRS takes different positions on what the current-year accrual is. For IRC 430, the first-year accrual would be the first-year pay credit. But for IRC 401(a)(4), the IRS takes the position that the first-year accrual would be the sum of the opening account balance and the first-year pay credit. There is no explicit, formal guidance on what the accrual would be for IRC 411 under this circumstance.

One safe approach is to set the opening account balance equal to 25% of the second-year pay credit and the first-year pay credit equal to 75% of the second-year pay credit. This way you generate some cushion, but you are guaranteed that the second-year pay credit does not exceed the first-year pay credit by more than 33-1/3%.

3. How do the accrual rules work when you grant past service in a traditional plan?

The issues with granting past service in a traditional plan are typically easier because you typically can use the fractional rule or 3% rule which provide minimum cumulative benefits. However, similar to the cash balance situation described above, caution needs to be used with past service and the 133-1/3% rule if the accrual rate increases after the first year of the plan.

4. How do the accrual rules work when a cash balance plan has a negative rate of return?

In 2014, the IRS amended 1.411(b)-1(b) and provided that a plan could use a 0% constant interest rate for demonstrating satisfaction with the 133-1/3% accrual rule. (See 1.411(b)-1(b)(2)(ii)(G).) This was necessary because a negative investment return has the effect of making each subsequent year of accrual more valuable because of the shorter discounting period in which to apply the negative investment return. So, if the negative return is high enough (as an absolute value) compared to the discounting period, the 133-1/3% rule would be violated.

5. How do the accrual rules work when a participant is at the Section 415 limit?

For the 3% rule, both the normal retirement benefit and the accrued benefit are limited to the Section 415 limit. So, if a participant is currently at that limit, the benefit is essentially front-loaded and there should not be an issue.

According to the Internal Revenue Manual Chapter 72, plans using the fractional accrual must specify how the IRC 415 limit is applied in calculating the accrued benefit.

• Project, limit, and prorate — Calculate the projected benefit based upon the plan formula and then apply the Section 415 limit. Lastly, apply the fractional proration.
• Project, prorate, and limit — Calculate the projected benefit based upon the plan formula and then apply the proration factor. Lastly, apply the Section 415 limit.

There could be an issue for a plan that needs to satisfy the accrual using the 133-1/3% rule. In determining whether the plan satisfies the 133-1/3% rule, the Section 415 limit is considered. So, if a plan is at the Section 415 limit and there will be a period of no accruals, the 133-1/3 rule will not be satisfied if there are future years where the accrual is greater than zero. This could happen in the case where the entire Section 415 limit is used to setup an opening account balance so that the first-year accrual is zero, assuming that the IRS would not consider the initial account balance as part of the accrual for Section 411(b).

6. How do the accrual rules work in a floor offset plan?

Under Revenue Ruling 76-259, a floor offset plan satisfies the requirements of IRC 411 if the gross benefit satisfies the accrual rules and the offset is the vested equivalent of the profit sharing balance.

Thanks to Larry Deutsch for explaining these issues!

 

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