Using Different Crediting Rates in a Cash Balance Plan
Editor’s Note: The following presents a discussion between Karen Smith and Larry Deutsch about using different crediting rates for different groups of participants in a cash balance plan.
Karen: Hi Larry. I need your help. I am working on drafting a plan document for a brand new cash balance plan where I am using a different interest crediting rates for the HCEs and the NHCEs to help with my 401(a)(4) and 401(a)(26) testing. May I use a 0%, 1% or a fixed negative interest crediting rate for HCEs?
Larry: Let’s take the negative interest crediting rate first. Putting aside the preservation of capital requirement, a negative interest crediting rate would potentially cause you accrual rule problems. Cash balance plans usually use the 133-1/3 accrual rule, which basically says that the rate of accrual in a future year cannot exceed the current year accrual by more than 33-1/3%. As an individual gets older, less negative interest is credited, which increases the accrual as people get older — creating a back-loading issue.
Karen: Okay – what about the very low interest rates?
Larry: Using a very low interest crediting rate may cause a few issues. When you use an interest crediting rate of less than 5%, your post-65 Section 415 limit will be less. Also, in the first few years of the plan, the maximum deductible contribution could be less than the total contribution credit because the interest crediting rate is less than the maximum deductible segment rates.
Karen: Hmm. For now, I am going to stick to 4% for my HCEs. That seems to strike the right balance between my testing issues and the issues associated with a low interest crediting rate. Is the interest crediting rate subject to benefit, right and feature testing?
Larry: The interest crediting rate is part of the benefit formula and is tested as part of your 401(a)(4) test – not a BRF.
Karen: Great. So next, I have been thinking about how to write the actuarial equivalence in my plan document. An easy question first: What do you use for your post-retirement actuarial equivalence assumptions?
Larry: I generally have the post-retirement assumptions tie to the Section 415 limit lump sum assumptions. So, I generally use 5.5% post-retirement interest rate and the applicable mortality table as my post-retirement mortality.
Karen: That’s what I thought. I am going to use no pre-retirement mortality, but I am confused about the pre-retirement interest rate for actuarial equivalence. Does it need to match my interest crediting rate? I have usually drafted my plans so that the pre-retirement interest rate is the same of as my interest crediting rate and now I am not sure what to do.
Larry: I have two answers for that question. One answer is that it does not matter at all. The other answer is that it matters quite a bit.
Karen: That is as clear as mud.
Larry: Well, it depends on how your plan document is written. When a plan offers a lump sum in excess of $5,000, the plan must offer an immediate annuity. If your plan document defines the immediate annuity as the current account balance converted to an annuity, then it really does not matter if the plan’s pre-retirement interest rate and interest crediting rate are the same. Most cash balance plan documents are written this way. But if you have a document that uses old language that defines the immediate annuity as the actuarial equivalent of the account balance projected to the plan’s normal retirement age converted to an annuity, then it matters. In that case, you are projecting forward and discounting back at different rates if your interest crediting rate is different than your pre-retirement interest rate.
Karen: Does it matter other than the immediate annuity? If I don’t mind doing the projection forward and the actuarial reduction for the immediate annuity, do I have a problem? Or, am I creating some type of bigger whipsaw problem?
Larry: It only matters on the immediate annuity, but the immediate annuity impacts your Section 415 limit. If you project forward at a low rate and discount back at a higher rate, when you calculate the immediately payable Section 415 limit, it will be lower. If you project forward at a high rate and discount back at a lower rate, you could create an economic incentive for participants to elect annuities.
Karen: So, is it safer to say that the pre-retirement interest rate is my interest crediting rate, so that either way that I am okay?
Larry: Yes, but you might get a question from an IRS examiner about the different pre-retirement interest rates being a BRF. You may have to explain that the different interest rates are necessary to get back to the immediate annuity back to the same place and that it is not discriminatory. I think you will win that, but it make take some time.
Karen: How do you handle it when a participant switches from NHCE status to HCE status?
Larry: That is a problem that I hope does not happen when I use different interest crediting rates for different groups because you will have a 411(d)(6) issue on the accrued benefit at normal retirement age if the participant’s interest crediting rate goes down. And you could have a 411(d)(6) issue on the immediate annuity if the pre-retirement interest rate goes down.
Karen: Do you think that I could write into my document that a participant’s interest crediting rate is determined when an individual first becomes a participant and does not change even if their classification changes?
Larry: Yes, that would probably work.
Karen: That reminds me. Do you think that cash balance plans that use multiple interest crediting rates will fit on a volume submitter document when they are released? Right now, we are having to word things a little strangely to get the multiple interest crediting rates into the “other” box to draft our documents in an automated fashion.
Larry: I would hope, so since different interest crediting rates for different groups have been contemplated since the proposed regulations, but I don’t know.
Karen: I have spoken to one of our document vendors about this. When I asked if putting different interest crediting rates for different groups in the “other” box would destroy reliance on the IRS pre-approved opinion letter, they said that we would have to wait and see what parameters the IRS puts on us. I guess we will have to wait and see. Switching gears again, you were at the LA APC this year. Right?
Karen: I went to the session with Tom Finnegan and Kevin Donovan on interest crediting rates. Kevin talked about changing the interest crediting rate in an 11g amendment to solve a 401(a)(26) failure. Kevin said that he is concerned that if you raise both the HCE and NHCE interest crediting rate in the same 11g amendment, the 11g requirements will not be satisfied because the HCE benefits will increase more than the NHCE benefits and thus the amendment will be discriminatory. So, if Kevin wants to increase the interest crediting rate for all the participants, he does it in two different amendments: a retroactive 11g amendment for the NHCEs and a separate non-11g amendment for the HCEs in the following year. Do you share that concern?
Larry: Yes, unless all of the HCEs are already at the Section 415 limit, in which case it would not matter — which raises the question of why you would be bothering to increase the interest crediting rate. Most of my plans are very well funded, but if a plan has an AFTAP near 80% and one or more of the HCEs are not at the Section 415 limit, increasing the interest crediting rate for the HCEs could cause your AFTAP to go below 80%.
Karen: Yes, that might be another reason to separate the 11g for NHCEs from the HCE interest crediting rate increase. As always, thanks for your help. I am going to run and get back to plan drafting. Talk to you soon!