Are ERFs BRFs? (Or, Can I Use Different Interest Credit Rates for HCEs and NHCEs?)

By Tom Finnegan • November 16, 2016 • 0 Comments

Recently, cash balance designs have emerged in which the HCEs of the sponsor receive a lower interest credit rate for their hypothetical accounts than do the NHCEs. This is done frequently as a compromise for sponsors that wish to provide a realistic account return for employees while limiting the guaranteed return for HCEs and the associated risk for the plan sponsor. This design also results in lower projected normal retirement benefits for HCEs, leading to better general test results for a given set of pay credits.

At first glance, this design appears to provide lower benefits for HCEs than NHCEs and gives no suggestion of potential nondiscrimination issues. However, it appears the IRS may believe the design runs afoul of the rules regarding the availability of benefits, rights and features (BRFs). At both the recent Intersector Meeting and the “Ask the Experts” panel at the ASPPA Annual Conference, IRS and Treasury officials made it clear that they see potential discrimination issues with the design.

The questions are as follows:

Is the Early Retirement Factor (ERF) used to convert the Normal Retirement Benefit to an early retirement benefit a separate BRF for each set of factors? And, if the ERFs are in fact BRFs, would the fact that the early retirement benefit under a cash balance plan is inherent in the plan’s benefit formula be sufficient to exempt differing interest credit rates from BRF testing?

The regulations can be read to say that, while the ability to retire at a certain age is a BRF, the amount of benefits payable at each early retirement age is not a BRF; rather, it is to be tested solely through the Most Valuable Benefit portion of the General Test. The other reading is that the Normal Retirement Benefit is tested solely through the General Test but the reduction from NRA to ERA is subject to BRF testing if it is not uniform.

Consider a traditional DB plan that provides a benefit at NRA (65) of 1% of pay times years of service. The earliest retirement age for all participants is age 55. No employees have yet reached age 55. The plan has different ERFs for different groups. HCEs have a reduction of 5% per year for early commencement, and the reduction for NHCEs is 1/15th for each of the first five years and 1/30th for each of the next five years. Under each of these schedules, the earliest retirement date will produce the most valuable benefit and, under each schedule, the benefit payable at age 55 is 50% of the normal retirement benefit. Thus, under most valuable benefit testing, the two schedules will yield the same result.

The first reading of the regulation would say that this is all the testing necessary and the design yields no BRF issues. The other reading says that the two schedules are not equivalent and in fact yield the following benefits: 


The subject was broached at the September 2016 Intersector Meeting (without the above example), and the discussion is summarized below from the Intersector Meeting notes

8. Treating early retirement factors as benefits, rights, and features for nondiscrimination testing — rather than simply reflecting those factors in the average benefits percentage test and in the most valuable accrual rates of the general test — and the resulting serious adverse implications for closed plans and a range of ongoing plan designs.

IRS and Treasury representatives indicated this was not a new position and that benefits, rights, and features testing is necessary because “most valuable” amounts testing looks at just a single age, not the entire schedule of early retirement factors.

Research indicates that IRS has taken this informal position before. Gray Book Question 1992-19 dealt with a plan similar to the one shown in the example above. The IRS concluded that most valuable testing was insufficient as it tested only the most valuable benefit and not necessarily the benefit payable at other ages. 

A recent example can be seen in the preamble to the proposed regulation on closed defined benefit plans issued earlier this year. In the proposed regulation, relief from BRF testing would be given to plans that grandfathered some or all existing participants in the plan’s existing benefit formula while providing a new formula for new participants. The relief applies for the purpose of testing certain BRFs retained by the old formula but not compatible with the new formula. The preamble states:

For example, a conversion to a cash balance plan would be a significant change in the type of benefit formula, so that the special testing rule would apply to facilitate preservation of any subsidized early retirement factors for the employees who continue to benefit under the prior benefit formula.

It is clear from the preamble, then, that the IRS believes the Early Retirement Factors constitute separate BRFs, and BRF testing would not be limited to the ability to commence benefits at a certain age. Otherwise there would be no issue with the conversion to a cash balance plan, as those plans commonly provide more commencement dates than traditional plans.

So how does this affect cash balance plans with differing interest credit rates by group? Early Retirement Factors refer to the formula used to convert a plan’s Normal Retirement Benefit (Accrued Benefit Payable at NRA) to an Early Retirement Benefit. In a cash balance plan, the Normal Retirement Benefit is the current account balance projected to NRA with the plan’s interest credit rate and divided by an annuity purchase rate (APR) at NRA. The Early Retirement Benefit is normally the account balance at ERA divided by an APR at ERA. To convert from NRB to ERB at age 55, the formula is:

NRB x (APR65 /APR55) / ((1+ IC Rate)^10) = ERB so the ERF is
ERF = (APR65 / APR55) / ((1+IC Rate)^10)

As a result, the smaller the IC Rate, the larger the ERF and the larger the ERB in relation to the NRB. If this results in separate BRF testing, providing a lower interest credit rate to HCEs than NHCEs would result in the better ERF associated with the lower rate being provided only to HCEs, and the group to whom the BRF is available being discriminatory.

Of course, cash balance early retirement structures are much different than those for traditional plans. In traditional plans the age 65 benefit is described and factors to convert the NRB to ERB are stated or described; while in cash balance plans the ERB is a direct and necessary consequence of the plan benefit formula. (It should be noted that in a cash balance plan, the IC Rate is an inherent part of the Normal Retirement Benefit formula). The BRF regulations provide that differences in benefits attributable to different Normal Retirement Benefit formulas do not create separate BRFs:

1.401(a)(4)-4(e)(1)(ii)(A) Differences in benefit formula or accrual method. A distribution alternative available under a defined benefit plan does not fail to be a single optional form of benefit merely because the benefit formulas, accrual methods, or other factors (including service-computation methods and definitions of compensation) underlying, or the manner in which employees vest in, the accrued benefit that is paid in the form of the distribution alternative are different for different employees to whom the distribution alternative is available. Notwithstanding the foregoing, differences in the normal retirement ages of employees or in the form in which the accrued benefit of employees is payable at normal retirement age under a plan are taken into account in determining whether a distribution alternative constitutes one or more optional forms of benefit.

In the “Ask the Experts” session at the 2016 ASPPA Annual Conference, the IRS was asked this question: 

Q3 Cash Balance Plans with Multiple Formulas

A cash balance plan provides for immediate commencement upon termination of employment with the distribution actuarially equivalent to the current theoretical balance. The plan further provides HCEs with a pay credit of $50,000 and all other employees with a pay credit of 5% of pay. For HCEs the Interest Credit Rate is 4% and for NHCEs the interest credit rate is 5%. Gray Book Q&A 1992-19 could be interpreted to treat the resulting implicit early retirement reductions as separate BRFs and, since the reduction for HCEs is less than the reduction for NHCEs, find the arrangement discriminatory. However 1992-19 dealt with a traditional plan. In this circumstance, under a cash balance plan, the accumulation at ERD is the direct result of the benefit formula and appears to meet the exception under 1.401(a)(4)-4(e)(1)(ii)(A). Would the ability to take distributions at termination of employment be considered a single BRF?


The IRS responded to the effect that the exception for differing benefit formulas applies only to differences in the benefit payable at NRA not to differences in the factors used to convert the NRB to ERB. Thus, for purposes of BRF testing, a cash balance plan must examine the effective ERFs derived from projecting the accumulation forward to derive the NRB and back to determine the ERB. To the extent the implicit factors differ for different groups, these are separate BRFs and each must be tested to ensure it is available to a nondiscriminatory classification of employees.

The IRS emphasized that the Gray Book and their answers at conference sessions do not constitute formal guidance and cannot be relied on as precedent. It should be noted that an example in the preamble to a proposed regulation also does not constitute guidance.

From a practitioner standpoint, while this is not formal guidance and a court may or may not agree with the IRS position, it should raise a flag of caution for those contemplating these designs.

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