3716 / What special qualification requirements apply to defined benefit pension plans?

Limitation on Benefits

A defined benefit plan must contain a limit on the projected “annual benefit” under the plan or under all such plans aggregated if the employer has more than one defined benefit plan
( Q 3868, Q 3719).

Accrued Benefit Requirements

A defined benefit pension plan may not exclude from participation employees who are beyond a specified age, but the benefit of an employee who is within five years of normal retirement age when employment begins is computed using a retirement age that is the fifth anniversary of the time that plan participation begins for that employee.¹ A defined benefit plan must benefit a minimum number or percentage of employees (i.e., the 50/40 test) as explained in Q 3717.

Accrued Benefit Requirements for Not Fully Insured Plans

A defined benefit plan, other than a fully insured plan, must satisfy one of the following three accrued benefit tests:

The 3 percent test. The accrued benefit to which a participant is entitled upon separation from service must be not less than 3 percent of the normal retirement benefit to which the participant would have been entitled if the participant commenced participation at the earliest entry age under the plan and served continuously until the earlier of age 65 or the normal retirement age specified under the plan, multiplied by the number of years (not in excess of 33?) of participation in the plan.²

The 133? percent test. In any particular plan year when qualification of the plan is tested, the plan must not allow for the annual rate of accrual of a participant’s normal retirement benefit in any later plan year to exceed 133? percent of the annual rate of accrual in any previous year.³

The fractional (or pro rata) test. The accrued benefit to which a participant is entitled upon his or her separation from service must be not less than a fraction of the participant’s assumed retirement benefit, the numerator of which is the participant’s total number of years of participation in the plan and the denominator of which is the total number of years the participant would have participated in the plan had the participant separated from service at normal retirement age.⁴ The participant’s assumed retirement benefit is computed as though the participant had continued to earn the same rate of compensation annually that he or she had earned during the years that would have been taken into account under the plan (but not in excess of 10 years of service immediately preceding separation) had the participant reached normal retirement age at the date of his or her separation. For the calculation method (and examples) that will produce the lowest accrued benefit satisfying the fractional test where benefits are accrued following a break in service, see Revenue Ruling 81-11.⁵

A defined benefit plan that provides a stated benefit offset by the benefits of a profit sharing plan will satisfy the benefit accrual requirements if the benefit determined without the offset satisfies the requirements and if the offset is equal to the amount deemed provided by the vested portion of the account balance in the profit sharing plan on the date the amount of the offset is determined.⁶

A defined benefit plan must require separate accounting for the portion of each employee’s accrued benefit derived from any voluntary employee contributions permitted under the plan.⁷ Revenue Ruling 78-202⁸ discusses the rules relating to calculation of accrued benefits derived from mandatory employee contributions.⁹ A plan generally may not be amended to reduce a participant’s accrued benefit.¹⁰ Procedures for obtaining approval of a retroactive plan amendment reducing a participant’s accrued benefit are specified in Revenue Procedure 94-42.¹¹

In addition, if a defined benefit plan subject to the minimum funding rules adopts an amendment that would increase current liability under the plan, and the funded current liability percentage under the plan (the ratio of the value of the plan’s assets to its current liability) is less than 60 percent, the plan must require that the amendment will not become effective until the employer (or a member of the employer’s controlled group) provides adequate security in favor of the plan.¹² See also Q 3838 to Q 3936 and Q 3736 for other qualification requirements.

In plan years beginning after December 31, 2007, defined benefit plans that are “at risk” ( Q 3744) became subject to a qualification requirement that suspends many benefit increases, plan amendments, and accruals in single-employer plans when funding falls below specified levels ranging from 60 percent to 80 percent.¹³ Notice must be provided to participants and beneficiaries when funding falls below 60 percent.¹⁴ If a single employer plan in bankruptcy is funded at or above 80 percent, the plan may adopt an amendment, after November 8, 2012, to eliminate an option or form of benefit that includes a prohibited payment under IRC Section 436(d)(5), if certain conditions are met.¹⁵ See Q 3743 for the funding requirements applicable in plan years beginning after 2007 through date of publication including MAP-21 and HATFA 2014. There was a special relief provision in the WRERA 2008 just for plan years beginning after September 2008 and before October 2009.¹⁶ Final regulations on minimum required contributions, effective January 1, 2016, are specified in Treasury Regulation Section 1.430(a)-1.¹⁷

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Planning Point: There are also prohibitions for transferring company general reserve assets in connection with a Section 409A-covered “nonqualified deferred compensation plan” during the period a defined benefit plan is “at risk” (see Q 3564 and Q 3568).

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Accrued Benefit Requirements for Fully Insured Plans

An insurance contract plan (formerly a Section 412(i) plan, but now governed by IRC section 412(e)(3)) automatically satisfies any of the foregoing accrued benefit tests if (1) the plan is funded exclusively by insurance contracts calling for level annual premiums from the date the insured becomes a participant in the plan to not later than retirement age, (2) benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age and are guaranteed by the insurer, and (3) an employee’s accrued benefit at any time is not less than the cash surrender value his or her insurance contracts would have assuming that all premiums currently due are paid and there is no indebtedness against the contracts.¹⁸ See Q 3812 and Q 3813 for details on fully insured plans.

A plan is considered a fully insured 412(i) plan when funded exclusively by group insurance or group annuity contracts if the group contract has the requisite characteristics of individual contracts.¹⁹ The IRS has taken the position that, for example, amounts received by an insurer under a group contract must be allocated to purchase individual benefits for participants: “A plan which maintains unallocated funds in an auxiliary trust fund or which provides that an insurance company will maintain unallocated funds in a separate account, such as a group deposit administration contract, does not satisfy the requirements of … [a fully insured insurance contract plan].”²⁰

If at the time an employee separates from service the value of his or her employee contributions exceeds the cash surrender value of the insurance contract(s) funding the employee’s retirement benefit, the plan could supplement the cash surrender value or values to satisfy the minimum vesting standard and the plan would not fail to be a fully insured plan.²¹