IRS Guidance on Cash Balance Benefit Formulas: Avoiding Employer Discretion
The IRS has issued guidance applicable to cash balance plans which base benefits on only a portion of annual compensation. The issue arises out of a requirement that pension plans, including cash balance plans, provide a “definitely determinable benefit.” If a plan fails to do so, the plan will not be qualified.
In a memorandum to the Employee Plans (EP) staff dated April 7, 2017, the IRS confirmed that a cash balance formula based on only a portion of a participant’s annual compensation can nevertheless meet the “definitely determinable” requirement so long as the formula is not subject to employer discretion under the plan terms. The EP staff is directed to apply this analysis when (i) reviewing a cash balance plan’s determination letter request, or (ii) auditing a cash balance plan.
A pension plan must “provide systematically for the payment of definitely determinable benefits” for a specified period after retirement; such benefits are generally based on factors such as length of service and compensation received. Treas. Reg. §1.401-1(b)(1)(i). The “definitely determinable” requirement is met if benefits are determined in accordance with a “stipulated formula” and are not subject to employer discretion. Rev. Rul. 74-385.
Cash balance plans, like traditional defined benefit plans, use a formula to determine pension benefits. However, cash balance plan benefits are determined in reference to a hypothetical account balance, which consists of a formula based on (i) pay credits (e.g., a specified percentage of compensation), and (ii) interest credits (adjustments to a participant’s accumulated benefit that does not exceed a market rate of return). Some cash balance plans base pay credits on only a portion of compensation — e.g., compensation for a certain month, a special bonus, or compensation over a certain threshold.
What the IRS Memo Says
The IRS memorandum says that if a plan gives the employer discretion to determine the portion of compensation taken into account, that plan violates the “definitely determinable” rule. On the other hand, if the plan terms do not provide for employer discretion, benefits will be considered “definitely determinable” even though the employer may have the inherent ability to determine the amount of compensation.
For example, benefits may be based on W-2 compensation received in March, even though the employer may have the inherent ability to determine how much W-2 compensation is paid in March. But the plan terms may not state that the employer has discretion to determine each employee’s March compensation. Further, even if the plan does not by its terms provide for employer discretion, if the employer exercises its inherent discretion in a way that manipulates the amount of pay credits, there may be an operational disqualifying defect. (This might happen if, for example, an employer accelerates payment of an employee’s regular March compensation into February in order to decrease or even eliminate an employee’s pay credits.)
What Should You Do?
Employers that sponsor cash balance plans should review their cash balance formulas to confirm that they meet the “definitely determinable” requirement under this guidance, and should consider the following questions:
Is the cash balance formula based on only a portion of compensation?
If so, do the plan terms provide for employer discretion to determine a portion of compensation (such as a month’s compensation, special bonuses, or excess salary)? If the plan provides for employer discretion, does the plan have a determination letter?
Even if the plan terms do not provide for employer discretion, is the employer effectively able to manipulate compensation in a way that affects pay credits under the cash balance benefit formula?
If the plan seems to provide for employer discretion, employers should consult with their plan advisors or counsel to determine whether the terms of the plan need to be modified.