Compliance November 7, 2016

IRS Considering Changes to Interest Crediting Rules for Certain PEPs

The agency is considering amendments to hybrid plan rules to address implicit interest pension equity plans.

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The Internal Revenue Service (IRS) has issued Notice 2016-67 describing the applicability of the market rate of return limitation rules to a defined benefit plan that expresses a participant’s accumulated benefit as the current value of an accumulated percentage of the participant’s final average compensation, highest average compensation, or highest average compensation during a limited period of years (a type of plan often referred to as a pension equity plan or PEP).

In particular, this notice addresses the applicability of the market rate of return limitation rules to a type of PEP that applies a deferred annuity factor to the participant’s accumulated benefit in order to determine deferred benefits (a type of PEP often referred to as an implicit interest PEP). The IRS explains that such a PEP is often referred to as an implicit interest PEP because preretirement interest is implicitly reflected in the deferred annuity factor.

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Under an explicit interest PEP, because the accumulated benefit is adjusted with interest credits to determine the benefit payable at annuity starting dates after principal credits cease, those interest credits are subject to the market rate of return limitation rules under hybrid plan regulations issued in 2015. Thus, any amendments necessary to bring the interest crediting rate into compliance with the market rate of return limitation rules under the hybrid plan regulations must be made by the applicable deadline of the transition regulations (generally before the beginning of the first plan year that begins on or after January 1, 2017) in order for the amendments to be eligible for the exception from rules against reducing benefit accruals provided by the transition regulations.

NEXT: Implicit interest PEPs not subject to interest crediting rules

By contrast, under an implicit interest PEP, the preretirement interest that is implicit in applying a deferred annuity factor to the accumulated benefit is not included in the definition of an interest credit under rules because the accumulated benefit remains a constant percentage of average compensation and is not adjusted with interest credits after principal credits cease, the IRS explains. Thus, under the hybrid plan regulations, no amendment is required to the deferred annuity factors under an implicit interest PEP in order to reduce the preretirement interest that is implicit in those factors to a rate that does not exceed a market rate of return and the exception from rules against reducing benefit accruals under the transition regulations does not apply to such an amendment.

The IRS says stakeholders have expressed uncertainty as to whether the market rate of return limitation rules under the final hybrid plan regulations apply to implicit interest PEPs. Due to this uncertainty, some plan sponsors of implicit interest PEPs might have believed that the preretirement interest that is implicit in a deferred annuity factor was subject to the market rate of return limitation rules and, as a result, might have already adopted plan amendments to reduce that interest in accordance with the rules under the transition regulations that apply to amendments reducing interest crediting rates that exceed a market rate of return.

Even though the preretirement interest that is implicit in a deferred annuity factor under an implicit interest PEP is not subject to the market rate of return limitation rules in the final hybrid plan regulations, the Treasury Department and the IRS are considering whether to propose amendments to those regulations that would subject implicit preretirement interest to the market rate of return limitation. The IRS is requesting comments about adopting amendments.