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Pension Equity Plans

A pension equity plan is another type of hybrid pension plan where the benefit formula defines a lump-sum amount. The lump-sum amount is generally defined as a percentage of the participant's average pay over the final years of his or her employment. Unlike a cash balance plan, a pension equity plan typically does not have annual interest credits on a hypothetical account. Instead, the pay component of the formula can increase if the participant's pay increases. However, many pension equity plans start crediting interest on the hypothetical account once the participant has terminated employment, until the benefit is commenced. The PPA addresses pension equity as a hybrid plan in its definition of an applicable defined benefit plan, which includes a defined benefit plan under which the accrued benefit is calculated "as an accumulated percentage of the participant's final average compensation." [I.R.C. § 411(a)(13)(C)(i); ERISA § 203(f)(3)(A)] Regulations on hybrid pension plans, proposed December 28, 2007, do not include any rules specific to pension equity plans other than to include the "accumulated percentage of final average compensation" in the definition of accumulated benefit for purposes of the age discrimination safe harbor. [Prop. Treas. Reg. § 1.411(b)(5)-1(e)(2); IRS Notice 2007-6, part II]

Example 1

A pension equity plan may provide a benefit at retirement defined as a lump sum equal to 5 percent of final average pay for each year worked. If Alexa is a participant in the plan and retires after 25 years of service, she would have a benefit defined as 125 percent of her final average pay (5 percent times 25 years). If Alexa's final average pay was $60,000, her lump-sum benefit value would be $75,000 (125 percent of $60,000).

Plan ParticipationAlexa's Lump-Sum Benefit
Final average pay
$60,000
Percent of final average pay for each year of service
5%
Years of service at retirement
25
Lump-sum benefit value at retirement
$75,000

Similar to a cash balance pension plan, a pension equity pension plan defines the benefit payable to an employee in terms of a lump-sum amount. The difference is in how the lump-sum amount is calculated. Instead of accruing the lump sum to look more like a defined contribution plan, a pension equity plan accrues the lump sum based on a formula that is typically based on final average pay or could be based on career average pay.

The accrual under a pension equity plan can be based on additional factors such as service and points (typically age plus service). For instance, a pension equity plan could have a service-related schedule so a different percentage applies at various service levels. Suppose the formula was based on the following service-related schedule:

Years of ServicePercent
Up to 5 years
3% per year
5, up to 10 years
4% per year
10, up to 20 years
5% per year
20 years or more
6% per year

Then, Alexa's accumulated lump-sum benefit would then be calculated as follows:

Final three-year average pay $60,000
Total Years of service25
 Percent Years Total
Lump-sum accrual per year of service up to 5 3% 5 15%
Lump-sum accrual per year of service from 5 up to 10 4% 5 20%
Lump-sum accrual per year of service from 10 up to 20 5% 10 50%
Lump-sum accrual per year for service of 20 years or more 6% 5 30%
Total percent of final three-year average pay
115%
Accumulated lump-sum benefit (115% of $60,000)
$69,000

If an employee terminates from an employer and has a vested pension equity benefit, many pension equity plans provide that the benefit is increased after employment terminates based on a specified interest rate.

Example 2.

Alexa's (the employee mentioned above) pension equity lump-sum benefit was $69,000 and she terminated her employment. Since she had 25 years of service, she was 100 percent vested in her benefit. If she waited one year to receive her benefit, her benefit may be increased to account for "interest" from the time it was calculated to the time it is received. If the current interest crediting factor was 5 percent, she could receive a benefit of $72,450 a year after she terminated employment.

In the preamble to the proposed hybrid plan regulations, the IRS recognizes that interest credits typically commence in a pension equity plan only after employment terminates, presenting comments received previously on this subject in response to IRS Notice 2007-6. To be an interest credit, rather than a pay credit, the interest credit cannot be conditioned on current (or future) service, [Prop. Treas. Reg. § 1.411(b)(5)-1(d)(1)(ii)] so presumably the right to an interest credit on the pension equity pension plan benefit beginning with employment termination would have to coincide with the accrual of the pension equity pension plan benefit (i.e., the interest credits would be frontloaded even though the interest crediting would not start until employment terminates). The IRS further notes that the comments received indicate a pension equity design often provides either explicit or implicit interest credits by determining the normal retirement benefit as either:

  • The accumulated percentage of final average compensation divided by a deferred annuity factor, which implicitly provides interest (and mortality) credits for deferred benefits; or
  • The lesser of the following two amounts converted to an annuity:
    • The current lump-sum benefit projected to normal retirement age and using an interest rate specified in the plan; or
    • The projected lump-sum benefit based on projected service to normal retirement age under the plan's formula for accumulated percentage of final average compensation, but without salary increases.

Neither the proposed regulations nor the Revenue Ruling 2008-7, which provides guidance on how a cash balance plan may satisfy the accrual rules (see chapter 10), address the application of the accrual rules to pension equity plans. Presumably, future guidance will provide the same clarification of the accrual rules for pension equity plans that the Revenue Ruling 2008-7 provided for cash balance plans; i.e., that accrual rule testing must be based on the annuity commencing at normal retirement age, and that any of the three accrual rule tests under section 411(b) may be used for this purpose.

Compared to a cash balance pension plan, a pension equity plan typically has a benefit value that is more heavily weighted to later ages. That is because a pension equity plan typically is based on final average pay, and pay generally increases as a participant's service with the employer increases. A cash balance plan works, on the other hand, not only to provide pay credits for work each year, but future interest accruals are provided on that pay credit in the form of interest credits. A participant typically has the right to the future interest accruals even if he or she terminates employment. From that perspective, a cash balance plan is frontloaded compared to other forms of defined benefit plans, including pension equity plans. Thus, a plan sponsor may choose a pension equity plan over a cash balance plan if it wanted to emphasize benefits for mid-career hires or when looking for a way to more easily transition from a final average pay plan.

Some employers may view a pension equity formula as easier to understand than a cash balance plan because there is no need to track annual pay credits and interest credits in order to calculate the benefit. However, a number of pension equity plans provide interest credits beginning when a participant terminates employment with the plan sponsor.

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