IRS Finalizes Anti-Cutback
Regulations: Heinz and Utilization Test Included

by RONALD J. TRICHE

On August 8, 2006, the Internal Revenue Service (the "IRS") released the final regulations under Section 411(d)(6) of the Internal Revenue Code (the "Code").¹ The regulations provide guidance regarding the U.S. Supreme Court's holding in Central Laborers' Pension Fund v. Heinz, 541 U.S. 739 (2004) and the use of the utilization test for determining whether the elimination of certain benefits in a qualified plan is permissible.

The Heinz Rule

In Heinz, the U.S. Supreme Court held that Section 204(g) of the Employee Retirement Income Security Act of 1974, as amended, ("ERISA") prohibits any amendment to a defined benefit plan that expands the categories of post-retirement employment that results in suspension of early retirement benefit payments which had previously been accrued. The Court further stated that while ERISA permits certain conditions that are elements of the benefit itself (such as the suspension of benefit payments), these conditions may not be imposed on a benefit after the benefit has accrued. Finally, the right to receive benefit payments on a certain date may not be eliminated by a new condition narrowing that right.

The Final Regulations

Restrictions or ConditionsThe final regulations retain the Heinz rule in the 2005 proposed regulations which states that, effective June 7, 2004 (the date Heinz was decided), a plan amendment placing greater restrictions or conditions on a participant's right to receive a protected benefit by adding or modifying a plan provision relating to suspension of benefit payments during a period of employment or reemployment violates Code section 411(d)(6) (the "suspension amendment"). If the suspension amendment was adopted prior to June 7, 2004, a plan can maintain its qualified status if, on or before January 1, 2007, the plan takes the following actions:

• Adopts a reforming amendment (e.g., an amendment limiting the effect of the suspension amendment);

• Operates in compliance with the reforming amendment; and

• Provides affected participants with a notice of the right to elect retroactively to commence payments of benefits.

Several commentators on the 2005 proposed regulations (including Trucker Huss) requested relief from the requirement to adopt a reforming amendment for plans that had adopted suspension amendments many years in the past. In response to this request, the preamble to the final regulations provides an exception to the reforming amendment requirement discussed above. If the suspension amendment was adopted before January 1, 1989 (January 1, 1991, for collectively-bargained plans), then the plan is not required to adopt a reforming amendment (or take the other required actions described above) in order to retain its qualified status.

Vesting

The final regulations also apply the holding in Heinz to issues related to the vesting of benefits under qualified plans. Generally, the final regulations provide that any plan amendment that decreases a participant's accrued benefit, or otherwise places greater restrictions or conditions on the participant's rights to receive protected benefits, violates Code section 411(d)(6), even if the amendment merely adds a restriction or condition that is otherwise permitted under the vesting rules in Code section 411(a). The final regulations do provide, however, that such a plan amendment does not violate Code section 411(d)(6) to the extent it applies to benefits accruing after the effective date of the amendment.

The final regulations provide a good example of this rule. Employer O sponsors Plan D, a qualified profit sharing plan with a seven-year graded vesting schedule (0% vested with fewer than 3 years of service, 20% with 3 years, 40% with 4 years, 60% with 5 years, 80% with 6 years and 100% with 7 years). In January 2006, Employer O acquired Company X. Company X maintains Plan E, a qualified profit sharing plan that has a five-year cliff vesting schedule (0% vested with fewer than 5 years of service, and 100% vested with 5 years).

In 2007, Plan E is merged with and into Plan D. As of the merger date, Plan D is amended to provide that Plan E participants in Plan D will be subject to the seven-year graded vesting schedule. As required by the Code, any Plan E participant who has at least 3 years of service prior to the amendment's effective date can elect to have the old or new vesting schedule apply to his or her benefit. Several Plan E participants have less than 3 years of service as of the amendment date. As a result, they would be 0% vested under either vesting schedule.

The conclusion in the example is that the amendment does not satisfy the requirements of the final regulations and violates Code section 411(d)(6) because the amendment places greater restrictions or conditions on the rights to Code section 411(d)(6) protected benefits with respect to those Plan E participants who had less than 5 years of service and elected (or were automatically subject to) the seven-year graded vesting schedule. In order for the amendment to satisfy the regulation and qualify under Code section 411(d)(6), the amendment would have to provide that the vested percentage of the account balances and earnings thereon of all Plan E participants in Plan D as of the effective date of the amendment would be no less than the greater of the vesting percentages under the two vesting schedules. In other words, the account balances (and earnings thereon) of these participants as of the amendment's effective date would have to be at least as favorable as: 0% vested with fewer than 3 years of service, 20% with 3 years, 40% with 4 years, and 100% with 5 years).

The vesting schedule rule changes in the final regulations are effective for all amendments adopted after August 9, 2006. If a plan amendment was adopted prior to that date, the requirement for a special vesting schedule for those participants with less than 5 years of service would not apply.

Elimination of Redundant Benefit — The Utilization Test

Under the final regulations, use of the utilization test allows a plan to be amended to eliminate optional forms of benefits that comprise a generalized optional form for a participant with respect to benefits accrued before the amendment's effective date if certain requirements relating to the use of the generalized optional form are satisfied. A "generalized optional form" is defined as a group of optional forms of benefit that are identical except for differences due to the actuarial factors used to determine the amount of the distributions under the optional forms and the annuity starting dates.

However, under the utilization test, a plan is not permitted to eliminate any core option (e.g., a straight life annuity, a 75% joint and survivor annuity, a 10-year term certain and life annuity, and the most valuable option for a participant with a short life expectancy) offered under the plan. The utilization test further provides that the plan amendment eliminating the generalized optional form cannot apply to an optional form of benefit with an annuity commencement date within the 90-day period after the date the amendment is adopted. The Pension Protection Act of 2006 extends the 90-day period to 180 days, effective January 1, 2007.

In order to eliminate a non-core optional form of benefit under the utilization test, the plan must satisfy two conditions:

• First, the generalized optional form must have been available to at least 50 sampled participants during the look-back period. A participant can be part of the sample group only if he or she was eligible to elect to commence payment of an optional form of benefit that is part of the generalized optional form being eliminated with an annuity commencement date that is within the look-back period. As a general rule, the following participants cannot be included in the participant sample: a participant who did not elect any optional form of benefit with an annuity starting date within the look-back period; a participant who elected a single-sum distribution of at least 25% of his or her accrued benefit (see exception below); a participant who elected an optional form of benefit that was available only during an early-retirement window; or a participant who elected a form of benefit with an annuity commencement date that was more than 10 years before normal retirement age. The 50-particpant sample size is increased to 1,000 participants if the plan takes into account any participant who elects a single-sum distribution of at least 25% of his or her accrued benefit.

  The look-back period includes the two plan years immediately preceding the date the amendment is adopted, as well as the portion of the plan year during which the amendment is adopted that precedes the date of adoption. However, a plan is permitted to exclude from the look-back period the calendar month in which the amendment is adopted and the one or two immediately-preceding calendar months (to the extent these months are in the adoption plan year). In addition, the plan can extend the look-back period to include an additional one, two, or three plan years, in order to have a look-back period that satisfies the requirement for a 50 (or 1,000) participant sample.

• Second, no participant elected to receive his or her accrued benefit in the optional form of benefit that is part of the generalized optional form with an annuity commencement date that is within the look- back period. The rationale for this requirement is that if at least one participant among the 50 or 1,000 participants sampled has elected any optional form of benefit within the generalized optional form during the look-back period, the election is evidence that the elimination of the generalized optional form could adversely affect the rights of another plan participant in more than a de minimis manner. In other words, if no participant among the participants sampled elected the optional form of benefit during the look-back period, then elimination of the generalized optional form would not adversely affect the rights of any participant in more than a de minimis manner.

For example, a plan offers a 5-year, 10-year, and 15-year term certain and life annuity (non-core options), all with and without a social security leveling option. The plan wants to eliminate the 5-year term certain and life annuity with a social security leveling option. This annuity form has been made available to at least 50 participants during the look-back period. In addition, none of the sampled participants has elected to receive his or her benefits in the form of a 5-year term certain and life annuity with a social security leveling option within the look-back period. Under the final regulations, the plan can be amended to eliminate the 5-year term certain and life annuity with a social security leveling option without violating the terms of Code section 411(d)(6).

The utilization test provision in the final regulations is applicable for amendments adopted after December 31, 2006.

Conclusion

The final regulations contain provisions that will affect many companies sponsoring qualified plans. Plan sponsors will need to determine if their defined benefit plans must be amended in order to conform to the Heinz rule. In addition, before any qualified plan can be amended to eliminate a non-core optional form of benefit, plan sponsors should run the utilization test on the generalized optional form to determine whether the non-core optional form of benefit can be eliminated without violating Code section 411(d)(6). Please contact us if you would like to discuss the new provisions of the final regulations.

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¹ The final regulations were published in the Federal Register on August 9, 2006 (71 FR 45379), with two minor correcting amendments being released in September 2006 (both of which are effective August 9, 2006).

Copyright © 2006 Trucker Huss. All rights reserved. This article is published as an information source for our clients and colleagues. The article is current as of the date shown above, is general in nature and is not the substitute for legal advice or opinion in a particular case. In response to new IRS rules of practice, we inform you that any federal tax information contained in this writing cannot be used for the purpose of avoiding tax-related penalties or promoting, marketing or recommending to another party any tax-related matters in this writing.