“415(b)(2)(E)(ii)” – Sole content of a recent somewhat esoteric websearch that brought a reader to Pen&Ben Weblog. I’m not the expert you want to see on that one; but as I’ve not seen any Internet traffic this year on it, I’ll pass along what little I know.
For purposes of adjusting any benefit under subparagraph (B) for any form of benefit subject to section 417(e)(3), the applicable interest rate (as defined in section 417(e)(3)) shall be substituted for “5 percent” in clause (i), except that in the case of plan years beginning in 2004 or 2005, “5.5 percent” shall be substituted for “5 percent” in clause (i).
Background – Benefits under a qualified defined benefit plan are limited under IRC §415(b)(a)(A) to $175,000 for 2006, expressed in terms of a life annuity. [IRC §415(b)(2)(A)] For other forms of benefit (other than qualified joint and survivor annuities), that dollar ceiling must be adjusted to the actuarial equivalent amount. [IRC §415(b)(2)(B)] For forms of benefit other than those subject to IRC §417(e)(3), the interest rate assumption for the actuarial equivalence assumptions is limited to the greater of 5 percent or the rate specified in the plan. [IRC §415(b)(2)(E)(i)]
Which brings us to IRC §415(b)(2)(E)(ii), the text of which I’ve quoted above. §101(b)(4) of the Pension Funding Equity Act of 2004 (P.L. 108-218) added the temporary 5.5% interest rate, meaning that for distributions with annuity starting dates in plan years that begin in 2004 or 2005, the interest rate assumption for the actuarial equivalence assumptions for forms of benefit subject to IRC §417(e)(3) is limited to the greater of 5.5 percent or the rate specified in the plan. Benefit forms subject to IRC §417(e)(3) most notably include lump sum distributions, but also include other non-level alternative distribution forms such as payment streams that include temporary Social Security supplements. See Notice 2004-78 for IRS guidance on the PFEA temporary 5.5% interest rate and Benefitsblog for discussion.
Pension Reform Legislation – Pending legislation carried over from congressional action during 2005 would essentially extend the PFEA phrase for 415(b)(2)(E)(ii) permanently, retroactive to years beginning on or after 1/1/06. See S. 1783 §302 and H.R. 2830 §303.
The House version would add an extra twist: rather than PFEA’s simple 5.5%, the interest rate would be required to be the greater of 5.5% or “the rate that provides a benefit of not more than 105 percent of the benefit that would be provided if the applicable interest rate (as defined in section 417(e)(3)) were the interest rate assumption,” or as always, the rate specified under the plan if greater. Noting that under both the House and Senate versions, the 417(e)(3) applicable rate itself would phase in to a yield-curve basis, the determination of the rate that would apply under 415(b)(2)(E)(ii) would turn into a bit of rocket science whenever interest rates rise above about 5.6%, that exact margin depending on the particular form of benefit being limited and the participant’s age. The simplified version essentially being that when interest rates rise high enough, the actuarially equivalent dollar ceiling under 415(b)(2)(E)(ii) becomes 105 percent of the accrued benefit amount determined under 417(e).
Meanwhile, Current Law – For plans with calendar plan years or non-calendar plan years beginning early in the year (e.g., 2/1), the expiration of the temporary PFEA rule combined with the delay in enactment of a permanent extension could pose a tough dilemma. If any participant takes a lump sum distribution or other 417(e)(3) distribution during the interim period, and if the 415(b)(2)(E)(ii) ceiling would restrict the benefit payment, then technically the interest rate under current-law 415(b)(2)(E)(ii) is the greater of the rate specified under the plan or the applicable interest rate under 417(e)(3), currently a shade below 5%. But determination using that rate produces a ceiling that is higher than the ceiling that would be in force if 5.5% is applied retroactively under compromise legislation. If the higher amount based on current law is paid out, then recovery by the plan of excess payout amounts from the participant might be necessary if the legislation produces a retroactively lower ceiling.