Qualified Retirement Plans: What is a Protected Benefit?
By Michelle Freiholtz, MBA
Plan sponsors are prohibited from reducing benefits that participants have already earned. Found in Internal Revenue Code Section (IRC Sec.) 411(d)(6), this is known as the anti-cutback rule.
When would a plan sponsor need to consider protected benefits?
Plan sponsors should evaluate their plans for protected benefits when they make a discretionary amendment or when there is an acquisition or merger of plans.
What benefits are protected?
Accrued benefits are protected. These are easy to see when looking at a participant’s account balance or the accrued benefit under a defined benefit plan. For example, a participant’s vested account balance may not be reduced. If a plan sponsor amends the document to provide a less favorable vesting schedule, the following rules will apply.
Pre-amendment accruals for affected participants are subject to a combined “best of both worlds” schedule.
Post-amendment accruals for participants with less than three years of service are subject to the new vesting schedule, but their accrued benefit cannot be reduced. Their vested percentage may be “frozen” until the new schedule provides for an increase.
Post-amendment accruals for participants with three or more years of service are subject to the new schedule unless the participant irrevocably elects to remain with the old schedule. The accrued benefit cannot be reduced.
Some accrued benefits are more difficult to determine. For example, plan sponsors may not reduce any benefit that has been accrued for a plan year under a pre-amendment formula, even if the contributions have not yet been made to the participant. Amendments to make allocation conditions less favorable are usually timed for the start of the next plan year.
Optional forms of benefit are also protected. For example, while not required to provide benefits upon attainment of early retirement age, if a plan document allows for 100 percent vesting, certain distributions, or a waiver of allocation conditions, the optional form of benefit is protected. Forms of payment under a defined contribution plan may be removed as long as the option for an identical lump-sum distribution is available and it is based on an equal or greater portion of the participant’s account as the form that is being eliminated.
Events triggering the availability of a distribution must also be considered. If a plan sponsor amends the document to allow less favorable distribution events, the assets accrued before the amendment’s effective date must have the distribution triggers preserved. To illustrate, if a plan document allows for in-service distributions upon attainment of age 59½, and is later amended to remove in-service distributions, then any benefits accrued before the date of the amendment may still be withdrawn as an in-service distribution at age 59½. Other distributable events may include
Termination of employment
Disability
Normal retirement age
Early retirement age
Inservice distributions (other than hardship)
Distributions of rollovers at any time
Distributions of transfers at any time
Distributions of after-tax contributions at any time
Distributions after any stated age or period of service, and
Distributions taken within a certain period.
Timing of distributions is also a protected benefit. For example, if a plan document allows immediate distributions upon separation from service, and is later amended to allow distributions in the plan year following the year of separation from service, any benefits accrued before the date of the amendment will retain the more beneficial timing for processing.
Are there special rules for safe harbor 401(k) plans?
Plan sponsors may remove the safe harbor feature effective the first day of a plan year. They may also amend in the middle of a plan year if they are operating at an economic loss or if they’ve provided participants advanced notice, at least 30 days before the start of the plan year, indicating they may reduce or suspend the safe harbor mid-year. Plan sponsors must meet one of the two criteria before taking the additional steps required to remove the safe harbor.
Treasury Regulation 1.401(k)-5, Special rules for mergers, acquisitions, and similar events, has been reserved for future guidance. Plan sponsors facing a merger or acquisition and considering eliminating a safe harbor plan design should proceed with caution. Lacking appropriate guidance in the regulations, the industry has split opinions regarding a plan sponsor’s options. One side asserts that the plan sponsor should follow guidance offered in IRS Notice 2016-16 and Treasury Regulations 1.401(k)-3 & 1.401(m)-3. The sponsor’s minimum actions would include
providing a supplemental notice 30 days ahead of the change;
allowing the opportunity to change deferral elections;
funding safe harbor contributions through the date of the merger; and
conducting ADP/ACP testing for the full plan year.
Others believe that if the sponsor still exists, a safe harbor feature should remain in place through the end of the plan year to avoid risking the plan’s safe harbor status. The plan cannot be treated as a terminating plan for safe harbor purposes. Because of the varied opinions, plan sponsors may want to consider consulting legal counsel before determining a path forward.
What benefits are not protected?
Plan sponsors may remove certain optional forms of benefit as allowed in the Treasury Regulations. Examples include the right to take loans and hardship distributions. They can also change their involuntary cashout provisions, plan investment options, and the timing of valuations.
