EA2b – Partial Study Manual

Prepared by

Traci M. Christian

Enrolled Actuary

The following manual consists of 5 subjects covered on the EA2b exam. This is NOT an all-inclusive manual. Please refer to the SoA syllabus for the exam for a complete list of all subjects covered.

This download for the 2004 exam is the first time I’ve shared these notes – I welcome any criticism of the presentation and would appreciate knowing about any errata.

GOOD LUCK in the Spring!!

Traci

Acknowledgement:

Special thanks go to David Farber for his review of this material.

Chapter 3

Requirements with Respect to Vesting, Service Credits, Employee Contributions, Accrued Benefits, Normal Retirement, Early Retirement, Postponed Retirement, Joint and Survivor Annuities, and Preretirement Death Benefits

Relevant readings include:

  • IRC Section 411 (excluding subsection e): Minimum vesting standards
  • IRC Section 417: Minimum Survivor Annuity Requirements
  • Regulation 1.411(d)(4) – (6): Protected Benefits
  • Regulation 1.417(e) – 1: Valuing Distributions
  • Revenue Ruling 81-140: Suspension of benefits due to reemployment
  • Revenue Ruling 92-66: Early retirement windows
  • Notice 88-25: expanded by Notice 88-126.
  • Notice 88-126 – Service allowed or disallowed for benefit accrual
  • Notice 97-75 – Minimum distributions under 401(a)(9)

General vesting rules of IRC Section 411(a)

Note: In general, the rules described in this section apply to defined benefit plans. Special exceptions may apply to defined contribution plans, and are not discussed here.

A participant is always 100% vested in benefits derived from his own contributions. A plan must provide for 100% vesting upon attainment of Normal Retirement Age.

For benefits provided by the employer’s contributions, a schedule providing vesting at least as quickly, for each year of service, as one of the following vesting schedules, must be used:

  • 5-year cliff vesting: That is, 0% vesting prior to 5 years of service, 100% vesting upon attainment of 5 years of service; OR
  • 7-year graded vesting (also referred to as 3 to 7 year vesting): 20% after 3 years of service and an additional 20% for each year thereafter with 100% vesting reached after attainment of 7 years of service.

A plan may provide for more generous vesting rules – but, as indicated above, must grant vesting at least as generously as one of the above tables and must do so for ALL years of service.

Example 3-1

Years of ServiceVesting %

10%

225%

330%

440%

550%

660%

7100%

The above table satisfies the 5-year cliff schedule for the first 4 years, but fails to provide 100% vesting after 5 years. It satisfies the 7-year graded schedule for the first 4 years as well, but fails to provide at least 60% vesting after 5 years and 80% vesting after 6. This is not a valid table.

Example 3-2

Years of ServiceVesting %

10%

210%

320%

430%

5100%

The above table provides for vesting at least as generous than the 5-year cliff schedule at each year of service. Therefore, this table would satisfy the requirements of 411(a).

Example 3-3

Years of ServiceVesting %

10%

20%

30%

40%

560%

680%

7100%

The above table again satisfies the 5-year cliff schedule for the first 4 years, but fails to provide 100% vesting after 5 years. It satisfies the 7-year graded schedule in the later years, but fails in years 3 and 4. This is not a valid table.

Prior to 1999, multi-employer plans were subject to a minimum 10-year cliff vesting schedule. This has now changed to a 5-year cliff minimum.

If a plan requires more than one year of service before plan participation commences (but not more than 2 years) then it must provide for 100% vesting upon plan participation.

Government plans, church plans, plans that have not made employer contributions since 9/2/1974, and plans that are sponsored by an organization that does not accept employer contributions are NOT subject to the vesting requirements of IRC section 411.

Years of Service Included for Vesting Purposes (See IRC section 411(a)(4))

All years of service are included for vesting purposes, with the following exceptions:

  • Years before age 18
  • Years before the plan was established (or a predecessor plan was in place)
  • Years excluded due to Breaks in Service (see below)
  • Years when the participant elected not make mandatory employee contributions
  • Years prior to the effective date of ERISA (if they would have been excluded under the plan on that date) or years prior to 1971 (unless the participant had at least 3 years of service after 1970)
  • For multi-employer plans: years after a complete or partial withdrawal

Break-in-Service (See IRC sections 411(a)(5) and (6))

A year of service is generally defined as a 12-month period (plan year, calendar year, or anniversary of hire year) during which an employee completes at least 1000 hours.

A one-year break-in-service is defined as the same time period where less than 500 hours are worked.

If an employee is not vested in his accrued benefit at the time of his termination of employment and is subsequently rehired, his years of service prior to his original termination date may be disregarded if the number of consecutive one-year-breaks-in-service exceeds the greater of 5 or the number of years of service prior to the original termination date.

Following a one-year break-in-service, years of service prior to the break need not be taken into account until a year of service is completed upon reemployment.

Example 3-4

Smith is hired on 1/1/1993 and terminates on 12/31/1996 with 4 years of vesting service. The vesting schedule is the 5-year cliff vesting. Therefore, Smith is non-vested at the time of termination of employment.

If Smith is rehired before 1/1/2002 (within 5 years), the years of service prior to the termination date will be reinstated after completing a year of reemployed service. So, if Smith is rehired on 1/1/2001, the vesting service as of 12/31/2001 is 5 years, and Smith is 100% vested.

However, if Smith is reemployed after 12/31/2001, then the prior service may be disregarded and Smith would be treated as a new employee for plan participation and vesting purposes. So, if Smith is rehired on 1/1/2002, the vesting service as of 12/31/2002 is 1 year, and Smith would be non-vested.

Note however the rule of “once vested always vested”. In the case of a graded vesting schedule, such as the 7-year graded vesting, Smith would have been 40% vested at the time of termination of employment. Smith would remain 40% vested at the time of re-employment. In addition, the 4 years of past service that Smith had earned before the original termination of employment would be restored upon completion of one year of service.

Predecessor Plans

A predecessor plan is a plan that is terminated within 5 years (before or after) the establishment of a new plan.

If an employee was covered by a predecessor plan, then his years of service for vesting purposes are counted under the new plan (assuming the break-in-service rules do not apply)

Predecessor Employers

Service with a predecessor employer is considered service with a successor employer who continues to maintain the plan.

Likewise, in a related group of employers (for example, a controlled group) vesting service for one employer counts as vesting service for a related employer.

Forfeitable Benefits (See IRC section 411(a)(3))

Benefits provided by an employee’s own contributions are always 100% vested and non-forfeitable. However, the following employer provided benefits may be forfeited in certain circumstances:

  • An unmarried participant may forfeit his retirement benefit if he dies prior to commencement of that benefit. (IRC section 401(a)(11) requires a qualified joint and survivor benefit payable to a surviving spouse for participants married at least one year)
  • If a retired participant receiving an annuity is subsequently reemployed, his benefit payments may be suspended for the duration of his full-time employment.
  • Early retirement reductions may result in the loss of part of the accrued benefit
  • If a participant is less than 50% vested and he withdraws his mandatory employee contributions, he may forfeit his entire accrued benefit. However, the plan must allow for a payback of those contributions with interest and allow for a restoration of the forfeited benefit if payback occurs within 5 years of the date of withdrawal, or, in the case of withdrawal due to termination of employment, within 5 years of reemployment (or the end of the period of time in which the participant suffered 5 consecutive one-year breaks-in-service, if earlier).
  • If benefits are conditioned upon the availability of assets, then those benefits may be forfeited due to insufficiency of those assets.

Plan amendments allowed under IRC section 412(c)(8) may not reduce already accrued benefits

General Accrued Benefit Issues

When calculating the accrued benefit, a plan may disregard years of service for which a distribution has been paid provided that the plan allows for the distribution to be repaid. The repayment provision may require that repayment occur within 5 years of separation.

The accrued benefit cannot be less than the accrued benefit attributable to the employee’s own contributions. (See IRC section 411(a)(7).)

The following are not considered to be accrued benefits (See regulation 1.411(a)-7(a)(1)):

  1. Ancillary benefits such as disability, life insurance, health benefits or other incidental benefits not related to the retirement benefit.
  2. Subsidized early retirement benefits – unless they are part of the normal retirement benefit
  3. Subsidized joint and survivor benefits
  4. Social Security Supplements that cease when social security payments begin.

Normal Retirement Age defined in IRC section 411(a)(8) means the earlier of 1) the normal retirement age as defined in the plan or 2) the later of age 65 and the 5th anniversary date of plan participation.

The term Normal Retirement Benefit under IRC section 411(a)(9) means the greater of the early retirement benefit under the plan or the benefit commencing at normal retirement age.

Changes to the vesting schedule (See IRC section 411(a)(10))

A plan may not be amended to reduce a participant’s accrued vested percentage.

If the vesting schedule is changed by a plan amendment, participants with at least 3 years of service must be given the option to stay under the old schedule. This includes changes from or to a top-heavy schedule.

Distributions (See IRC section 411(a)(11))

If the present value of the vested accrued benefit is less than $5,000, a plan may involuntarily pay the lump sum value in lieu of any other benefits under the plan. The lump sum value must be calculated in accordance with IRC section 417(e)(3) – that is, not less than the actuarial equivalent using the applicable interest rate (currently the 30-year Treasury Rate) and the applicable mortality table (currently the 1994 GAR table, but note that prior to 12/31/2002, the applicable table was the GAM 83 table blended 50-50 for males and females).

Lump sums in excess of $5,000 require the informed consent of the participant and his spouse. The plan sponsor must provide an explanation of the other optional forms available including an explanation of the qualified joint and survivor option.

Pre-retirement Death Benefits (See IRC section 401(a)(11))

A defined benefit plan must provide for a minimum qualified pre-retirement survivor annuity for all vested participants married at least one year (sometimes referred to as an REA benefit). The minimum spouse’s benefit is calculated as follows: The employee is assumed to have terminated employment on his date of death, to have retired as soon as the plan would have allowed, to have chosen a qualified joint and survivor annuity (50% J&S), and then to have died the next day. The spouse then receives as a life annuity 50% of the amount that the annuity would have been under these circumstances.

Example 3-5

A plan offers normal retirement benefits at age 65 and early retirement benefits as early as age 55 with an early retirement reduction of 5% per year.

Conversion Factors from a life annuity to a 50% J&S annuity:

Age 55 = .85

Age 62 = .92

Age 65 = .95

Employee Smith, age 62, has an accrued benefit of $500 per month. Upon his death, what is the minimum qualified pre-retirement survivor annuity payable to his spouse?

Solution:

First assume that Smith terminated his employment on the date of his death. His accrued benefit of $500 would be payable at age 65. However, the plan would allow him to retire immediately with a reduced benefit. The annuity had he retired immediately would have been $500  (1 - .05  3) = $425. Next assume that Smith chose the 50% joint and survivor option and convert the benefit: $425  .92 = $391. Smith’s spouse would be entitled to 50% of this amount or $195.50.

What if Smith was age 42?

Again assume that Smith terminated his employment on the date of his death. His accrued benefit of $500 would be payable at age 65. However, the plan would allow him to retire as early as age 55 with a reduced benefit. The annuity had he retired at 55 would have been $500  (1 - .05  10) = $250. Next assume that Smith chose the 50% joint and survivor option and convert the benefit at age 55: $250  .85 = $212.50. Smith’s spouse would be entitled to 50% of this amount or $106.25 payable when Smith would have turned 55.

Minimum Survivor Annuity Requirements (See IRC section 417)

When choosing a form of payment for his retirement benefit, a participant may elect to waive the qualified joint and survivor form or other joint and survivor forms. These elections may be revoked during the applicable election period. A spouse must consent to the waiver of the qualified joint and survivor forms of payment either by consenting at the time the election is made or by consenting to the prior designation of another beneficiary.

Each plan must provide to each participant, within a reasonable period of time before benefits commence, a written explanation of the qualified joint and survivor benefits, the participant’s right to make, and the effect of, an election to waive the joint and survivor form of payment, and the rights of the spouse with respect to the joint and survivor form.

Distributions (See regulation 1.417(e) –1)

This is another regulation to skim for True/False questions. Here are some highlights:

A plan must provide participants with a written explanation of the Qualified Joint and Survivor Annuity (QJSA) no less than 30 days and not more than 90 days before the annuity starting date.

No consent of the spouse is needed for distribution of a QJSA at any time. A distribution cannot be made at any time in a form other than QJSA unless the QJSA is both waived by the participant and consented to by the spouse.

A participant is permitted to revoke a distribution election up to the annuity starting date or up to 7 days after the explanation of the QJSA has been provided.

The annuity starting date may be BEFORE the distribution is permitted to commence under these rules.

For lump sum distributions: The present value cannot be less than the present value calculated using the applicable interest rate (30-year Treasury) and mortality table (1994 GAR).

Early Retirement Windows (See Revenue Ruling 92-66)

This contains potential material for True/False questions.

Early retirement windows are limited periods of time in which early retirement can be elected, with the early retirement benefit received under the terms of the window generally being substantially larger than would otherwise be available under the plan’s regular early retirement provisions. For example, the early retirement window benefit can provide that there is no actuarial reduction of the accrued benefit for early retirement. These windows are not protected benefits under the rules of IRC section 411(d)(6) because they are not a permanent part of the plan.

Early retirement windows are generally used as a means to encourage retirement of older workers so that they can be replaced by younger, lower paid employees.

This revenue ruling deals with the situation in which an early retirement window is offered at various times during a short period of time. This could lead to the conclusion that the early retirement windows are really not windows, but actual ongoing benefits being provided by the plan, which would result in the protections of IRC section 411(d)(6). According to the revenue ruling, as long as there are valid business reasons to offer the early retirement windows, they would not be considered a permanent part of the plan benefit structure.

Minimum Distributions under IRC section 401(a)(9) (See Revenue Notice 97-75)

This notice provides guidance relating to the amendments to the minimum distribution requirements of IRC section 401(a)(9) of the Internal Revenue Code ("Code") made by section 1404 of the Small Business Job Protection Act of 1996, Pub. L. 104-188 ("SBJPA"). Skim this notice for potential True/False questions. Here are some highlights:

  • For an employee (other than a 5-percent owner) who retires after the calendar year in which he attains age 70-1/2, the employee's accrued benefit must be actuarially increased in order to take into account the period after age 70-1/2 in which he is not receiving benefits under the plan.
  • The requirement that minimum distributions be made only to 5% owners does not violate the nondiscrimination rules of 401(a)(4).
  • Plans are permitted to allow participants who commenced distributions under pre-SBJPA section 401(a)(9) to stop receiving those distributions

Accrued Benefit Requirements under IRC section 411(b)

Benefits under a defined benefit plan must accrue according to one of the three following structures:

  1. The 133 1/3% Rule
  2. The 3% Rule
  3. The Fractional Rule

A plan amendment that changes the accrual rates of future benefits is treated as always having been in effect. In other words, once a plan benefit formula is amended, it is not necessary to look at the prior benefit formula in making the determination of whether or not it satisfies one of the three statutory benefit structures specified above. For integrated plans, assume constant CPI and wage bases. For salary-based plans, assume future earnings equal the current average under the plan.

133 1/3% rule - no accrual can exceed 133 1/3% of any prior year’s accrual.

Example 3-6

A plan offers a benefit of 2% of final salary times the first 10 years of service, 2.5% of final salary times the next 10 years of service and 3% of final salary times the remaining years of service.

Although each year’s accrual is within 133 1/3% of the prior year’s accrual, the final 3% rate is 150% of the earlier 2% rate, and the test applies to ANY prior year, so the plan fails under the 133 1/3% rule.