Flat Benefit, Safe Harbor

[jmelbye]

I'm not sure I fully understand what a "flat benefit' is (in the context of safe harbor formulas, 1.401(a)(4)-4(b)(4)(i)(C)(2)).

The regulation goes on to specify that a flat benefit is one that:

is the same percentage of average annual compensation or the same dollar amount for all employees who have a minimum number of years of service at normal retirement age (e.g. 50 percent of average annual compensation), with a pro rata reduction in the flat benefit for employees who have less than the minimum number of years of service at normal retirement age.

This sounds simple enough, but I'm wondering why more examples in the regulation, and practice problems in Farber's manual are not solved by satisfying this rule. I think this sounds like the easiest safe harbor rule to satisfy (for fractional rule formulas) since it can be done purely by inspection. No need to look at ratios of accruals or perform an average benefit percentage test. Since it is not used more, I'm doubting my understanding of the rule.

Example1 in the same section of the regulation goes as follows:

Plan A provides a normal retirement benefit equal to 1.6 percent of average annual compensation times each year of service up to 25.

It also goes on to say that the benefit is accrued according to the fractional rule, so I know which set of safe harbor rules I'm going to be dealing with.

As for how the plan satisfies the safe harbor rules, the example shows that the smallest annual accrual (for employees with 33 years of service) is 1.212%, while the largest is 1.6%, and 1.6/1.212 = 1.32 < 1.333, so the safe harbor rule of section (b)(4)(i)(C)(1) is satisfied.

But isn't it also true (and easier to show) that (b)(4)(i)(C)(2) is satisfied? Can't I describe the benefit as 40% of average annual compensation, with a pro rata reduction for employee's with fewer than 25 years of service at normal retirement age?

I'm just looking for confirmation that this is true, or clarification as to why such formulas do not satisfy safe harbor rule (2) since I would think more of the regulation's examples, and Farber's problems would use this rule to satisfy safe harbor as to me it seems easier.

Thanks

[davefarber]

Originally Posted by jmelbye

I'm not sure I fully understand what a "flat benefit' is (in the context of safe harbor formulas, 1.401(a)(4)-4(b)(4)(i)(C)(2)).

The regulation goes on to specify that a flat benefit is one that:


This sounds simple enough, but I'm wondering why more examples in the regulation, and practice problems in Farber's manual are not solved by satisfying this rule. I think this sounds like the easiest safe harbor rule to satisfy (for fractional rule formulas) since it can be done purely by inspection. No need to look at ratios of accruals or perform an average benefit percentage test. Since it is not used more, I'm doubting my understanding of the rule.

Flat benefit formulas like this are more typically used in the small plan area, while unit benefit formulas tend to be large plan formulas. Regulations tend to be written with large plans in mind, which is why you are finding the greater focus on the unit benefit formulas. But you are understanding the rule just fine.

Originally Posted by jmelbye

Example1 in the same section of the regulation goes as follows:

It also goes on to say that the benefit is accrued according to the fractional rule, so I know which set of safe harbor rules I'm going to be dealing with.

As for how the plan satisfies the safe harbor rules, the example shows that the smallest annual accrual (for employees with 33 years of service) is 1.212%, while the largest is 1.6%, and 1.6/1.212 = 1.32 < 1.333, so the safe harbor rule of section (b)(4)(i)(C)(1) is satisfied.

But isn't it also true (and easier to show) that (b)(4)(i)(C)(2) is satisfied? Can't I describe the benefit as 40% of average annual compensation, with a pro rata reduction for employee's with fewer than 25 years of service at normal retirement age?

I'm just looking for confirmation that this is true, or clarification as to why such formulas do not satisfy safe harbor rule (2) since I would think more of the regulation's examples, and Farber's problems would use this rule to satisfy safe harbor as to me it seems easier.

You are absolutely right that these formulas (the unit benefit in the example, and your conversion to a flat benefit) are equivalent. So you could certainly analyze it as you have done here.

[jmelbye]

Thanks for confirming my understanding of the rule. When a formula has no bend points in it, this is the first thing I check. No need to bring ratios into the mix.

[jmelbye]

Note: When I originally posted, I had the wrong citation. What I cited was from 1.401(a)(4)-3, not 1.401(a)(4)-4.

I'm making my second pass through my study manual, and have a follow-up question to this topic. Farber's practice question 44 includes the following formula:

1.00% of highest consecutive 3-year average compensation for each of the first 15 years of service

Further, you are told that the plan accrues benefits according to the fractional rule. The question asks if the formula is a safe harbor formula.

The solution shows that in the worst case (33 years of accrual service), the annual accrual is 15% / 33 years = 0.455%. In the best case (a participant with no more than 15 years of accrual service), the annual accrual is 1%. Clearly 1% is more than 4/3 times the 0.455% accrual, and therefore the safe harbor described in 1.401(a)(4)-3(b)(4)(i)(C)(1) (the 133 1/3 rule) is not satisfied.

However, using the same logic as in the previous post, I could restate this formula as a flat benefit formula:
15% of the highest consecutive 3-year average compensation with a pro-rata reduction for service less than 15 years.

This formula accrues over less than 25 years, so safe harbor (2) is not available. However, safe harbor (3) still appears available to me. Of course, to determine whether or not safe harbor (3) is satisfied, information would need to be provided to compare the average benefit percentages under the formula for NCHEs and HCEs. This information is not given, so in an exam situation, I would be okay saying the formula does not satisfy safe harbor. But safe harbor (3) (flat benefit, passes an average benefit percentage test) is still available, correct?

If the formula had any bend points in it, I believe that would cease to be the case.

Thanks,
Jason

[davefarber]

Originally Posted by jmelbye

Farber's practice question 44 includes the following formula:

Further, you are told that the plan accrues benefits according to the fractional rule. The question asks if the formula is a safe harbor formula.

The solution shows that in the worst case (33 years of accrual service), the annual accrual is 15% / 33 years = 0.455%. In the best case (a participant with no more than 15 years of accrual service), the annual accrual is 1%. Clearly 1% is more than 4/3 times the 0.455% accrual, and therefore the safe harbor described in 1.401(a)(4)-3(b)(4)(i)(C)(1) (the 133 1/3 rule) is not satisfied.

However, using the same logic as in the previous post, I could restate this formula as a flat benefit formula:
15% of the highest consecutive 3-year average compensation with a pro-rata reduction for service less than 15 years.

This formula accrues over less than 25 years, so safe harbor (2) is not available. However, safe harbor (3) still appears available to me. Of course, to determine whether or not safe harbor (3) is satisfied, information would need to be provided to compare the average benefit percentages under the formula for NCHEs and HCEs. This information is not given, so in an exam situation, I would be okay saying the formula does not satisfy safe harbor. But safe harbor (3) (flat benefit, passes an average benefit percentage test) is still available, correct?

If the formula had any bend points in it, I believe that would cease to be the case.

Thanks,
Jason

Yes, you are correct.

[Ricardo]

I think i am missing someting to!

Question 39 ( of Dave's outline)
Which of the following are safe harbor benefit formulas (each accrued using the fractional rule over all years of service) under IRC section 401(a)(4)?
I. 1.00% of highest consecutive 3-year average compensation for each of the first 15 years of service

the answer was:
Formula I: A participant with 15 years or fewer of total service will accrue 1% of average compensation per year. In the worst case, a participant with 33 years of service will have an accrual of:
(1% × 15 years)/33 years = 0.455%
The 1% accrual is more than 133 1/3% of the 0.455% accrual, so the safe harbor rules are not satisfied for formula I.

The formula though look very front loaded and it looks to me like it satisfies the 133.33% rule under section 411(b) -one of the safe harbors under IRS regulation 1.401(a)(4)-3(b)-therefore is a safe harbor formula!
what i am missing?
Thank you

[davefarber]

Originally Posted by Ricardo

I think i am missing someting to!

Question 39 ( of Dave's outline)
Which of the following are safe harbor benefit formulas (each accrued using the fractional rule over all years of service) under IRC section 401(a)(4)?
I. 1.00% of highest consecutive 3-year average compensation for each of the first 15 years of service

the answer was:
Formula I: A participant with 15 years or fewer of total service will accrue 1% of average compensation per year. In the worst case, a participant with 33 years of service will have an accrual of:
(1% × 15 years)/33 years = 0.455%
The 1% accrual is more than 133 1/3% of the 0.455% accrual, so the safe harbor rules are not satisfied for formula I.

The formula though look very front loaded and it looks to me like it satisfies the 133.33% rule under section 411(b) -one of the safe harbors under IRS regulation 1.401(a)(4)-3(b)-therefore is a safe harbor formula!
what i am missing?
Thank you

You would be correct that this formula satisfies the 133 1/3% rule of 411(b) -- if not for the fact that the data in the question specifically tells you that the benefit is "accrued using the fractional rule over all years of service." If a formula is accrued using the fractional rule, then it satisfies the fractional rule of 411(b), and not by either one of the other rules. Note that the general conditions of the exam state that unless you are told otherwise, the benefit accrues as the formula is written. So what you need to look for in questions is whether the question states that the fractional rule is being used to accrue benefits -- if it is, then that is how the formula satisfies 411(b). Otherwise, you need to satisfy either the 133 1/3% rule or the 3% rule of 411(b). As you say, if the benefit formula satisfies 411(b) via the 133 1/3% rule, then it is generally a safe harbor formula under 401(a)(4). If it satisfies 411(b) via the 3% rule then it is not a safe harbor formula under 401(a)(4).

[Ricardo]

Thank you Dave