The IRS recently issued long-awaited final regulations on hybrid pension plans, along with proposed transitional relief for hybrid pension plans that are not in compliance with the final rules.  The newly issued final rules provide guidance on issues not covered in the final hybrid plan regulations that were issued in 2010, and clarify certain issues in the 2010 final regulations.  The final rules are generally effective for plan years beginning on or after January 1, 2016, except that provisions in the final rules clarifying provisions in the 2010 final rules are effective for plan years beginning on or after January 1, 2011. 

The primary issue covered by the final rules is what constitutes a “market rate of return” for purposes of the Internal Revenue Code (the “Code”) requirement that interest crediting rates under a hybrid pension plan not be greater than a market rate of return.  Under the final regulations, the following interest crediting rates satisfy the “market rate of return” requirement: 

• A fixed interest rate up to 6% (up from the 5% originally proposed in 2010).
• A variable governmental bond index (plus appropriate margins set forth in Notice 96-8), with a permitted floor of up to 5% (up from the 4% originally proposed in 2010).
• The 1st, 2nd or 3rd segment rate, with a permitted floor of up to 4% (newly added under the final rules).
• The consumer price index (plus a margin of up to 3%), with a permitted floor of up to 5% (up from the 4% originally proposed in 2010).
• The actual rate of return on plan assets (or subset of plan assets if certain conditions are met).
• The rate set forth in annuity contract issued by a State-licensed insurance company.
• The rate of return on a regulated investment company that is reasonably expected to be not significantly more volatile than a broad U.S. or similar international equities market. 

The regulations also permit the Commissioner of the IRS to set forth other permissible interest crediting rates, or to modify the permissible rate floors and ceilings at a later date.  The IRS made clear in the Preamble to the final rules that the rates listed are the only permitted interest crediting rates that will satisfy the market rate of return requirements.  Treasury and the IRS are continuing to study whether a hybrid plan design that bases the interest crediting rate on participant self-direction of investments should be permitted.  If they decide that such design is not permissible, only plans that have this feature on September 18, 2014 will be granted relief from the anti-cutback rules of Code Section 411(d)(6). 

The final regulations also provided guidance on several other issues pertaining to hybrid pension plans, including the following: 

• Plans can obtain the whipsaw relief provided by the Pension Protection Act of 2006 even if early retirement subsidies or other optional forms of payment are offered under the plan, provided that the optional form of benefit is not less than the actuarial equivalent of the hypothetical account or pension equity plan accumulation.
• If a plan uses a variable interest crediting rate, the rate of interest used to determine accrued benefits upon plan termination must be equal to the average of the plan’s interest crediting rate for the five-year period ending on the termination date.  The final rules provide guidance on how to calculate this five-year average.
• Pension equity plans are not required to provide interest rate credits, but if they do, the crediting rate needs to satisfy the market rate of return requirement. 

The proposed regulations are designed to permit sponsors of hybrid plans with a noncompliant interest crediting rate to be amended without violating the 411(d)(6) anti-cutback rules.  The relief provided under the proposed rules would apply to amendments made to bring the plan into compliance by changing only the feature of the interest crediting rate that is noncompliant, while not changing other features of the existing crediting rate. 

Sponsors of hybrid pension plans may want to carefully review the final rules with their actuaries and ERISA counsel, and determine whether any changes to their plans need to be made before the plan year beginning on or after January 1, 2016 in order to bring their plans into compliance with the final rules.