Defined benefit plan administration gotcha – 415 compensation limit

There is a provision in Internal Revenue Code (IRC) Section 415 that states that a participant’s pension benefit cannot exceed the highest three-year average compensation. For example, suppose that a participant’s highest three years of compensation are $45,000, $50,000, and $55,000 (for an average of $50,000). According to IRC Section 415, the participant’s pension benefit cannot exceed $50,000 a year.

On the surface, this may seem like a non-issue. After all, pension plans rarely replace 100% of a participant’s compensation. However, the devil is in the details, and we will explore a situation where this limit can come into play.

First, consider the applicable provisions of the IRC:

• Section 415(b)(1) – Provides that a participant’s annual benefit cannot exceed the lesser of:
• A specified dollar amount indexed each year ($230,000 for 2020). This is the “§415 dollar limit.”
• “One hundred percent of the participant’s average compensation for his high three years” where compensation is limited to the 401(a)(17) compensation limit. This is the “§415 comp limit.”
• Section 415(b)(2)(A) - States that the term “annual benefit” means a benefit payable annually as a straight life annuity.
• Section 415(b)(2)(B) – Provides that the limit shall be adjusted for other forms of benefit (e.g., a 10-year certain and life annuity). Note that the limit is not adjusted for qualified joint and survivor forms of benefit.
• Section 415(b)(5)(B) – Provides that the limit shall be prorated if the participant has fewer than 10 years of service.
• Section 415(b)(11) – Provides that this limit is not applicable for governmental plans.
• Section 401(a)(17) – Provides that a participant’s annual compensation cannot exceed a specified dollar amount indexed each year ($285,000 for 2020).

The IRC does provide for adjustments to the §415 dollar limit for benefits commencing prior to age 62 or after age 65, but not to the §415 comp limit. This means that for a late commencement (after age 65), the 415 dollar limit will be adjusted (increased), but the 415 comp limit will not.

Because most plans do not target 100% replacement ratios, when would the §415 comp limit come into play? Some plans target a 60% replacement ratio, so assume a full career participant in such a plan and, as in the example cited above, the three-year average compensation at termination is $50,000. Therefore, the annual accrued benefit payable as a straight life annuity at normal retirement is $30,000 ($30,000 = 60% of $50,000).

Additional assumptions include:

• The participant defers commencement of benefits until age 70.
• The plan provides actuarial increases for benefits commencing after age 65.
• The plan’s definition of actuarial equivalence is the 1994 Group Annuity Reserving (GAR) mortality table and 7.5% interest.

Because the participant is commencing after normal retirement age, the $30,000 accrued benefit must be actuarially increased from age 65 to age 70. Assuming benefits are increased for both interest and mortality, the accrued benefit is increased by the ratio of the age 65 single life annuity factor divided by the age 65 deferred to age 70 annuity factor. In numerical terms, $51,856 = $30,000 * (9.694952 / 5.608816). Note, though, that $51,856 is greater than the §415 comp limit of $50,000. Therefore, this participant’s actuarially increased benefit would have to be limited to $50,000 to avoid violating IRC Section 415.

Those of us who work in pension administration may be more familiar with the §415 dollar limit than the §415 comp limit. As such, when we think of IRC Section 415, our focus may be on high benefit amounts. After all, the §415 dollar limit for someone commencing at age 65 in 2020 is $230,000, and it is even higher for someone commencing after age 65 in a plan that provides an actuarial increase for late retirement.

But with the §415 comp limit, it is not, strictly speaking, the size of the benefit that presents an issue but rather the size of the benefit relative to the compensation received by the participant. Thus, even participants with relatively modest benefits can be affected by the §415 comp limit if the actuarial increase for late retirement provided by the plan is large enough.

It is quite possible for terminated vested participants who are commencing after their normal retirement date to receive an actuarial increase on their accrued benefit that violates IRC Section 415, even if their accrued benefit amounts are relatively modest. Staying aware of this contingency as benefits are processed will help eliminate this possible pitfall in defined benefit plan administration.

It is especially important to review your terminated vested participant population every year and reach out to them to commence benefits if they are at or beyond normal retirement age. If your plan is not pay-related, pay close attention to long-service participants whose benefit (based on a benefit multiplier and length of service) may exceed the §415 comp limit. For active employees past normal retirement age, the actuarial increase provided by the plan should be compared each year with additional accruals unless the plan sends suspension of benefits notices and/or is frozen. If an active participant has reached the §415 comp limit, an in-service distribution may be required depending on the plan provisions.