Rev. Rul. 84-45

ISSUE

Whether a defined benefit offset plan that uses estimated wages for an employee in determining that employee's old-age insurance benefit provided under the Social Security Act fails to satisfy the nondiscrimination requirements of sections 401(a)(4) and (5) of the Internal Revenue Code and the minimum vesting requirements of section 411.

FACTS

A defined benefit plan is integrated with old-age, survivors, and disability insurance benefits by offsetting the retirement benefit otherwise payable to a participant by 83 1/3 percent of the old-age insurance benefit payable to such participant under the Social Security Act. The plan's retirement benefit is an annuity payable at age 65 for the life of a participant. The plan does not provide benefits upon death, disability or early retirement. All optional forms of benefit (including a qualified joint and survivor annuity) are the actuarial equivalent of the life annuity.

In determining the actual benefits to be paid under the plan, a participant's old-age insurance benefits under the Social Security Act are calculated by estimating the participant's compensation (rather than using actual compensation) for years before the year of the participant's separation from service on or before retirement. Further, in the case of a participant who separates from service before age 65, the social security old-age insurance benefit is determined under the plan on the assumption that the participant continues to receive compensation until age 65 at the same rate as the participant was receiving compensation at the time of his or her separation from the service of the employer.

LAW AND ANALYSIS

Section 401(a)(4) of the Code provides that a plan will not satisfy the qualification requirements of section 401(a) if the contributions and benefits provided under the plan discriminate in favor of employees who are officers, shareholders, or highly compensated.

Section 401(a)(5) of the Code provides that a plan shall not be considered discriminatory within the meaning of section 401(a)(4) merely because the contributions or benefits based on that part of an employee's remuneration which is excluded from "wages" by section 3121(a)(1) (relating to the Federal Insurance Contributions Act) differ from the contributions or benefits based on an employee's remuneration not so excluded.

Section 1.401-3(e) of the Income Tax Regulations establishes the general basis for the integration of pension, annuity, profit-sharing and stock bonus plans with old-age, survivors, and disability insurance benefits provided under the Social Security Act (OASDI benefits).

Rev. Rul. 71-446, 1971-2 C.B. 187, provides additional rules for the integration of plans with old-age, survivors and disability insurance benefits provided under the Social Security Act. Section 2.07 of Rev. Rul. 71-446 defines, in part, an "offset plan" as a plan under which all the provisions including the benefit rates apply uniformly to all covered employees regardless of compensation, except that an employee's benefit otherwise computed under the plan formula is reduced or offset by a stated percentage of such employee's old-age insurance benefit under the Social Security Act. Section 7 of Rev. Rul. 71-446 provides, in general, that an offset plan is integrated if the rate at which the offset to any employee's benefit is computed does not exceed 83 1/3 percent. Because the amount of such old-age insurance benefit under the Social Security Act is determined based on the actual wage history of the employee, the old-age insurance benefit under the Social Security Act used to offset an employee's benefit must also be computed based on the actual wage history of the employee. Section 11 of Rev. Rul. 71-466 requires that, in the event of retirement or severance of employment by an employee before age 65, the permissible offset must be calculated on the basis of the employee's actual wage history for the period before retirement or severance and an assumed compensation determined under one of the alternatives provided in that section for the period thereafter.

In this case, because the offset specified in the plan is based upon an estimated or assumed wage history for all years of employment, such offset may exceed the maximum offset permitted by Rev. Rul. 71-446. Thus, the plan fails to satisfy the integration requirements of Rev. Rul. 71-446.

Furthermore, aside from the specific integration requirements of Rev. Rul. 71-446, the plan may fail to satisfy the nondiscrimination requirements of section 401(a)(4) of the Code. The use of an assumed wage history may effectively result in an offset that varies from participant to participant as a percentage of the old-age benefit based upon the actual wage history of each participant. If employees who are officers, shareholders, or highly compensated receive, in effect, offsets that are lower than the offsets (as a percentage of actual old-age benefits) for other employees, the plan will not satisfy the requirements of section 401(a)(4).

Section 411(a) of the Code provides rules under which certain rights of employees to benefits accrued under a qualified plan must be nonforfeitable.

Section 1.411(a) 4(a) of the regulations states that "nonforfeitable rights are not considered to be forfeitable by reason of the fact that they may be reduced to take into account benefits which are provided under the Social Security Act or under any other Federal or State law and which are taken into account in determining plan benefits." (emphasis added). That section does not consider a forfeiture to occur when the accrued benefit decreases, because the participant has not lost a benefit when social security is taken into account with other plan benefits in accordance with section 401(a)(5) of the Code. Consequently, in the case of an offset plan where social security offsets are calculated based on actual compensation history, a forfeiture will not occur merely because a participant, who has not separated from service, suffers a dollar reduction in the actual annual benefit provided under the plan because the offset portion of the benefit formula, over some interval, increases more rapidly than the positive portion of the benefit formula.

In the case of an offset plan where offsets are calculated based on estimated compensation, the mere offset of social security benefits based on estimated previous compensation will not constitute an impermissible forfeiture to the extent that the offset limits the accrued benefit without causing a reduction in the accrued benefit previously nonforfeitable. If a plan calculates offsets on the basis of estimated compensation, it is possible for a participant to suffer an impermissible forfeiture under section 411 of the Code. For example, it is possible, from one year to the next, for the estimated offset to increase more rapidly than the actual offset and more rapidly than the positive portion of the benefit formula. In such a case, a participant for whom the estimated offset is greater than the actual offset will suffer an impermissible forfeiture because the dollar reduction in the accrued benefit under the plan is not matched by actual benefits under social security or any other Federal or State law. Similarly, it also is possible for social security benefits to increase by a percentage (such as by a cost-of-living adjustment) that causes the estimated offset with respect to a participant to increase more rapidly than the actual offset. In this case, a participant for whom the estimated offset is greater than the actual offset will suffer an impermissible forfeiture because such participant's accrued benefit under the plan is decreased as a result of such increase in social security.

In Alessi v. Raybestos Manhattan, Inc., 451 U.S. 504 (1981), 1981-1 C.B. 219, the Supreme Court held that certain pension plan provisions for offsets based on workers' compensation awards do not contravene the nonforfeiture provisions of the Employee Retirement Income Security Act of 1974 (ERISA), Pub.L. 93-406, 1974-3 C.B. 1. However, the Supreme Court acknowledged that the right of the parties to create a plan providing for offsets is not absolute. The Supreme Court, citing Rev. Rul. 78-178, 1978-1 C.B. 118, noted that the Internal Revenue Service does not permit qualified plans to offset pension benefits by reimbursement of medical expenses, fixed sums made for bodily impairment, or unemployment compensation because such payments do not match up with any benefits available under a pension plan qualified under the Internal Revenue Code or ERISA. The court pointed out that "Without speaking directly of its own rationale, Congress embraced such IRS rulings." Id. at 521. See H.R.Conf.Rept. No. 93-1280, 93d Cong., 2d Sess. 277 (1974). In the facts in Alessi the benefits that were offset were actual benefits provided not estimated benefits.

HOLDING

The defined benefit plan in this case fails to satisfy the requirements of section 411 of the Code and may fail to satisfy the requirements of sections 401(a)(4) and (5).

GENERAL RULES FOR USE OF ESTIMATED EARNINGS HISTORY

However, under this revenue ruling, a defined benefit plan will not fail to satisfy the requirements of sections 401 and 411 of the Code merely because the maximum offset under the plan is determined using an estimated wage history for some or all years before retirement or separation from employment (and therefore estimated old-age benefits) if and only if all of the following rules are satisfied:

(1) The pre-separation or pre-retirement salary history (or pre-hire salary history) is estimated by applying a salary scale, projected backwards, to the employee's compensation (as defined in section 3.03 of Rev. Rul. 71-446) at separation or retirement (or compensation at hire) and the salary scale is either

(A) the actual change in the average wages from year to year as determined by the Social Security Administration, or

(B) a level percentage per year that is not less than six percent per annum.

(2) A plan gives clear written notice to each employee of the employee's right to supply actual salary history and of the financial consequences of failing to supply such history. The notice must be given each time the summary plan description is provided to the employee and must also be given upon separation from service. The notice must also state that the employee can obtain the actual salary history from the Social Security Administration.

(3) The plan provides that the benefit for a participant will be adjusted to the offset based on an actual salary history for years previously estimated before separation from service (and an assumed post-separation or post-retirement compensation in accordance with section 11.01 of Rev. Rul. 71-446 when applicable) if the participant supplies documentation of that history. A plan may provide that such documentation must be provided no later than a reasonable period of time following the later of the date of separation from service (by retirement or otherwise) and the time when the participant is notified of the benefit to which he or she is entitled.

The estimated wages may be used either only for years before employment with the employer or for all years before retirement or separation from employment.

The use of estimated wage histories subject to the above rules will not, in and of itself, cause the plan to fail to satisfy sections 401 and 411 of the Code.

This revenue ruling does not preclude an employer from basing the social security offset upon the actual wage history of the participants. Also, the offset may be determined by assuming that a participant earned no compensation for periods before the participant was employed by the employer and using actual compensation paid by the employer for periods of service with the employer. In determining an offset using this latter approach, such years of zero compensation are averaged together with the compensation for subsequent years to compute average indexed earnings.

For purposes of this revenue ruling, the term "employer" includes all entities that are treated as a single employer under sections 414(b), 414(c), or 414(m) of the Code, relating respectively to controlled corporations, controlled trades or business, and affiliated service groups.

PROSPECTIVE APPLICATION

Inasmuch as employers may have plans that provide for an offset based upon an estimated wage history but fail to satisfy the requirements set forth above, pursuant to the authority contained in section 7805(b) of the Code, this revenue ruling is effective only with respect to any employee who has any service during a plan year beginning after December 31, 1983.

Offset plans using estimated wages in determining old-age insurance benefits must be amended to comply with the requirements of this revenue ruling in order to satisfy the requirements of Rev. Rul. 71-446, as modified by this revenue ruling. The amendment must be adopted by the end of the first plan year beginning after December 31, 1983, and made effective as of the beginning of such plan year.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 71-446 is clarified and is modified to allow the use of an estimated wage history as specified in this revenue ruling.