ALLOCATION OF LIABILITIES UNDER THE UNIT CREDIT METHOD TO PAST AND FUTURE SERVICE MUST TAKE INTO ACCOUNT SEC. 145 BENEFIT LIMITS

Rev. Rul. 85-131

ISSUE

Whether the version of the unit credit (accrued benefit) funding method described below, under which certain liabilities are allocated to the current plan year rather than to prior plan years, is a reasonable funding method under section 1.412(c)(3)-1 of the Income Tax Regulations?

FACTS

A defined benefit pension plan was established effective January 1, 1983. The taxable year of the employer and the plan year both coincide with the calendar year. The plan provides that a participant's normal retirement benefit (payable as a life annuity at age 65) is 50 percent of the participant's high three consecutive years' compensation. However, the plan also provides that the accrued benefit of a participant at any time is 50 percent of the participant's high three consecutive years' compensation at that time, subject to the maximum benefit limitation under section 415(b)(1) of the Internal Revenue Code (which is explicitly stated in the plan). This limitation prohibits the accrual of an annual benefit in excess of the lesser of 100 percent of a participant's high three consecutive years' compensation at such time or $90,000. Further, section 415(b)(5) of the Code provides that, for a participant with less than 10 years of service with the employer, the maximum benefit limitation determined under section 415(b)(1) of the Code is reduced to an amount equal to that limitation (before such reduction) multiplied by a fraction, the numerator of which is the number of years (or part thereof) of service with the employer and the denominator of which is 10.

A version of the unit credit (accrued benefit) funding method is used to determine plan costs for the 1983 plan year for purposes of section 404 and 412 of the Code. The method determines the projected retirement benefit and allocates all of such benefit to the first year of participation in the plan. Because of this allocation, the normal cost of the plan for the 1983 plan year is the present value of the projected retirement benefits.

LAW

Section 412(c)(3) of the Code provides that all costs, liabilities, rates of interest, and other factors under a plan shall be determined on the basis of actuarial methods which are reasonable.

Section 1.412(c)(3)-1(c)(5) of the regulations provides that under a reasonable funding method that allocates liabilities among different elements of past and future service, the allocation of liabilities must be reasonable.

Section 1.412(c)(3)-1(e) of the regulations provides special rules for a funding method that determines normal cost as an amount equal to the present value of benefits accruing under the method for a particular plan year. The unit credit funding method is a method that determines normal cost in this manner.

Section 1.412(c)(3)-1(e)(3) of the regulations provides that, in determining a plan's normal cost and accrued liability for a particular plan year, the projected benefits of the plan must be allocated between past and future years. Except in the case of a career average pay plan, the allocation of projected benefits of the plan between past years and future years must be in proportion to the applicable rates of benefit accrual under the plan. Thus, the allocation to past years is effected by multiplying the projected benefit by a fraction, the numerator of which is the participant's credited years of service and the denominator of which is the participant's total credited years of service at the anticipated benefit commencement date. However, in formulating this fraction, adjustments are made to account for changes in the rate of benefit accrual.

ANALYSIS

For an employee who was hired on January 1, 1983, and commenced participation on that date, the benefit that accrues under the plan described above for the first plan year is the lesser of 10 percent (100 percent multiplied by 1/10) of high three consecutive years' compensation at such time or $9,000 ($90,000 multiplied by 1/10). If the plan provided a greater benefit accrual in such plan year, the plan would exceed the maximum benefit limitation described in section 415(b)(1) of the Code. Accordingly, for purposes of section 1.412(c)(3)-1(e) of the regulations and pursuant to the limitation under section 415(b)(5) of the Code, the plan is viewed as providing a rate of benefit accrual equal to 10 percent of compensation (subject to the dollar limitation of section 415(b)(1) of the Code) for each year of the participant's first five years of service.

For an employee with four years of service on January 1, 1983, the benefit that accrues under the plan described above in the first plan year (i.e., the employee's fifth year of service) is the lesser of 50 percent (100 percent multiplied by 5/10) of high three consecutive years' compensation at such time or $45,000 ($90,000 multiplied by 5/10). Of this accrued benefit, the lesser of 40 percent of high three consecutive years' compensation as of the end of the first plan year or $36,000 is provided by the plan due to past years of service. Thus, for purposes of section 1.412(c)(3)-1(e) of the regulations, the initial accrued liability for this employee under the unit credit funding method (assuming 25 credited years of service at the anticipated benefit commencement date), after applying the fraction described in section 1.412(c)(3)-1(e)(3) of the regulations, is the present value of the lesser of 40 percent of high three consecutive years' compensation as of the anticipated benefit commencement date or $36,000. The 40 percent amount is calculated in the following manner:

     50 percent of compensation (4x10)

Similarly, for any employee with other than four years of service on January 1, 1983, any benefit that accrues under the plan described above in the first plan year in excess of the lesser of 10 percent of high three consecutive years' compensation as of such time or $9,000 is only on account of past services. Thus, for purposes of section 1.412(c)(3)-1(e) of the regulations, the maximum benefit that may be treated as accruing in the first plan year for such an employee is the lesser of 10 percent of higher consecutive years' compensation as of the anticipated benefit commencement date or $9,000.

Under the version of the unit credit funding method utilized for the plan described above, the normal cost is determined as the present value of benefits accruing during the plan year. Thus, the funding method used for such plan allocates a participant's entire projected retirement benefit to the 1983 plan year (the first plan year) and allocates no liabilities to previous years. Because the funding method used for the plan does not reasonably allocate liabilities between past and future service in proportion to the applicable rates of benefit accrual under the plan, as illustrated by the preceding analysis, such method does not satisfy the requirement of section 1.412(c)(3)-1(e) of the regulations.

HOLDING

The allocation of liabilities between past and future years of service under the version of the unit credit funding method used for the plan described above does not satisfy the requirements of section 1.412(c)(3)-1(e)(3) of the regulations. Thus, the actuarial cost method utilized for the plan is not reasonable under section 412(c)(3) of the Code.