Honor thy 409A grandfather

Pizzano-DominickThis blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.

Section 409A certainly has set forth more than its fair share of commandments; however, “Honor thy 409A grandfather” has to rank very close to the top of the “most need to follow” list. While Section 409A’s regulatory reach has been described as overwhelmingly widespread, there is still one 409A-free safe haven for NDCP sponsors and participants—the past. Because the 409A rules generally are effective only for amounts deferred after December 31, 2004, benefits attributable to the period prior to January 1, 2005, can avoid 409A coverage provided that they are correctly calculated under and maintained in accordance with the grandfather rules. This blog will review these rules in an effort to provide NDCP sponsors with a reminder of the importance of preserving their grandfathers and a guide to assisting them with such maintenance.

Correct creation and identification of the grandfather
As briefly indicated above, this topic only affects those NDCPs that were in effect prior to January 1, 2005 (i.e., the date that 409A officially became effective). Furthermore, even if an NDCP was in effect prior to that date, the grandfather treatment is only available if the NDCP sponsor made a timely decision to elect grandfathering and met the required documentation and administrative conditions to effect such treatment. To meet the documentation requirement, the sponsor would have had to adopt an amendment to the plan clearly stating that the applicable amounts would be grandfathered and that only the benefits accrued on and after January 1, 2005, would be subject to the 409A rules. The administrative requirement is a bit trickier. First, the plan sponsor had to correctly identify and calculate the permissible amount to be grandfathered. The general rule is that grandfathered treatment is available for any amounts that were both earned and vested as of December 31, 2005. The specific calculation of the applicable amounts depends on whether the NDCP under consideration is a defined contribution (DC) or defined benefit (DB) style plan:

DC style
The permissible grandfather amount equals the sum of (1) the vested portion of the participant’s account balance as of December 31, 2004, plus (2) any future contributions to the account, the right to which was earned and vested as of December 31, 2004, to the extent such contributions were actually made, plus (3) any future earnings (whether actual or notional) on such amounts.

DB style
As one might imagine, the calculation of the permissible grandfathered amount under DB style is considerably more complex. It equals the present value of the amount to which the participant would have been entitled under the plan if such participant (1) voluntarily terminated services without cause on December 31, 2004, (2) received a payment of the benefits available from the plan on the earliest possible date allowed under the plan to receive a payment of benefits following the termination of services, and (3) received the benefits in the form with the maximum value. There are various ways that this amount may increase over time without violating the grandfather rules; however, an increase in the potential benefits under a DB NDCP that is due to, for example, an application of an increase in compensation after December 31, 2004, to a final average pay plan, or to subsequent eligibility for an early retirement subsidy, would not constitute earnings on the amounts deferred under the plan before January 1, 2005, and thus are not permissible reasons to increase the grandfathered amount. A complete description of how such increases can occur without violating the grandfather rules is beyond the scope of this blog. The calculation of any such increases should be made by the sponsor only after consultation with its actuary and legal counsel to ensure that they are completed in a permissible manner. The 409A rules indicate that when performing such calculations, “reasonable” actuarial assumptions and methods must be used. While no exact definition of “reasonable” is offered, the rules do provide two pieces of guidance to assist with this process:

(1) Whether assumptions and methods are reasonable for this purpose is determined as of each date the benefit is valued for purposes of determining the grandfathered benefit, provided that any reasonable actuarial assumptions and methods that were used by the plan sponsor with respect to such benefit as of December 31, 2004, will continue to be treated as reasonable assumptions and methods for purposes of calculating the grandfathered benefit.

(2) Actuarial assumptions and methods will be presumed reasonable if they are the same as those used to value benefits under the qualified plan maintained by the NDCP, provided that such qualified plan’s benefits are part of the benefit formula, or otherwise affect the amount of benefits, under the NDCP.

Accordingly, sponsors need to have not only correctly calculated their plan’s original grandfathered amounts, but also to have established and continue to maintain administrative systems that accurately track such amounts (along with any applicable future earnings attributable to such amounts) separately from any non-grandfathered amounts that may exist under their plans.

How to keep your grandfather safe
The principle behind 409A permitting grandfathering for the amounts calculated in accordance with the above-described rules is that because such amounts were accumulated during a time when the 409A rules were not a consideration, these amounts (plus future earnings attributable to them) and the past plan provisions that govern them should not be required to now change to comply with 409A. However, there is a limit to this free pass and the key to preserving it is to ensure that such “past plan provisions” not undergo any “material modifications” after October 3, 2004. The reason this particular legal line in the sand is drawn at October 3, 2004, as opposed to January 1, 2005, is that the earlier date represents the date that the new legislation was signed into law. Because, naturally, there was some advance warning that these new rules were arriving, the 409A grandfathering guidelines were written to prevent sponsors from squeezing in material modifications during the window between October 3, 2004, and the official effective date of January 1, 2005.

So what exactly constitutes a material modification for this purpose? Does any change or amendment to the plan provisions governing grandfathered amounts automatically revoke the grandfather, thereby triggering 409A coverage and penalties for noncompliance? Fortunately, there is some leeway here and the final 409A rules provide helpful guidance by describing both those actions that are deemed “material” as well as those that are “immaterial” and thus can be made without jeopardizing the plan’s grandfather status.

Material modifications = grandfather gone
In general, a modification of an NDCP is material if a benefit or right existing as of October 3, 2004, is materially enhanced or a new material benefit or right is added, and such material enhancement or addition affects amounts earned and vested before January 1, 2005. Such material benefit enhancement or addition is a material modification whether it occurs pursuant to an amendment or to the service recipient’s exercise of discretion under the terms of the plan. For example, an amendment to a plan to add a provision that payments of deferred amounts earned and vested before January 1, 2005, may be allowed upon request if participants are required to forfeit 20% of the amount of the payment (a haircut) would be a material modification to the plan. Similarly, a material modification would occur if a plan sponsor exercised discretion to accelerate vesting of a benefit under the plan to a date on or before December 31, 2004. In addition, a plan amendment or the exercise of discretion under the terms of the plan that materially enhances an existing benefit or right or adds a new material benefit or right will be considered a material modification even if the enhanced or added benefit would be permitted under section 409A. For example, the addition of a right to a payment upon an unforeseeable emergency of an amount earned and vested before January 1, 2005, would be considered a material modification.

Immaterial modifications = grandfather survives
However, it is not a material modification for a plan sponsor to exercise discretion over the time and manner of payment of a benefit to the extent such discretion is provided under the terms of the plan as of October 3, 2004. It is also not a material modification for a participant to exercise a right permitted under the plan in effect on October 3, 2004. In addition, the amendment of a plan to bring the plan into compliance with the provisions of section 409A will not be treated as a material modification. Furthermore, the reduction of an existing benefit is not a material modification. For example, the removal of a haircut provision generally would not constitute a material modification. Other modifications that are also considered to be immaterial include, but are not limited to, the following:

• The establishment of, or contributions to, a trust or other arrangement from which benefits under the plan are to be paid, provided that the contribution to the trust or other arrangement would not otherwise cause an amount to be includible in the participant’s gross income.

• Compliance with a domestic relations order with respect to payments to an individual other than the participant or an amendment to a plan to require compliance with a domestic relations order with respect to payments to an individual other than the participant.

• The modification of a plan providing a life annuity form of payment to permit an election between the existing life annuity form of payment and other forms of life-based annuity payments (e.g., a plan that only offers a single life annuity option being amended to also offer joint and survivor annuity options).

• The addition of a limited cash-out feature in accordance with the 409A rules.

• Suspension or termination of a plan (i.e., cessation of deferrals under, or termination of, a plan, pursuant to the provisions of such plan); however, note that amending a plan to provide participants an election whether to terminate participation in a plan generally constitutes a material modification of the plan.

• Changes affecting the investment measures in a DC NDCP (e.g., changing a notional investment measure or adding to an existing investment measure), provided that such investment measures either qualify as a predetermined actual investment or otherwise reflect a reasonable rate of interest.

Do not take your 409A grandfather for granted
NDCP sponsors of plans with pre-2005 benefits are faced with many complicated rules to which they must adhere if they want to keep these amounts from becoming subject to 409A. Caring for a 409A grandfather to ensure its continued viability is an ongoing process that requires an expert knowledge of the various do’s and don’ts as well as attentive administration. Consequently, sponsors should not hesitate to seek out qualified specialists in this field to keep their grandfathers 409A-fit.