Rev. Rul. 74-166

Section 1. Purpose.

The purpose of this Revenue Ruling is (1) to reconsider the position taken in Rev. Rul. 65-266, 1965-2 C.B. 138, and (2) to provide acceptable methods for comparing the benefits of two or more plans which have different vesting schedules.

Sec. 2. Background.

.01 Section 401(a)(3) of the Internal Revenue Code of 1954 specifies certain coverage requirements that must be satisfied in order for a plan to qualify. Section 1.401-3(f) of the Income Tax Regulations permits a plan, that does not satisfy the coverage requirements of section 401(a)(3) of the Code standing alone, to qualify under section 401(a) if the employer designates several trusts, or a trust or trusts and an annuity plan or plans, to be considered as a unit, and such unit satisfies the requirements of sections 401(a)(3) and 401(a)(4). Section 401(a)(4) provides that contributions or benefits shall not discriminate in favor of employees who are officers, shareholders, persons whose principal duties consist in supervising the work of other employees, or highly compensated employees.

02. In Rev. Rul. 65-266, an employer established a pension plan, with full and immediate vesting, covering individuals on whose behalf discrimination is prohibited by section 401(a)(4) of the Code (the "higher plan"). The employer also established a pension plan, with less than full and immediate vesting, covering the rank-and-file employees (the "lower plan").

The higher plan, standing alone, did not satisfy the coverage requirements of section 401(a)(3) of the Code nor the nondiscrimination requirements of section 401(a)(4). The two plans considered by Rev. Rul. 65-266, taken together, satisfied the coverage requirements of section 401(a)(3)

The question considered by Rev. Rul. 65-266is whether benefits provided by the two plans taken together satisfy the requirements of section 401(a)(4) of the Code, since the higher plan provides better vesting.

Rev. Rul. 65-266holds, under the given fact situation, that the benefit requirement of section 401(a)(4) of the Code is not satisfied since vested benefits are more valuable than non-vested benefits and the higher plan provides better vesting. That holding does not consider the value of all of the respective benefits provided by the two plans.

Sec. 3. Conclusion.

The Internal Revenue Service now holds that differences in vesting are not discriminatory per se and that such differences should be taken into consideration for purposes of comparing the benefits provided under two or more plans with unlike vesting provisions. This conclusion also is consistent with the conclusion reached by the court in the following cases: United States v. Hall, 398 F.2d 383 (8th Cir. 1968) and Loper Sheet Metal, Inc., 53 T.C. 385 (1969).

Sec. 4. Methods of Comparing Benefits

01. Section 401(a)(4) of the Code requires, assuming benefits rather than contributions are being tested, that benefits must not discriminate in favor of members of the prohibited group. In comparing the benefits provided under two plans, the total benefits provided for any member of the prohibited group in the higher plan must not exceed in value, stated as a percentage of compensation, the total benefits provided for participants in the lower plan. Vested benefits are more valuable than an equal amount of non-vested benefits. If the higher plan provides greater vesting than the lower plan, benefits under the higher plan must be adjusted upward in relation to benefits under the lower plan, for purposes of computing their value stated as a percentage of compensation, to reflect differences in vesting. Various methods may be used to reflect differences in vesting where the higher plan provides better vesting than the lower plan.

02. One acceptable method of adjusting the value of benefits to reflect differences in vesting is to adjust upward, for comparison purposes, the value of benefits payable to any given member of the prohibited group participating in the higher plan. Such adjustment in the value of benefits should reflect the difference applicable to such participant between the vesting actually provided in the higher plan and the vesting that would be provided in such plan if the vesting provisions in the lower plan were applied to the higher plan.

Under this method, the "average vesting" for each member of the prohibited group participating in the higher plan is determined as the average of the percentage of the accrued benefit vested for each year of plan participation for such participating member, such average being taken over the 25-year period commencing with the date of such participating member's initial plan participation. The "average vesting' under the lower plan is similarly determined with respect to such participating member by assuming that the vesting provisions in the lower plan apply to each such participating member in the higher plan. For purposes of applying these guidelines, eligibility for early, normal or deferred retirement is considered to be equivalent to 100 percent vesting, and years after those dates will be included in the 25-year period if it extends beyond such dates. The value of the benefits for each such participant, stated as a percentage of compensation, is then increased by a factor equal to 50 percent of the difference in average vesting, if the average vesting under the higher plan is greater than the average vesting under the lower plan.

03. Another acceptable method of adjusting the value of benefits to reflect differences in vesting is to adjust, for any participant in a given plan, the value of the benefits provided under that plan by the value of the vesting provided under that plan applicable to the given participant.

Under this method, average vesting is determined for each member of the prohibited group participating in the higher plan in the same manner as in the first method, but based solely on the vesting provisions of the higher plan. Average vesting is similarly determined for each participant in the lower plan based on the vesting provisions of the lower plan. If, for any two individuals being compared, the average vesting of the participant in the prohibited group in the higher plan exceeds the average vesting of the participant in the lower plan, then the value of the benefits provided for the participant in the higher plan is increased by 50 percent of his average vesting in the higher plan, and the value of the benefits provided for the participant in the lower plan is increased by 50 percent of his average vesting in the lower plan.

04. Either of the above-described methods may be used to reflect differences in vesting for the purpose of comparing benefits provided under the higher plan with benefits provided under a lower plan in any instance where the average vesting for members of the prohibited group in the higher plan exceeds such vesting in the lower plan. Neither of these methods may be used, however, in adjusting for more favorable vesting in a lower plan.

Sec. 5. Examples.

01. Example of Application of First Method: The higher plan covering only salaried employees of the employer provides a vesting schedule of 10 percent of the accrued benefit after completion of the first year's service, increasing 10 percent after completion of each subsequent year's service until attaining 100 percent vesting after completion of ten years' service. The lower plan, covering rank-and-file hourly workers covered by a union-negotiated collective-bargaining agreement, provides no vesting for each of the first ten years' service, but 100 percent vesting thereafter. Normal retirement age of both plans is age 65. The hourly plan contains no members of the prohibited group. The salaried plan, on its effective date, covers three members of the prohibited group (A, B & C). The vesting adjustment under the first method described above is illustrated below:

                                               Age at

Employee B is 20 percent vested the first year of participation under the plan (since he has two years of service), 30 percent the second year, and so forth until he is 100 percent vested at the beginning of the ninth year of participation under the plan. The average vesting applicable to employee B is

20% + 30% + 40% + 50% + 60% + 70% + 80% + 90% + (17 X 100%)

                      (8 X 0%) + (17 X 100%)

Employee C has 0 percent vesting the first year, 10 percent vesting the second year, increasing to 70 percent vesting in the eighth year, and 100 percent vesting thereafter since he will then have reached his normal retirement age (age 65). His average vesting in the higher plan is

0% + 10% + 20% + 30% + 40% + 50% + 60% + 70% + (17 X 100%)

                      (8 X 0%) + (17 X 100%)

02. Example of Application of Second Method: The higher plan covering only salaried employees of the employer provides a vesting schedule of 10 percent of the accrued benefit after completion of the first year's service, increasing 10 percent after completion of each subsequent year's service until attaining 100 percent vesting after completion of 10 years' service. The lower plan, covering rank-and-file hourly workers covered by a union-negotiated collective-bargaining agreement, provides a vesting schedule of 5 percent of the accrued benefit after completion of the first year's service, increasing 5 percent after completion of each subsequent year's service until attaining 100 percent vesting after completion of 20 years' service. The salaried plan, on its effective date, covers one employee in the prohibited group (Employee A) who has 2 years' completed service. The hourly plan has two employees (Employee B and Employee C) with 3 and 15 years' completed service, respectively. All three employees have at least 25 years participation remaining before eligibility for early or normal retirement under their respective plans. The vesting adjustment under the second method described above is illustrated below:

Employee A in the higher plan has 2 years' completed service. His average vesting is therefore

20% + 30% + 40% + 50% + 60% + 70% + 80% + 90% + (17 X 100%)

15% + 20% + 25% + 30% + 35% + 40% + 45% + 50% + 55% +

             75% + 80% + 85% + 90% + 95% + (20 X 100%)

Sec. 6. Effect on Other Documents.

Rev. Rul. 65-266 is hereby revoked.