Employers continue to move from traditional defined benefit pension plans providing monthly payments to 401(k) plans and other defined contribution plans providing lump-sum cash distributions. As a result, increasing numbers of retirees, now including baby boomers leaving the workplace, are faced with managing a cash distribution for 20 or 30 years and possibly running out of funds. Uncertain markets have made plan participants wary of their ability to maintain their nest eggs.
For several months, the Department of the Treasury (Treasury), including the Internal Revenue Service (IRS), and the Department of Labor (DOL) have been exploring ways to provide “income-stream” options for more retirement plan participants. The agencies have focused on finding a balance between lump-sum cash distributions (which provide liquidity) and lifetime-income options (which provide a steady stream of income over the participant’s lifetime and protect against financial risk).
This past February, the Treasury and the IRS released two proposed regulations, and the IRS issued two revenue rulings, that provide different strategies for achieving such a balance:
- A partial annuity option, providing a bifurcated benefit of both a lump-sum cash distribution and an annuity under a defined benefit plan.
- A longevity annuity option, providing an annuity that begins at an advanced age under a defined contribution plan.
- An annuity purchase option from a participant’s employer’s defined benefit plan, using assets from his or her account in the employer’s defined contribution plan.
- A deferred annuity option from a defined contribution plan.
This guidance was the product of an effort by these two agencies, as well as the DOL, that included a two-day public hearing and a request for information that resulted in some 800 written comments. The agencies have emphasized that this guidance is a first step, and encourage further comments and innovations from plan sponsors, providers of investment and financial products, participants and other stakeholders.
Partial Annuity Option under Defined Benefit Plan
One of the major issues outlined in the guidance package is the perception that the form of benefit under a tax-qualified defined benefit plan is an “all-or-nothing” choice, typically either a lump-sum payment or an annuity. Most such plans do not offer a combination of forms of benefit distribution, such as part of the accrued benefit paid as a cash distribution and part going to purchase an annuity. Consequently, in a proposed regulation the Treasury has outlined a bifurcated benefit distribution form, where a portion of a participant’s plan benefit is taken as an annuity, while the remainder is paid as a single lump-sum cash payment.
The current legal hurdle in calculating a bifurcated benefit is the requirement to calculate the amount of the total benefit as a lump sum in accordance with the interest rate and mortality table specified under Section 417(e)(3) of the Internal Revenue Code of 1986 (Code), rather than using the plan’s regular annuity conversion factors (i.e., the factors used to convert a single-life annuity to a joint-and-survivor annuity) to calculate the portion of the benefit separately that would be paid in annuity form. The proposed regulation would amend this requirement by providing that the Section 417(e)(3) actuarial assumptions need only be used to calculate the portion of the distribution being paid as a lump sum.
To provide for a bifurcated benefit, a plan would need to be amended to offer this option and to clarify the application of the plan’s actuarial factors. Such an amendment should state that the plan is permitted to use the actuarial factors that generally apply to annuity distributions to determine the annuity portion of a bifurcated benefit, instead of the currently required Section 417(e)(3) assumptions. Any plan amendment would also need to comply with the prohibition on cutbacks of accrued benefits provided in Code Section 411(d)(6).
Note: The proposed regulation on partial annuity distributions is intended to be effective for distributions with annuity starting dates in plan years beginning after the publication date of a final regulation. Thus, a plan cannot rely on the proposed regulation to implement a partial annuity option at this time.
Longevity Annuity Option under Defined Contribution Plan
To address the concern that retirees may outlive their savings, especially where the only retirement plan distribution received by the retiree is a lump sum from a defined contribution plan, the guidance package includes a proposed regulation that introduces a new concept, the “qualified longevity annuity contract” (QLAC). Such a contract would provide a stream of income commencing at an advanced age, such as 80 or 85, and would continue as long as the individual lives. The proposed regulation details how a defined contribution could provide for a QLAC while simultaneously complying with the required minimum distribution (RMD) rules under Code Section 401(a)(9). In most cases, the RMD rules require commencement of plan benefits upon the later of a participant’s retirement or attaining age 70½.
Currently, each calendar year’s RMD to a plan participant is determined by dividing his or her entire account balance in the plan at its last valuation date in the preceding calendar year by a factor based upon his or her life expectancy. Consequently, if the participant bought a longevity annuity with a portion of his or her account balance, the value of the annuity would have been included in calculating the RMD each year before the annuity began, thus increasing the amount of the RMD, even to the point where the RMD was greater than the value of the remaining account balance (excluding the value of the annuity). This would have triggered an earlier distribution from the annuity.
Under the proposed regulation, if a plan offered a QLAC, the QLAC would be disregarded in determining RMDs. Therefore, a participant would not need to commence distributions from the QLAC before the age selected under the QLAC contract.
Also under the proposed regulation, a QLAC would be an annuity contract purchased from an insurance company for a plan participant that satisfies each of the following requirements:
- Premiums for the contract satisfy a specific dollar limitation and percentage of assets limitation, i.e., the lesser of $100,000 (to be adjusted in accordance with Code Section 415(d)) or 25 percent of the account balance.
- The contract provides that distributions must commence not later than a specified annuity starting date, and that annuity starting date cannot be later than the first day of the month coincident with or next following the participant’s attainment of age 85.
- The contract provides that, after distributions under the contract commence, those distributions must satisfy the requirements of Treasury Regulation Section 1.409(a)(9)-6 (other than the requirement that annuity payments commence on or before the required beginning date).
- The contract does not make available any commutation benefit, cash surrender right or other similar feature.
- There are no benefits provided under the contract after the death of the employee, other than a life annuity payable to a designated beneficiary.
- The contract, when issued, states that it is intended to be a QLAC.
Additionally, issuers of QLACs are subject to certain reporting and disclosure requirements.
QLACs could also be provided under 403(b) plans and traditional IRAs, but not under 457(b) plans, defined benefit plans or Roth IRAs.
Note: Similar to the proposed regulation on partial annuity distributions, the new guidance on QLACs would be effective for contracts purchased after the publication date of a final regulation; in the interim, plans cannot rely on the proposed regulation.
Annuity Purchase From Employer’s Defined Benefit Plan Using Defined Contribution Plan Assets
The third piece of guidance, Revenue Ruling 2012-4, explains how a qualified defined benefit pension plan that accepts a participant’s direct rollover of an eligible rollover distribution from a qualified defined contribution plan maintained by the same employer can use the transferred assets to provide an immediate annuity distribution to the participant while satisfying Code Sections 411 and 415.
This ruling makes it clear that such a transfer and resulting annuity are permissible where the plan language supports the rollover and where the annuity is actuarially equivalent to the amount transferred. Additionally, the transferred amount must meet additional criteria:
- It cannot be forfeitable under the terms of the defined benefit plan.
- While the amount is generally not counted in the determination of the participant’s annual benefit limitations under Code Section 415(b) (because it is a direct rollover), where the resulting annuity is determined using a more favorable actuarial basis than is required under Section 411(c), the excess amount is includable in any Section 415(b) testing.
- The defined benefit plan must contain adequate notice and consent rules for benefit elections consistent with Code Sections 401(a)(11), 411(a)(11) and 417.
Note: An open issue remains regarding whether the rolled-over amount from the defined contribution plan would be considered a “priority category” if the defined benefit plan undergoes a distress termination. Such amounts could be treated as mandatory employee contributions with a higher priority, but final clarification may have to come from the Pension Benefit Guaranty Corporation.
Deferred Annuities from Defined Contribution Plans
The final piece of guidance is Revenue Ruling 2012-3. This ruling describes how the qualified joint-and-survivor annuity (QJSA) and qualified pre-retirement survivor annuity (QPSA) requirements in Code Sections 401(a)(11) and 417 apply when a deferred annuity contract is purchased under a defined contribution plan.
The ruling provides three examples that illustrate different deferred annuity design alternatives, each with different conditions: a revocable annuity, a fixed annuity and a fixed annuity with an election not to pay amounts attributable to matching contributions under the annuity contract in the event the participant dies prior to the annuity starting date. The ruling then provides an analysis of how each alternative would necessitate certain plan terms, including compliance with QJSA and QPSA notice, waiver and consent requirements.
The ruling clarifies that where the plan separately accounts for the deferred annuity contract, the remainder of the plan is not subject to the QJSA and QPSA requirements.
Employers may wish to provide comments to the Treasury on either or both of the proposed regulations; these comments must be provided by May 3, 2012. In addition, plan sponsors interested in the new options should evaluate how the options could be integrated into current plan design and communicated to participants.
For more information regarding retirement plans and the ongoing development of lifetime-income options, please contact the authors or any other members of McGuireWoods’ Employee Benefits team.