Administration provides guidance on annuities

IRS and the Treasury Department have released four regulatory initiatives — two revenue rulings and two proposed regulations — generally designed to encourage the use of annuities in or with respect to tax qualified retirement plans. The announcement of these initiatives was accompanied by the release of a report (the CEA Report) by the White House Council of Economic Advisors: Supporting Retirement For American Families February 2, 2012. (The CEA Report also discusses the finalized provider-sponsor (ERISA section 408(b)(2)) fee disclosure regulation.)

In this article: we begin with some background; we then discuss the CEA Report; then we provide a summary of the four initiatives (two proposed regulations and two revenue rulings); then we discuss the significance of these initiatives for plan sponsors; and finally we review each initiative in detail.


There is, in the retirement policy community, a concern that the spread of account-based retirement plans, which generally provide lump sums and, unlike traditional defined benefit plans, do not provide annuity options, may result in employees not adequately protecting against longevity risk. The simple version of this concern is: some employees may spend their lump sum too soon, or live longer than they thought, and wind up running out of retirement savings before they die.

But there are more complicated issues. Some employees may underspend in retirement out of a concern about living “too long.” And there is a more general concern that account-based plans, which communicate the benefit as a simple account balance, may not give employees a good idea of how long their account balance will last, i.e., how much they “need” to save to provide an “adequate” retirement income.

Council of Economic Advisors (CEA) Report

The Treasury/IRS initiatives and the CEA Report provide useful insight into how the Administration sees these issues. Let’s begin with some excerpts from the CEA Report.

The aggregate shift from traditional DB plans to 401(k)-type plans and hybrid DB plans highlights the problem of diminished prevalence of lifetime income benefits. This trend is exacerbated by lump-sum payouts from defined-benefit plans.

Workers seeking to bolster their lifetime income through the private market have limited access to private annuities. Annuities can be purchased either through an employer-sponsored plan or directly by an individual. Access to annuities through employer-sponsored plans is fading.

The shift in the retirement saving landscape away from lifetime income products has raised particular concern over longevity risk — the risk that retired workers will outlive their assets. The continued movement away from traditional DB plans towards 401(k) and hybrid DB plans means that fewer people can count on a guaranteed stream of pension income in retirement. Given declining but uncertain mortality, retirees are faced with the difficult task of choosing how much of their DC plan assets and other savings to spend in any given year. Retirees who live longer than expected may find themselves without sufficient assets at the point in their life when they are most vulnerable. This risk is particularly salient for women, who have longer expected lifespans than men and therefore are more susceptible to longevity risk.

Despite the potential that lifetime income products have to mitigate risk, very few retirees elect to purchase either immediate or longevity annuities. Economists refer to this disconnect as the “Annuity Puzzle.” A variety of explanations have been offered. Individuals may avoid annuities because of concerns over the irrevocability of the choice to purchase an annuity; the desire to retain liquid assets in case of unexpected medical costs or as a bequest to heirs; concerns over the complexity of annuities, their lack of transparency, or the long-term financial soundness of annuity providers; a lack of understanding of longevity risk and how lifetime income products can help manage it; or a lack of familiarity with annuity products, among other factors. Individuals may also be dissuaded from purchasing annuities due to their price. Like other financial arrangements that protect from risk, the present value of annuity payments can be expected, on average, to be somewhat lower than the annuity’s price. Part of this difference is due to adverse selection — the increased likelihood that healthier individuals purchase annuities. As more individuals enter the annuity market, the adverse selection problem can be expected to decline and the price of annuities may fall.

Several factors (beginning with limited demand from employees and plan sponsors) have constrained the purchase of annuities, including certain regulatory barriers and plan sponsor concerns about violating fiduciary responsibility by selecting an annuity provider with limited long-term financial stability. The proposed actions taken by Treasury today will help remove some of those constraints by easing and simplifying regulations that have limited lifetime income options.

Next, let’s take a brief look at what these initiatives are.


Briefly, there are four Treasury/IRS proposals:

1. Proposed regulation allowing the use of deferred annuities. This proposal would allow DC plans, IRAs, and certain other account-based plans (but not DB plans) to provide “qualified lifetime annuity contracts” (QLACs), annuities under which payments do not start until as late as age 85) without violating Tax Code minimum required distribution (MRD) rules, subject to certain limits (generally, the annuity premiums can’t be more than the lesser of 25% of the employee’s account or $100,000) and provided certain requirements were met.

2. Proposed regulations allowing DB plans to simplify the treatment of benefits paid partly as an annuity and partly in a more accelerated form (e.g., a lump sum). This proposal would make it easier for plans to offer “bifurcated benefits” — benefits that are, e.g., part lump sum and part life annuity.

3. Rev. Rul. 2012-3, clarifying the application of QJSA rules to 401(k) plans offering annuities as investment options. This revenue ruling holds that the QJSA rules (described below) do not apply until annuitization where, under an annuity investment option in a DC plan, the employee can transfer assets out of the annuity contract at any time before annuitization.

4. Rev. Rul. 2012-4 — roadmap for DC to DB rollovers. This revenue ruling generally provides a compliance roadmap for DC to DB rollovers. The idea is to make it easy for a DC participant to “annuitize” her DC account by directly rolling it over to an (annuity-providing) DB plan.

Relevance to plan sponsors

It’s unclear how much employee interest there is in annuity options, in DC plans or DB plans where employees have a lump sum option. The four initiatives reflect thinking about how to encourage annuities — by making the annuity piece of the benefit smaller (in the case of the deferred annuity and bifurcated benefit proposals) or “easier/cheaper” (in the case of DC to DB rollovers). The idea of a “trial annuity” (as envisioned by the revenue ruling dealing with the application of the QJSA rules to an annuity investment option) has also been floated as a way to get employees “used to” the idea of an annuity payment form.

Aside from the question of whether there is any employee interest in annuities (in any form), there are, at least with respect to DC plans, two regulatory issues that remain. First, if the annuity is to be provided “inside the plan” (as some of these initiatives envision), then selection of the annuity provider would be a fiduciary “act,” creating some risk to the sponsor (e.g., if the insurance company winds up in insolvency and cannot pay the annuity).

Second, as IRS notes in the preamble to the QLAC proposal, “[annuity] contracts provided under plans are priced on a unisex basis, while contracts offered under IRAs generally take gender into account in establishing premiums. Presumably, an insurance company providing annuity contracts under a plan will take this into account.” The obligation to determine “in the plan” annuity values on a unisex basis may be seen by some to reduce their utility.

That said, for those sponsors that wish to encourage more use of annuities in account-based plans, these initiatives provide a number of options they may find appealing.

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What follows is a more detailed discussion of each initiative.

1. Proposed regulations allowing the use of deferred annuities in qualified plans and IRAs

For some time, practitioners, providers and plan sponsors have considered the possibility of offering some sort of deferred annuity product in a defined contribution plan. In this context, a deferred annuity would, typically, provide for payment of a life annuity beginning at age 85. The idea is that an employee retiring at age 65 (with, more or less, a 20 year life expectancy), could allocate a portion of her account to the purchase of the deferred annuity and then draw down the remaining balance of her account over 20 years, secure in the knowledge that if she survives to age 85, the deferred annuity will provide retirement income for her.

There is, however, a problem with using deferred annuities with respect to qualified DC plan distributions. The distribution of an employee’s account in a DC plan generally must be made over a period not longer than the employee’s life expectancy. The amount of the account allocated to a deferred annuity is, for purposes of this rule, still counted as part of the employee’s account. As a result, there will be circumstances in which a portion of the employee’s benefit (under the deferred annuity contract) will not be distributed until after the end of the employee’s life expectancy period.

The proposed regulation provides a limited exception to that rule for qualifying longevity annuity contracts (QLACs). To get a flavor for the Administration’s view of the significance of deferred annuities in managing longevity risk, it’s worth quoting the preamble to the proposal:

The Treasury Department and the IRS have concluded that there are substantial advantages to modifying the required minimum distribution rules in order to facilitate a participant’s purchase of a deferred annuity that is scheduled to commence at an advanced age — such as age 80 or 85 — using a portion of his or her account …. Purchasing longevity annuity contracts could help participants hedge the risk of drawing down their benefits too quickly and thereby outliving their retirement savings. This risk is of particular import because of the substantial, and unpredictable, possibility of living beyond one’s life expectancy. Purchasing a longevity annuity contract would also help avoid the opposite concern that participants may live beneath their means in order to avoid outliving their retirement savings. If the longevity annuity provides a predictable stream of adequate income commencing at a fixed date in the future, the participant would still face the task of managing retirement income over that fixed period until the annuity commences, but that task generally is far less challenging than managing retirement income over an uncertain period.

The proposal

Under the proposal, a QLAC would not be considered part of the employee’s account for purposes of the MRD rules. A QLAC is an annuity that is purchased from an insurance company for an employee that satisfies each of the following requirements:

Generally, the premiums paid for the contract do not exceed the lesser of $100,000 or 25% of the employee’s account balance. There are rules for the adjustment of the $100,000 limit to reflect inflation. There are also rules for the netting against these limits of QLAC contributions under other plans, IRAs, etc.; in that regard, the plan administrator may rely on the employee’s written representation as to the amount of the QLAC premiums paid under arrangements not sponsored by the employer.

Distributions under the contract must start not later than age 85.

Distributions must satisfy the MRD rules generally applicable to annuities (e.g., that periodic annuity payments must be nonincreasing).

The contract does not make available any commutation benefit, cash surrender right, or other similar feature. Some view this limitation as reducing the appeal of a deferred annuity — generally, if the employee dies “early” (say, at age 84), she “loses” her benefit.

No benefits are provided under the contract after the death of the employee other than certain life annuities payable to a designated beneficiary. (There are several technical rules with respect to the amount of benefit that may be paid on death.)

The contract, when issued, states that it is intended to be a QLAC.

The issuer of the annuity contract is subject to detailed reporting and disclosure rules.

QLACs may, under the proposal, be provided under tax-qualified defined contribution plans, 403(b) plans, individual retirement annuities and accounts (IRAs), and eligible governmental section 457 plans. They may not be provided under DB plans.

2. Proposed regulations allowing DB plans to plans to simplify the treatment of benefits paid partly as an annuity and partly in a more accelerated form (e.g., a lump sum)

Under current rules, the present value of any “accelerated” form of benefit under a traditional DB plan generally must not be less than the amount calculated using Tax Code section 417(e) interest rates and mortality tables. (Tax Code section 417(e) rates are, generally, the same as the yield curve-segment rates used for funding, but without 2-year smoothing.)

In plain English: if you pay a lump sum under a traditional DB plan, it cannot be less than the present value of the lump sum using 417(e) interest rate and mortality assumptions. Optional annuity forms of payment, on the other hand, can be calculated using “reasonable” actuarial equivalency factors (you do not have to use 417(e) rates/tables).

And, under current rules, if you pay part of a participant’s benefit as a lump sum and part as a life annuity, then both the lump sum and the annuity must be calculated using 417(e) rates/tables. This “all or nothing” rule has made employers reluctant to allow a participant to elect a lump sum with respect to one part of his benefit and an annuity with respect to the other part.

Employees, on the other hand (according to IRS and the Treasury Department), are reluctant to elect an “all annuity” benefit. Quoting from the preamble to the proposed regulation:

[M]any participants have been reluctant to elect lifetime payments to insure against unexpected longevity, choosing instead an accelerated distribution form in order to maximize their liquidity. However, participants who elect a single sum or other accelerated form of distribution may face a greater challenge in protecting themselves against the risk of outliving their retirement savings. … The IRS and the Treasury Department believe that many participants would be better served by having the opportunity to elect to receive a portion of their retirement benefits in annuity form (which provides financial protection against unexpected longevity) while receiving accelerated payments for the remainder of the benefit to provide increased liquidity during retirement.

The proposal

The proposed regulations would solve this problem by allowing a participant to elect a “bifurcated accrued benefit.” If the participant does so, then the two different distribution options — one that is “accelerated” (e.g., a lump sum) and one that is not (e.g., a life annuity) — are treated as two separate optional forms of benefit for purposes of the foregoing rules. The lump sum would have to be calculated in accordance with 417(e) rates/tables. The residual annuity would not.

The proposal provides technical rules for the calculation of the portion of the benefit allocable, e.g., to the lump sum and life annuity.

Anti-cutback rule

A plan would have to be amended to take advantage of this new rule (if and when finalized). As actuarial factors are considered part of the participant’s benefit and cannot be changed if the result of the change would reduce the participant’s benefit, any such amendment will have to (at least) provide that the amount of each portion of a distribution is not less than the amount that would have been payable under the plan provisions in effect before the amendment.

3. Rev. Rul. 2012-3 — clarification of the application of QJSA rules to 401(k) plans offering annuities as investment options

IRS Revenue Ruling 2012-3 clarifies the application of the qualified joint and survivor annuity rules to 401(k) plans (and certain other defined contribution plans) offering the option to invest in an annuity. Three situations are considered:

Situation 1. Participants may invest in a variety of options, one of which is a deferred annuity contract that is issued by an insurance company. The amount payable under the deferred annuity contract is fixed (based on then prevailing interest rates, etc.) when payment begins (the annuity starting date — e.g., termination of employment). Amounts invested in the deferred annuity contract can be transferred to other investments at any time before the annuity starting date. Benefits are paid under the annuity as a life annuity, but the participant can instead elect, at any time before the annuity starting date, to have a single-sum payment.

If the participant doesn’t transfer assets out of the annuity or elect a lump sum payment prior to the annuity starting date, then benefits are paid in conformance with the QJSA rules.

Situation 2. The same as Situation 1, except that once having invested in the annuity contract, the participant may not subsequently transfer out the assets so invested, and the amount of the annuity payable with respect to that investment is fixed on the date the investment is made.

Situation 3. The same as Situation 2, except that a participant who invests amounts in the annuity contract can make an election to have no benefits payable under the contract with respect to amounts invested in the contract that are attributable to matching contributions in the event of death before the annuity starting date.

DB plans, and DC plans that are subject to the minimum funding rules (a money purchase plan is, e.g., subject to the minimum funding rules; profit sharing, 401(k) and stock bonus plans generally are not), generally must comply with ERISA/Tax Code QJSA rules. The “normal form” of payment must be a life annuity for unmarried participants and a 50% joint and survivor annuity (with the surviving spouse as the joint annuitant) for married participants. If the participant dies before making a retirement election, a life annuity must paid to her surviving spouse.

DC plans not subject to the minimum funding rules (e.g., profit sharing, 401(k) and stock bonus plans) are not subject to the QJSA rules provided that the participant’s nonforfeitable accrued benefit is payable in full, on the death of the participant, to the participant’s surviving spouse (or, if there is no surviving spouse or the surviving spouse consents, to a designated beneficiary); and the participant does not elect a payment of benefits in the form of a life annuity.

The plan in Situation 1 generally qualifies for this “exception” (in quotes because the overwhelming majority of 401(k) plans are designed to meet this exception) to the QJSA rules. Thus, in Situation 1 and under applicable law, amounts invested outside annuity contract are not subject to the QJSA rules, and the benefit can be paid as a lump sum. The Revenue Ruling holds that, under Situation 1, if the participant invests in the annuity contract and later transfers money out of it or elects a lump sum, the QJSA rules do not apply. Thus, they would only apply if the participant actually takes an annuity form of distribution.

In Situations 2 and 3, where the annuity is “locked in” at the time of investment, the plan is subject to the QJSA rules because at the time a participant invests amounts in the contract she has elected a life annuity. The only difference in treatment of these two situations is that, in Situation 3, the plan must comply with certain pre-retirement survivor benefit rules (including providing a written explanation and requiring spousal consent), because a waiver of annuity treatment is provided for. In Situation 2 it does not have to comply with those rules.

4. Rev. Rul. 2012-4 — roadmap for DC to DB rollovers

IRS Revenue Ruling 2012-4 provides a roadmap for Tax Code compliance for programs under which a participant is allowed to make a direct rollover from a defined contribution plan (typically, a 401(k) plan) to a defined benefit plan, where the DC and DB plans are both sponsored by the same employer.

The idea behind such a program is to provide an annuity alternative for the DC plan benefit that does not involve buying an annuity from an insurance company. The participant rolls over his account balance from the DC plan to the DB plan, and then the DB plan converts the account balance to an annuity which is paid to the participant. That DB plan annuity is, potentially, greater (because there are no profit, overhead and regulatory charges) than the annuity the participant could buy with the account balance from an insurance company.

This sort of program raises a number technical issues under the Tax Code, and Revenue Ruling 2012-4 provides a “road map” as to those how those issues should be addressed:

The Revenue Ruling assumes that a participant in the DC plan separates from service under conditions that would allow for immediate commencement of payment under the DB plan. That is, the DC plan participant has reached “retirement age” under the DB plan.

The DB plan provides that it will accept direct rollovers from the DC plan with respect to a DC plan participant only if he has elected to commence receiving benefits under the DB plan at a specified annuity starting date for all DB plan benefits.

The amount of the annuity payable with respect to the rollover is the actuarial equivalent of the amount rolled over using the applicable 417(e) rates/tables. A rate less favorable than the 417(e) rate may not be used (doing so would result in a (prohibited) benefit forfeiture). A rate more favorable than the 417(e) rate would present a number of problems (it would, in effect, be considered an additional benefit provided under the DB plan). (We note that cash balance plans are generally not subject to Tax Code section 417(e), and the ruling does not address the issue of the application of these rules to cash balance plans.)

If there is any period between the date of the rollover and the annuity starting date, interest is paid on the rolled over account balance at the same rate used for interest on employee contributions to DB plans (120% of Federal mid-term rate). If the participant dies before the annuity starting date, a benefit equal to the amount rolled over (plus interest) is paid to the participant’s beneficiary (subject to any QJSA rules).

In connection with the distribution, rollover, and annuity payment, the participant is presented with a package of election forms. The package provides for notarized spousal consent if the participant is married and elects a distribution that is not a qualified joint and survivor annuity, and is accompanied by a disclosure that includes a statement that if the DB plan terminates with insufficient funds to cover its liabilities, the benefit resulting from the direct rollover will be subject to the rules of ERISA Title IV, and a description of the maximum benefit limitation and other relevant Title IV limitations on guaranteed benefits.

The ruling also notes that any benefit payments from the DB plan would be subject to any applicable funding-based benefit restrictions.

As indicated, this Revenue Ruling basically presents a roadmap for how to set up a program allowing direct rollovers from DC to DB plans for the purpose of providing an annuity with respect to the DC account balance out of the DB plan. Clearly, there are elements of the Revenue Ruling that are, in effect, definitions of a legal standard. For instance, you could not, under one of these programs, convert the account balance to an annuity at an interest rate lower than the 417(e) rate.

Other elements of the ruling are more on the order of “this is how we think this program should be implemented.” Sponsors should consult with legal and tax counsel about the best way to implement one of these programs.

It’s not clear how many sponsors have implemented these programs — they do not seem to be widespread. Those that have implemented a DC to DB rollover program may not be in compliance with these rules. To accommodate that possibility, the IRS delayed the effective date — the ruling does not apply with respect to rollovers made before January 1, 2013, although a sponsor may rely on it before that date if it chooses to.

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We will continue to follow these issues.