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Most of the focus on the new CARES Act 2020 retirement plan liquidity provisions – liberalized withdrawal rules, waiver of the 10% early withdrawal tax, and 3-year income tax recognition/rollover – has been on 401(k) plans. But the temporary relief also applies to defined benefit plans, and DB plans may serve as an indispensable resource for certain plan participants experiencing financial stress in the current crisis. There may also be other reasons for DB sponsors to consider offering such distributions.
In this article we review the issues presented by DB Coronavirus related distributions.
The basics
The CARES Act 2020 retirement plan withdrawal rules generally apply to DB plans in the same way they do to DC plans. Here’s a recap (with a focus on a couple of specific DB plan issues):
What distributions are allowed from a DB plan? The CARES Act does not change when a distribution may be made to a DB participant. The short version is that lump sum distributions to terminated vested participants are allowed, subject to participant (and, where applicable, spousal) consent where the present value of the benefit is greater than $5,000. For other participants, including those “furloughed” (but not permanently “separated from employment”) by the sponsor in the Coronavirus crisis, active employees over age 59 1/2, and retirees, the answer is more complicated – sponsors will want to review these issues with counsel if they are interested in making 2020 lump sum distributions to one or more of these groups.
What special tax incentives apply? CARES provides several provisions that make taking a lump sum Coronavirus related distribution in 2020 more attractive to participants than taking a “regular” lump sum would be at other times: (1) The 10% early withdrawal tax does not apply. (2) These distributions may be included in taxable income ratably over three years. And (3) they may be rolled over during that three-year period, if desired.
What is a Coronavirus-related distribution? The rules here are the same as they are for DC plans: a “coronavirus-related distribution” means any distribution from a tax-qualified retirement plan made on or after January 1, 2020, and before December 31, 2020, to an individual:
Who is diagnosed with a disease designated as coronavirus by a test approved by the Centers for Disease Control and Prevention;
Whose spouse or dependent is so diagnosed; or
Who experiences adverse financial consequences as a result of being quarantined, being furloughed or laid off or having work hours reduced due to the coronavirus, being unable to work due to lack of child care due to such virus or disease, closing or reducing hours of a business owned or operated by the individual due to such virus or disease, or other factors as determined by the Secretary of the Treasury.
For this purpose, the plan administrator may rely on an employee certification.
Reasons participants may wish to take a Coronavirus related distribution from a DB plan:
First (and most obviously), the participant may (indeed, given the requirements, probably is) experiencing adverse financial consequences because of the current crisis.
Second, adverse taxation (both the 10% additional tax and income “bunching”) may be one of main reasons a terminated vested participant hasn’t already taken a lump sum – the one-time relief from these rules presented by the CARES Act may be a significant motivator.
Third, “liquidating” a traditional DB or cash balance benefit may make more sense, from a portfolio management standpoint, than liquidating the participant’s position in her 401(k) plan.
Effect on plan sponsor
Each year we provide an article discussing the economic advantages/disadvantages of paying lump sums to terminated vested participants. (Our 2020 article is here.) Generally (and summarizing), de-risking/lump summing-out a terminated vested participant reduces the cost of paying ongoing Pension Benefit Guaranty Corporation premiums.
When to provide a lump sum option depends, in part at least, on the sponsor’s view of the interest rate trend. We are following interest rate activity closely (see, e.g., our recent article Markets 2020 – effect on PBGC variable-rate premiums and strategies to reduce them). In the current context, we would observe, first, that probably the most important issue for a sponsor is its view of the trajectory of future interest rates. And, second, that that trajectory may depend on the relative balance between a crisis-driven decline in demand and extraordinary federal fiscal and monetary stimulus efforts.
Finally, because of complications presented by partial withdrawals, sponsors may wish to limit distributions to those who have benefits of $100,000 or less.
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An important – probably the most important – reason to implement this sort of program is the need of participants experiencing financial stress, as a result of the effects of the disease or a related layoff, to take a distribution in the current crisis. Which makes the sponsor’s decision – whether to implement a DB Coronavirus lump sum window – somewhat urgent.
We will continue to follow this issue.