IRS bans lump sums to already retired pension participants

On July 9, 2015, IRS released Notice 2015-49, Use of Lump Sum Payments to Replace Lifetime Income Being Received By Retirees Under Defined Benefit Pension Plans. The Notice effectively prohibits, as of July 9, 2015, the payment of lump sums to retiree-annuity recipients in de-risking transactions.

In this article we review the Notice.

Background – the factual context

In recent years, defined benefit plan sponsors have employed a variety of strategies to ‘de-risk’ – to reduce the effect the DB plan has on sponsor cash and accounting. The most ‘thorough’ way to do that with respect to a given participant is to fully pay out the participant’s benefit, either by distributing an annuity purchased from an annuity carrier or by paying the participant’s benefit out as a lump sum.

Generally (and there certainly are exceptions), paying out a lump sum is ‘cheaper’ than buying an annuity. That’s because, under rules that fully phased-in in 2012, the lump sum required to be paid for a given DB benefit is (more or less) equivalent to the value of that benefit on the plan’s books. Buying annuities, on the other hand, can be much more expensive. Annuity carriers generally underwrite plan liabilities more conservatively than the plan’s sponsor does for funding purposes; the carrier has a margin for administration and profits; and regulatory costs increase the annuity price.

The benefits of certain participants (oversimplifying, those whose benefits are valued at $5,000 or less) may be paid as a lump sum without the participant’s consent. Participants whose benefits are valued at more than $5,000 must be given a choice to take either a lump sum (if one is being offered) or an annuity.

The ‘lowest hanging fruit’ for this sort of de-risking is lump sum payouts to terminated vested participants. Some sponsors, however, have gone further, offering lump sums to current retirees. That latter strategy has been particularly controversial (in this regard, see our article Concerns over pension de-risking).

The legal issue

One regulatory issue presented by de-risking transactions that involve paying lump sums to retirees is whether converting the participant’s benefit from an annuity to a lump sum violates the minimum distribution rules under Tax Code section 401(a)(9).

Tax Code section 401(a)(9) generally requires that distributions under a qualified plan must begin as of the required beginning date and continue over a period not exceeding the life (or life expectancy) of the participant or joint life (or joint life expectancy) of the participant and a designated beneficiary. The ‘required beginning date’ is April 1 of the year following the year the participant reaches age 70 1/2 or, if later and the participant is not a 5% owner, retires.

In a DB plan, a retired participant who does not take a lump sum distribution at retirement is typically receiving an annuity that began at retirement (the annuity starting date). Applicable regulations provide that once payments have commenced over a period (e.g., over the life of the participant as a life annuity), the period may only be changed in certain circumstances. One of those circumstances is an increase in benefits that is the result of a plan amendment.

2014 private letter rulings

In 2014, IRS issued several private letter rulings (PLRs) addressing the 401(a)(9) issue, holding that the de-risking transactions reviewed, which generally involved offering a lump sum to retiree-annuitants during a limited ‘window’ period, constituted “the payment of increased benefits as a result of the addition of the lump sum option. … Because the ability to select a lump sum will only be available during a limited window, the increased benefit payments will result from the proposed plan amendment and, as such, are a permitted benefit increase under [the regulation].”

PLRs generally only apply to the specific transaction under consideration, have no precedential value and cannot be relied on by taxpayers other than the applicant.

Notice 2015-49

Notice 2015-49 effectively reverses the position IRS took in the 2014 PLRs. Bottom line: effective July 9, 2015, sponsors may not offer lump sums to retirees receiving annuity benefits that have commenced under the 401(a)(9) rules. The Notice does not include an extensive legal analysis. In effect, this is simply the announcement of a change of position on a complicated issue. Here is the key language from the Notice:

[T]he Treasury Department and the IRS intend to propose amendments to [the applicable regulations] to provide that the types of permitted benefit increases described in that paragraph include only those that increase the ongoing annuity payments, and do not include those that accelerate the annuity payments. [Applicable exceptions] would not permit acceleration of annuity payments to which an individual receiving annuity payments was entitled before the amendment, even if the plan amendment also increases annuity payments.

The Notice is styled as a notice of intent to amend the applicable regulations. Presumably this approach – rather than the ‘normal’ process of simply proposing a regulation – was taken in order to move as quickly as possible on this issue.

While the general thrust of the change in policy is clear, the Notice is relatively brief and leaves several questions un-answered. May lump sums be offered to retirees under age 70 1/2 (the 401(a)(9) ‘required beginning date’)? It looks like the answer to this question will be ‘no.’ May lump sums be offered to retirees in connection with a plan termination? It looks like the answer to this question will be ‘yes.’ But we will have to wait for the actual proposal of a regulation (at least) before we get definitive answers to these questions.

Effective date – pre-Notice accelerations

The change (the reversal of IRS’s position) described in the Notice is effective as of July 9, 2015. The Notice also states that the new rule:

[W]ill not apply to an acceleration of ongoing annuity payments that is in association with a plan amendment specifically providing for implementation of a lump sum risk-transferring program: (1) adopted (or specifically authorized by a board, committee, or similar body with authority to amend the plan) prior to July 9, 2015; (2) with respect to which a private letter ruling or determination letter was issued by the IRS prior to July 9, 2015; (3) with respect to which a written communication to affected plan participants stating an explicit and definite intent to implement the lump sum risk-transferring program was received by those participants prior to July 9, 2015; or (4) adopted pursuant to an agreement between the plan sponsor and an employee representative (with which the plan sponsor has entered into a collective bargaining agreement) specifically authorizing implementation of such a program that was entered into and was binding prior to July 9, 2015. [Emphasis added.]

A “lump sum risk-transferring program” is defined (in the Notice) as a DB plan amendment providing “a limited period during which certain retirees who are currently receiving joint and survivor, single life, or other life annuity payments … may elect to convert that annuity into a lump sum that is payable immediately.”

Again, while the general thrust of this effective date/grandfather rule is clear, questions about specifics remain.

Recent PBGC premium increases have made de-risking particularly attractive (in this regard see our articles Reducing pension plan headcount reduces risk and PBGC premiums and Reducing PBGC variable-rate premiums: contribution timing). For sponsors involved in 2015 retiree de-risking transactions, the IRS Notice, announcing, in effect, a reversal in its position on the ‘legality’ of paying lump sums to retirees, is potentially disruptive to some plan sponsors.

Hopefully we will get an actual proposed regulation – answering some of the outstanding questions – relatively soon.

We will continue to follow this issue.