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On September 9, 2016 IRS published final regulations providing rules for “partial annuity distributions” in defined benefit plans, e.g., distribution of part of a participant’s benefit as a lump sum and part as an annuity. In this article we discuss the final regulation.
Under current rules, the present value of any optional form of DB benefit 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 and without interest rate stabilization.) This rule, however, does not apply where the distribution is an annual benefit that either does not decrease during the life of the participant or that decreases during the life of the participant merely because of the death of the survivor annuitant or the cessation or reduction of Social Security supplements or qualified disability benefits.
Thus, if you pay a lump sum under a DB plan, it must be at least as great as the lump sum calculated using 417(e) interest rate and mortality assumptions. If you pay a life annuity, you can calculate the benefit using plan actuarial equivalency factors. Just to connect the dots here, plan annuity factors are typically simpler and change less frequently than 417(e) factors. As a result, converting, e.g., a single life annuity to a 10-year certain and life annuity using plan factors generally will produce an economically different result than doing the same conversion using 417(e) factors.
And, under prior rules (in IRS’s view, at least), 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 the effect of changing the economics of the non-lump sum part of this transaction. That result has made some employers reluctant to allow a participant to elect partial lump sums.
Participants, on the other hand, are (in the view of IRS) 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 greater challenges in protecting against the risk of outliving their retirement savings. The Treasury Department and the IRS believe that many participants are 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 their benefits to provide increased liquidity during retirement.
Under the final regulation, a plan can use either of two approaches to calculate separate lump sum/annuity benefits:
Explicit bifurcation: A plan may apply the 417(e) lump sum calculation rules “to a specified portion of a participant’s accrued benefit as if that portion were the participant’s entire accrued benefit.” The remaining benefit (the participant’s total benefit minus the specified portion paid as a lump sum) can be paid in some other form of distribution that is available under the plan. For instance, if the participant’s benefit were $10,000 per year beginning at age 65, the plan could provide a lump sum (based on 417(e) valuation assumptions) with respect to 50% of that benefit. The remaining benefit, $5,000 per year beginning at age 65, could then be paid based on plan annuity factors: e.g., it could be converted from a single life annuity to a 10-year certain and life annuity using plan factors.
Implicit bifurcation: Alternatively, a plan may pay a specified amount as a lump sum (e.g., $50,000), provided that the remaining portion of her benefit (the part not being paid as a lump sum) is no less than:
The participant’s total accrued benefit (in the plan’s normal form); minus
The annuity payable in the plan’s normal form that is actuarially equivalent to the lump sum, determined using 417(e) rates/tables.
Under this “implicit” approach, the lump sum is given (e.g., $50,000). It’s value as an annuity (in the plan’s normal form) is then determined using 417(e) assumptions and then subtracted from the participant’s total normal form annuity. The remainder can then be paid using the plan annuity factors.
This is all a little technical but is actually pretty intuitive. You can either pay a specific portion (generally, a specified percentage) of the participant’s benefit as a lump sum, in which case you use the explicit bifurcation method. Or you can pay a specific amount (generally, a specified dollar amount), as a lump sum, in which case you use the implicit bifurcation method.
There are, in addition, some special “rules of application.” For instance, if a plan provides an early retirement benefit, a retirement-type subsidy, an optional form of benefit, or an ancillary benefit that only applies to part of the participant’s benefit, then the plan must identify which portion of the participant’s benefit is being paid as a lump sum. And, where the plan has eliminated an optional form but (because of Tax Code anti-cutback rules) preserved that eliminated optional form for part of the participant’s benefit, then the plan must use the explicit bifurcation method.
The final regulation generally applies to distributions with annuity starting dates in plan years beginning on or after on or after January 1, 2017. Limited anti-cutback relief is provided for plans that include language requiring the application of 417(e) factors to all calculations where a partial lump sum is paid.
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It’s unclear how much “demand” there is for this sort of hybrid lump sum/annuity payment option. To the extent that participants do want this sort of distribution, the new regulation provides a relatively intuitive set of rules for how to provide them.