Blogging Employee Benefits

August 1, 2006

PPA: Lump Sum Distributions

Filed under: Distributions, Legislation, Pensions — Fuguerre @ 9:15 pm

Various provisions under the Pension Protection Act of 2006 (H.R. 4) affect the valuation and distribution of lump sum distribution of the value of a participant’s accrued benefits under a defined benefit pension plan. For now just focusing on distributions from single-employer qualified pension plans —

Hybrid Pension Plans. The accrued benefit under a cash balance plan may be expressed as the balance of the hypothetical account. Similarly, the accrued benefit under a hybrid plan, such as a pension equity plan, may be expressed as the current value of the accumulated percentage of the employee’s final average compensation. [ERISA §204(f), added by PPA §701(a)(2)] Thus, a cash balance plan or other hybrid pension plan may distribute the value of the hypothetical account or accumulated percentage in a lump sum distribution as full payment of the value of accrued benefits. This new rule is similar to reliance on safe harbor interest rates under Notice 96-8, avoiding the projection-discounting calculation that produced windfall “whipsaw” amounts for young employees in certain interest rate environments under pre-PPA rules. Note that PPA includes additional rules for cash balance plans, such as a requirement to permit employees to age into previously promised early retirement subsidies, that could indirectly affect lump sum distribution amounts. The PPA provisions relating to distributions from hybrid pension plans apply to distributions made after the date of PPA enactment.

Valuation of Lump Sum Distributions in Traditional Pension Plans. For a pension plan other than a hybrid pension plan, the amount of a lump sum distribution will be valued using the 3-segment yield curve introduced by PPA for pension funding. [PPA §302] For the lump sum valuation, the yield curve is based on the rates for the month before the distribution, rather than on the 24-month average used for the plan’s funding. Lump sum amounts should generally be lower under the new rates than under the pre-PPA determination, which is based on 30-year Treasury bond rates, with the largest cuts going to youngest employees. The new rates take effect during a 5-year transition period beginning in 2008.

415 Limit on Lump Sum Distributions. Determination of the IRC §415 limit on the amount payable as a lump sum distribution must use the greater of 5.5%, an interest rate specified in plan terms, or a rate based on the valuation of lump sum distributions as described in my preceding paragraph. [PPA §303] The third of these rates is actually somewhat complicated; see my earlier posting on this topic regarding the House version’s reference to the rate that would produce 105% of the minimum lump sum amount. As also discussed in that posting, the PPA rule on 415 limits for lump sum distributions applies retroactively to the beginning of 2006, potentially exposing a plan to violations for any higher lump sum amounts paid during 2006 before PPA enactment under the pre-PPA interest rate of 5%.

Distribution Restrictions for Underfunded Plans. Annual distributions to a participant may not exceed the periodic payment that would be payable under a single life annuity (plus any Social Security supplements) under a plan with a funded ratio less than 60%. [IRC §436(d), added by PPA §113] In particular, a plan participant would not be permitted to receive a lump sum distribution of the full value of accrued benefits. If the funded ratio is at least 60% but less than 80%, the permissible distribution can be the lesser of 50% of the unrestricted distribution or the present value of the benefit guaranteed by the PBGC, but only one such distribution may be made in any two consecutive years during which the distribution restrictions apply. If the plan is maintained by an employer in bankruptcy, the funded ratio threshold is increased to 100%, with no special rule permitting payment above the floor level. Also note that the new distribution restrictions do not eliminate nor preempt similar distribution restrictions applicable to the highest 25 paid employees if the plan’s funded ratio is less than 110%, as prescribed under Treasury Reg. §1.401(a)(4)-5(b).

For purposes of the distribution restriction triggers, the funded ratio is adjusted by adding the amount of annuity purchases for nonhighly compensated employees during the preceding 2 plan years to both the numerator and denominator of the funded ratio. If the funded ratio exceeds 100% (phased in from 92% beginning in 2008) without reducing plan assets by the plan’s credit balances, then the distribution restrictions do not apply. Conversely, if the plan’s funded ratio without reducing assets by credit balance is less than 100%, but would exceed the distribution restriction funded ratio threshold without the credit balance reduction, then the employer is forced to reduce the credit balance to the extent necessary to avoid the distribution restriction.

The distribution restrictions do not apply to any plan under which all accruals have been frozen since 9/1/2005, regardless of the plan’s funded ratio. These rules apply beginning in 2008, with a delayed effective date applicable to collectively bargained plans.

Anti-Cutback Relief for PPA-Related Plan Amendments. Plan amendments necessary to implement PPA changes are treated as complying with the IRC §411(d)(6) prohibition against reductions in accrued benefits if the amendment is made by the close of the plan year beginning in 2009. [PPA §1107(b)] For example, reductions in lump sum amounts payable because of a plan amendment changing the valuation basis for lump sum distributions will not be considered violations of the anti-cutback rule.


  1. In regards to yhr paragraph about paying out a lump sum from your defined benefit plan. There is an exemption on page 83, 84 & 85 that deals with plans that have been frozen by September 1st, 2005. Would the 5% minimum interest rate used in the calcualtions of the lump sum payout apply immediately. Current GATT rate is 4.58% in our plan through November 2006 for me.

    John O’Hagan

    Comment by john ohagan — August 3, 2006 @ 11:05 am

  2. I am 60 years old and working full time. I have a concern regarding H.R. 4 that recently passed the Senate. If my employer were to convert from a defined benefit pension plan to a cash balance formula pension plan, would my vested lump sum retirement benefits be legally protected? Or, is there a possibility that my retirement lump sum would be decreased?

    Comment by Harry Jones — August 5, 2006 @ 2:04 pm

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