Blogging Employee Benefits

October 25, 2006

Working on Solving the Annuity Puzzle

Filed under: Distributions — Fuguerre @ 7:04 am

As traditional pensions go through a sea change of global freezing from defined benefit pension plans to individual account defined contribution plans, three main issues have required attention: (1) participation rates of employees in defined contribution plans, which typically have been more voluntary in nature than their defined benefit predecessors; (2) investment risk on retirement savings, shifted to employees during their working life; and (3) mortality risk during former employees’ retirement years, the danger that individuals and their spouses will outlive their defined contribution plan accounts.

We’ve seen the first two of those issues addressed by Congress in recent years, most recently in the Pension Protection Act of 2006, which included measures aimed at facilitating automatic enrollment and enhancing participant investment education, among other provisions reflecting the DB-to-DC transmogrification. But as yet, the annuity puzzle – how to encourage the converse of lump sum distributions from a DB plan – exists only in the form of white papers and preliminary legislative proposals.

An excellent summary of the annuitization issues is presented in Lifetime Annuities for US: Evaluating the Efficacy of Policy Interventions in Life Annuity Markets, written by William M. Gentry and Casey G. Rothschild for the American Council of Capital Formation. The paper focuses on the potential value of two different porposed tax incentives designed to encourage voluntary annuitization of retirement savings: one, exclusion of a portion of annuity income from taxable income; and two, refundable tax credits for life annuity income. Although empirical analysis is nonexistent regarding annuitization response to tax incentives, the study’s benchmark results suggest substantial potential effect of the amount of voluntary annuitization in the U.S. economy.

Side note: Although this paper did not touch on the truly diabolical annuity puzzle that will be presented if the Social Security system is ever even partially privatized, let’s put that cousin of this paper’s annuity puzzle off to the side of our desk. Annuities serving Social Security privatization would likely be under a protected market, even if commercial annuities are involved, thus would involve far more mind-bending math formulas than this paper already has.


August 8, 2006

Deference Denied for Unnecessary Multiple Valuations

Filed under: Distributions, Litigation — Fuguerre @ 10:34 pm

A money purchase plan administrator’s decisions to make multiple revaluations of plan assets for purposes of determining a distribution payout were not entitled to deference, according to a 1st Circuit ruling affirming the district court. [Janeiro v. Urological Surgery Professional Association, 05-2150]

Plan terms provided for annual valuation of plan assets each December 31, but gave the plan administrator discretion to construe plan terms and make benefits decisions, explicitly authorizing “an extraordinary adjustment date whenever market values of underlying assets have changed so much that it would be inequitable to do otherwise.” Bitter personal acrimony between the plan’s trustee and his departing former partner led to 5 successive revaluations of plan assets, eventually basing distribution of plan benefits at depressed market values of June 30, 2002, instead of the normal valuation date of December 31, 2000, that ought to have been used. Significant stuctural conflict of interest was present in that the distribution stood to deplete the plan of 70% of its assets, of which 92% would be in the trustee’s own account; but the district court looked further, finding additional evidence of conflict sufficient to abandon the deferential standard of review. Reviewing the benefit decision de novo, the district court found a fiduciary violation in the plan’s failure to timely segregate and liquidate plan assets sufficient to make the distribution, holding that the departing employee was entitled to a distribution valued as of 12/31/2000.

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.

March 24, 2006

Revised Regulations for Relative Value Disclosures

Filed under: Distributions, IRS, Regulations — Fuguerre @ 7:27 am

Revised final regulations have been published by the IRS under IRC §417(a)(3) relating to relative value disclosures in explanations of a pension plan’s qualified joint and survivors annuity (QJSA) and qualified preretirement survivor annuity (QPSA). [TD 9256; 71 FR 14798] Highlights –

  • Basic Effective Dates Retained – Although many plans and practitioners had sought further delay, the basic effective date remains intact: for QJSA notices, the requirements are generally effective for distributions with annuity starting dates on or after 2/1/2006. (Note: for 417(e)(3) distribution options with actuarial present value less than that of the QJSA – for example, a lump sum distribution that does not reflect the value of early retirement subsidies – the rules took effect 10/1/04.) However, revision of the rules relating to disclosures of optional forms of benefit approximately equal to the QJSA (described below) need not be applied to QJSA explanations provided before 1/1/2007. Moreover, except with respect to distribution options subject to the original 10/1/04 effective date, reasonable good-faith compliance with the relative value regulations is acceptable for QJSA notices provided before 1/1/07.
  • Eligibility for 2/1/06 Effective Date – As had been provided in 2005 proposed regulations, the actuarial present value of an optional form is treated as not less than the actuarial present value of the QJSA if two conditions are met: (i) The actuarial present value of the optional form is not less than that of the QJSA for an unmarried participant using 417(e) assumptions; and (ii) The actuarial present value of the QJSA for an unmarried participant is not less than that of the QJSA for a married participant using reasonable actuarial assumptions.
  • Retroactive Annuity Starting Dates – Required information must be provided for optional forms of benefit with retroactive annuity starting dates that are available with payments commencing at the time the QJSA notice is provided.
  • Coordination with QJSA-Most-Valuable Rule – As under the 2005 proposed regulations, disclosure of relative values of 417(e) distribution options using the applicable assumptions under 417(e)(3) does not cause a plan to fail the requirement that the QJSA be the plan’s most valuable form of benefit.
  • Approximate Equivalence to QJSA – Reflecting concerns over professional standards, the rules have been revised to restrict disclosure of optional forms as being approximately equal in value to the QJSA only to those within a range of 95% to 105% of the actuarial present value of the QJSA.
  • Social Security Level Income Option – Reflecting dispute over the applicability of 417(e)(3) to a social security level income option, examples of relevant optional annuity forms have been dropped from the regulatory provisions addressing effective dates, but merely because the IRS agrees that placement of the issue in that portion of the rules is inappropriate. The IRS points to separate regulations under 417(e) to retain the position that social security level income optional distribution forms are not eligible for exemption from the minimum present value requirements of 417(e)(3).
  • Reasonable Actuarial Assumptions – For optional forms other than those subject to 417(e), reasonableness of interest and mortality assumptions is determined without reference to individual circumstances (e.g., participant’s specific health conditions). Applicable assumptions under 417(e) are permitted, but not required, for relative value disclosures for those distribution options.
  • Bifurcated Distributions – If separate benefit elections are made with respect to two or more portions of a participant’s benefit (e.g., such as in the case of preservation of a portion of benefit from a predecessor plan), then relative value and financial effect disclosures may be made separately for each separate portion.
  • Disclosure of Normal Form – For purposes of disclosing the plan’s normal form of benefit, reasonable estimates such as are used to disclose participant-specific information may be used.
  • Use of Participant-Specific Information – Inclusion of participant-specific information does not cause a notice to fail rules permitting reliance on generally applicable information.
  • Simplified Disclosures of Financial Effect – Simplified presentations of financial effect and relative value are permitted for disclosure of a significant number of substantially similar optional forms (for instance, an array of joint and survivor annuities with survivor payments available at any whole number percentage between 50% and 100%).

February 26, 2006


Filed under: 415, Distributions — Fuguerre @ 1:33 pm

“415(b)(2)(E)(ii)” – Sole content of a recent somewhat esoteric websearch that brought a reader to Pen&Ben Weblog. I’m not the expert you want to see on that one; but as I’ve not seen any Internet traffic this year on it, I’ll pass along what little I know.

For purposes of adjusting any benefit under subparagraph (B) for any form of benefit subject to section 417(e)(3), the applicable interest rate (as defined in section 417(e)(3)) shall be substituted for “5 percent” in clause (i), except that in the case of plan years beginning in 2004 or 2005, “5.5 percent” shall be substituted for “5 percent” in clause (i).

Background – Benefits under a qualified defined benefit plan are limited under IRC §415(b)(a)(A) to $175,000 for 2006, expressed in terms of a life annuity. [IRC §415(b)(2)(A)] For other forms of benefit (other than qualified joint and survivor annuities), that dollar ceiling must be adjusted to the actuarial equivalent amount. [IRC §415(b)(2)(B)] For forms of benefit other than those subject to IRC §417(e)(3), the interest rate assumption for the actuarial equivalence assumptions is limited to the greater of 5 percent or the rate specified in the plan. [IRC §415(b)(2)(E)(i)]

Which brings us to IRC §415(b)(2)(E)(ii), the text of which I’ve quoted above. §101(b)(4) of the Pension Funding Equity Act of 2004 (P.L. 108-218) added the temporary 5.5% interest rate, meaning that for distributions with annuity starting dates in plan years that begin in 2004 or 2005, the interest rate assumption for the actuarial equivalence assumptions for forms of benefit subject to IRC §417(e)(3) is limited to the greater of 5.5 percent or the rate specified in the plan. Benefit forms subject to IRC §417(e)(3) most notably include lump sum distributions, but also include other non-level alternative distribution forms such as payment streams that include temporary Social Security supplements. See Notice 2004-78 for IRS guidance on the PFEA temporary 5.5% interest rate and Benefitsblog for discussion.

Pension Reform LegislationPending legislation carried over from congressional action during 2005 would essentially extend the PFEA phrase for 415(b)(2)(E)(ii) permanently, retroactive to years beginning on or after 1/1/06. See S. 1783 §302 and H.R. 2830 §303.

The House version would add an extra twist: rather than PFEA’s simple 5.5%, the interest rate would be required to be the greater of 5.5% or “the rate that provides a benefit of not more than 105 percent of the benefit that would be provided if the applicable interest rate (as defined in section 417(e)(3)) were the interest rate assumption,” or as always, the rate specified under the plan if greater. Noting that under both the House and Senate versions, the 417(e)(3) applicable rate itself would phase in to a yield-curve basis, the determination of the rate that would apply under 415(b)(2)(E)(ii) would turn into a bit of rocket science whenever interest rates rise above about 5.6%, that exact margin depending on the particular form of benefit being limited and the participant’s age. The simplified version essentially being that when interest rates rise high enough, the actuarially equivalent dollar ceiling under 415(b)(2)(E)(ii) becomes 105 percent of the accrued benefit amount determined under 417(e).

Meanwhile, Current Law – For plans with calendar plan years or non-calendar plan years beginning early in the year (e.g., 2/1), the expiration of the temporary PFEA rule combined with the delay in enactment of a permanent extension could pose a tough dilemma. If any participant takes a lump sum distribution or other 417(e)(3) distribution during the interim period, and if the 415(b)(2)(E)(ii) ceiling would restrict the benefit payment, then technically the interest rate under current-law 415(b)(2)(E)(ii) is the greater of the rate specified under the plan or the applicable interest rate under 417(e)(3), currently a shade below 5%. But determination using that rate produces a ceiling that is higher than the ceiling that would be in force if 5.5% is applied retroactively under compromise legislation. If the higher amount based on current law is paid out, then recovery by the plan of excess payout amounts from the participant might be necessary if the legislation produces a retroactively lower ceiling.

January 26, 2006

More on Hurricane Relief

Filed under: Distributions, IRS — Fuguerre @ 10:30 am

The IRS has published additional guidance on hurricane-related tax relief, including provisions regarding distributions and loans from qualified retirement plans. [IR-2006-18; Publication 4492] The IRS has also published Form 8915, Qualified Hurricane Retirement Plan Distributions and Repayments, to be used by individuals claiming hurricane relief for eligible transactions.

A few observations beyond those made earlier here at BeneBlog 1/7/06

  • A reduction or offset of a participant’s account balance in an eligible plan in order to repay a plan loan may be designated as a qualified hurricane distribution.
  • For purposes of the usual IRA restriction of one rollover per year, repayment of a qualified hurricane distribution will not be counted.
  • Although periodic benefit payments and required minimum distributions may be designated as qualified hurricane distributions, those distributions are not eligible for repayment.
  • For married taxpayers filing joint returns, a separate Form 8915 should be filed for each person. The $100,000 limit applies separately, as does the election to recognize all income tax on distributions immediately versus with 3-year averaging.

The latest IRS publications have the individual taxpayer in mind and generally seem to presume either that the terms of the individual’s retirement plans will be accommodating or will be amended to be so. For instance, although it is noted that repayments can be made to a retirement plan that accepts rollovers, the nuances of what to do if your employer’s plan doesn’t accept rollovers are probably lost on the common taxpayer, as are the opportunities if you are now employed by a different company and are participating under a different retirement plan than the one from which the qualified hurricane distribution was received.

And the IRS publication’s desciption of the plan loan relief completely assumes that the individual’s retirement plan will reflect the revised loan limits and payment relief. Although plans with affected individual will no doubt give serious consideration to extending the relief, they are not required to do so. And whereas it is acknowledged and relevant that a plan’s characterization of a distribution may differ from an individual’s designation vis a vis qualified hurricane distributions, the plan’s terms would seem to govern on the issue of a plan loan. For instance, if an individual skips loan payments for a year due to the hurricane, the individual is going to face the distribution rules if the plan terms consider the loan in default, even if the IRS would have been prepared to grant relief under the hurricane provisions.

Rules for Roth 401(k) Distributions

Filed under: 401(k), Distributions, IRS, Regulations — Fuguerre @ 6:34 am

The IRS has proposed regulations regarding the taxation of distributions from Roth 401(k) accounts. The proposed regulations also address Roth 401(k) reporting requirements and designated Roth contributions in 403(b) plans.  [71 FR 4320, REG-146459-05]  Final regulations covering the basic rules for Roth 401(k) accounts were issued earlier this year. (See BeneBlog 1/9/06.)

Designation of 401(k) deferrals as Roth 401(k) contributions is permissible beginning 1/1/2006.  Under current law, authorization of Roth 401(k) accounts would sunset December 31, 2010. Neither the earlier published regulations nor the newly proposed regulations address the potential sunset.

Qualified Distributions.  Taxation of distributions from a Roth 401(k) account depend upon whether or not the distribution is a qualified distribution. As prescribed by IRC 402A(d)(2), a qualified distribution must be made on or after attainment of age 59-1/2, death, or disability, and must be made at least 5 years after establishment of the Roth 401(k) account.

The 5-year period begins on the first day of the employee’s taxable year during which the employee designated the first Roth 401(k) contribution under the plan.  If the makes a direct rollover from a Roth 401(k) account under a different plan, then the 5-year period begins on the first day of the employee’s taxable year during which the employee had designated the first Roth 401(k) contribution under the transferor plan, if earlier.

Nonqualified Distributions.  Roth 401(k) distributions that do not satisfy the conditions for qualified distributions are not eligible for the tax exemption that would apply to qualified distributions. Accordingly, income attributable to the designated Roth 401(k) contributions is taxable, although the contributions themselves – which had been included in taxable income upon contribution – are tax-free basis upon distribution.

The IRS declined requests to apply the Roth IRA special ordering rules for taxation of nonqualified Roth 401(k) distributions. Thus, a nonqualified distribution from a Roth 401(k) account is taxed under the rules of IRC 402 and IRC 72, treating the Roth 401(k) account separately from any non-Roth 401(k) distributions as prescribed by IRC 402A(d)(4). Note that the preamble of the final regulations published earlier this year stated that a 401(k) plan could grant a plan participant the right to allocate the amount of a 401(k) distribution that would come from a Roth 401(k) account versus the non-Roth 401(k) account.

Roth 401(k) Rollovers. The portion of any Roth 401(k) distribution that is not includible in income may be rolled over to a designated Roth account under a 401(a) plan only if – (1) The transaction is made by a direct rollover, rather than through direct distribution to the employee; and (2) The transferee plan accepts rollovers and agrees to separately account for the amount not includible in income. The transferor plan must report to the transferor plan the investment under the account and the first year of the 5-year period.

An individual may roll over the portion of a Roth distribution that is taxable to a 401(a) or 403(b) plan within 60 days of receipt. In the instance of rollover of taxable Roth 401(k) amounts, Roth participation under the transferor plan is not carried over to the transferee plan for purposes of the 5-year rule.

If a Roth 401(k) distribution has been made directly to the individual, then a rollover to another plan may not be made, but the individual may roll over any portion of the distribution into a Roth IRA within 60 days. Participation under the Roth 401(k) account does not count for purposes of the Roth IRA version of the 5-year rule.

The Roth IRA income limits on contributions do not apply for purposes of a rollover from a Roth 401(k) account to a Roth IRA. If only a portion of the distribution is rolled over, then the portion not rolled over is treated as consisting first of the amount of the distribution that is taxable.

Treatment of Excess Deferrals. If secess deferrals are not distributed by April 15 of the following year, then any portion of that distribution that is attributable to a designated Roth contribution is included in taxable income, with no exclusion for amounts attributable to basis. The result is dobule taxation: although the contribution was included in taxable income during the year contributed, it would also be included in taxable income during the year of distribution. In most instances, the way to avoid this double hit would be to either distribute excess deferrals before the April 15 deadline, or for the plan to provide highly compensated employees with the right to designate that distribution of excess deferrals should be made entirely from the non-Roth 401(k) account. Note, however, that if excess deferrals have remained undistributed and if the individual takes a distribution from the Roth 401(k) account, then a special ordering rule prevails, characterizing the first portion of that distribution to constitute distribution of excess deferrals, thereby circling back to the double taxation problem. Thus, if excess deferrals are present and if the April 15 deadline has passed, the individual should distribute the excess deferrals from the non-Roth portion of the account, if possible under the plan terms to do so, before taking a distribution from the Roth 401(k) account.

Designated Roth Accounts under 403(b) Plans. Generally 403(b) plans may permit members to designate contributions as Roth contributions under rules parallel to those that have been prescribed for 401(k) plans.  The one additional nuance is the universal availability rule of 403(b)(12)(A)(ii): if any one member of a 403(b) plan is given the opportunity to designate a contribution to the plan as a Roth contribution, then all members of the plan must be given that same right.  In contrast, for a 401(k) plan the right to designate a deferral as a Roth 401(k) contribution would be a plan feature subject to the nondiscriminatory availability rules of Reg.1.401(a)(4)-4.

Reporting and Recordkeeping.  The administrator of a plan with Roth 401(k) accounts is generally responsible for keeping track of the 5-year period and the amount of contribution designated by a plan participant as Roth 401(k) contributions. 

Effective Date.  Reliance on the proposed regulations is permitted for any periods after the 1/1/2006 effective date of the statute. The reporting and recordkeeping requirements will not be effective prior to the 2007 plan year; but plan administrators are cautioned that compliance will necessitate keeping track of each account from the outset.

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