IRS Curtails Use of Lump Sum Distributions
On July 9, 2015, the IRS issued Notice 2015-49, which states that the Treasury Department and the IRS intend to amend the required minimum distribution rules under IRC §401(a)(9) to address the use of lump sum payments to replace annuity payments being paid by a qualified defined benefit pension plan. The Notice states that “The regulations, as amended will provide that qualified defined benefit plans generally are not permitted to replace any joint and survivor, single life, or other annuity currently being paid with a lump sum payment or other accelerated form of distribution.” These amended regulations are to apply as of July 9, 2015.
The questions that immediately arise are: (1) what if the effect of this notice; and (2) exactly what changes are likely to be made when the IRS issues regulations?
What is fairly clear is that the IRS is addressing certain situations that are commonly referred to as “risk transfers.” A typical risk transfer is the amendment of a defined benefit pension plan to provide for a limited time, current retirees, i.e., those currently receiving their benefit in the form of an annuity, are to be offered the option of (1) continuing to receive their benefit in the form of an annuity, or (2) receiving the present value of their remaining benefit in the form of an immediate lump sum distribution. This arrangement is referred to as a risk transfer because the risk associated with the retiree outliving his life expectancy and the investment risk associated with the assets used to fund that liability are transferred from the plan to the retiree.
The primary reason that this type of risk transfer has become popular lately has to do with changes made by the Pension Protection Act of 2006 (PPA). Prior to Jan. 1, 2008, the effective date for the PPA, the value of a lump sum distribution was based on the average rate of return for 30-year Treasury securities. This rate was almost always substantially lower than the rates used by insurance companies to determine the value of annuity contracts. In an effort to get the value of lump sum distributions in line with the cost of annuity contracts, PPA changed the basis for lump sums under IRC §417(e) from the 30-year Treasury rate to an average corporate bond yield curve, with this change phased in from 2008 through 2011 at the rate of 20% per year. The change was fully effective for plan years beginning in 2012. So, prior to 2012, risk transfers were more likely to take the form of an annuity purchase from an insurance company, simply because it cost less to purchase an annuity than it did to issue a lump sum distribution.
Now, however, in the wake of the changes made by PPA and the historically low level of interest rates that are used to determine the cost of annuity contracts (plus anticipated mortality improvement by insurance companies), annuity contracts cost more than the amount of the associated lump sum.
It is also clear that the IRS will be looking at this type of transaction from the perspective of compliance with the regulations relating to minimum required distributions under IRC §401(a)(9). As the Notice points out, IRC §401(a)(9) was adopted to limit the amount that could be tax-deferred under a qualified plan, or to make sure that the benefit was taxed in a reasonable fashion. From an editorial perspective, the use of IRC §401(a)(9) to limit lump sum distributions does not make much sense, because the payment of a lump sum distribution will accelerate the taxation of the benefit, unless it is rolled over to an IRA. If rolled into an IRA, the rate of taxation should not be materially different, because the IRA would also subject to the equivalent minimum distribution rules.
To date, plan sponsors have relied upon IRC Reg. 1.401(a)(9)-6, Q&A 14(a)(4) when amending plans to provide for the payment of lump sum distributions to current retirees. IRC §401(a)(9) generally requires distributions from defined benefit plans to be made in a series of equal (non-increasing) periodic payments for the life of the employee (or a period not exceeding the life expectancy) or life of the employee and a designated beneficiary.
Q&A 14 provides for an exception to the requirement that payments be non-increasing. It states that annuity payments may be increased to pay increased benefits that result from a plan amendment. The amendment to offer a lump sum distribution would increase the amount of the payment (the lump sum would be greater than the amount of the annuity payment) and has thereby been interpreted as satisfying the requirement of Q&A 14. The IRS has issued a number of private letter rulings to plan sponsors confirming that the offering of lump sum distributions to current annuitants for a limited time does not violate IRC §401(a)(9). The Notice now appears to override past precedent.
What is not clear is whether this Notice affects the ability of a defined benefit pension plan to offer lump sum distributions upon termination to retirees receiving their benefit in the form of an annuity at that time. For this purpose, plan sponsors have relied upon IRC Reg. 1.401(a)(9)-6, Q&A 13. While the Notice states that Q&A 14 will be amended, the Notice also makes reference to Q&A 13 by adding the phrase “(as intended to be amended).” This parenthetical addition makes it sufficiently unclear as to:
- whether Q&A 13 will be amended;
- whether the payment of lump sum distributions to retirees upon plan termination will be affected by future regulations; and
- whether the Q&A 13 rules are immediately affected by the Notice.
The Notice gives no reason for the issuance of this Notice, but the reason may have more to do with public policy than compliance with IRC §401(a)(9). In the past, Congress has expressed concern about the existence of lifetime income to retirees. Having to deal with very old people with no money is not desirable from anyone’s perspective. Realizing these risk transfers replace life income with lump sums, public policy might consider these risk transfers as a detriment to retirees.
Currently, retirees’ primary sources of income are likely to be Social Security, defined benefit pension plans and defined contribution plans (401(k)s or IRAs). We have seen that defined contribution plans, by their very nature, provide a number of money-management challenges for retirees generally not experienced by defined benefit annuity payments. Most significantly, post-retirement defined contribution plan accounts require both the management of investments on an ongoing basis and ongoing decisions on the amount to be withdrawn each year without depleting the funds prior to death. Most people have limited ability to make either of these decisions and generally do not seek outside guidance from planning professionals.
Another problem affecting the finances of retirees is the possible onset of cognitive impairments, such as Alzheimer disease or dementia. As many as 50% of people over the age of 85 may have some sort of cognitive impairment. While accurate numbers are not available, between ages 75 and 84, the rate of cognitive impairment may be in excess of 27%. These people may be unable to decide between a lump sum and an annuity, much less handle the investment of these funds and the budgeting required in their utilization. Even if there is no cognitive impairment, I have noticed in my own family, that once someone gets past age 75-80, the person may lose interest in or the desire to manage the finances, and is all too happy to delegate these responsibilities. Of course, once these responsibilities are delegated, the possibility arises that these funds may not be managed in the best interests of the retiree, due to dishonesty or lack of financial acumen, resulting in the possible impairment of the retiree’s finances.
Therefore, Congress may view the payment of lump sum distributions to retirees as detrimental to public policy, and enhancement of the disclosures in the required notices is not going to make any difference.
We will have to wait to learn exactly what changes are forthcoming at relating to IRC §401(a)(9). What is likely is that the world of retirement plan consulting and retirement plan administration will change once again.