Issues Regarding Optional Benefit Forms and Actuarial Equivalence

By Andrew Zimny • October 16, 2017 • 0 Comments

It is quite common for defined benefit plans to define optional benefit forms based upon the actuarial equivalence (AE) definition in the plan document. While this is most common for smaller plans, it is not unheard of among medium sized and larger plans as well. A recent situation led me to ask a series of questions that deal with three issues of AE, optional benefit calculations and relative value (RV): 

  • What are the acceptable parameters for defining AE and when does a particular definition become unreasonable? 
  • How are relative value disclosures affected by differing AE assumptions?
  • How informative is RV in light of the continuation of historically low medium and long-term interest rates that have raised the cost of annuities in the open market? And should we rethink some of the commonly used methodologies?
Actuarial Equivalence

Actuaries and DB plan administrators are used to working with actuarial equivalence both for funding and for benefit distributions. Practitioners tend to use a fairly narrow range of definitions in newer plans (especially smaller plans that are expected to be paying out mostly lump sums). Based upon my personal experience, the 417(e) Applicable Mortality Table or GAR 94 are the most commonly used mortality tables (usually with no pre-retirement mortality discount in the definition) and 5%-6% are the most commonly used interest rates. I am not aware of any specific rules in the law or regulations that preclude or require a particular definition of AE to use for determining benefits that commence prior to normal retirement age (NRA) or for determining optional benefit forms beyond the lump sum rules under 417(e) (and, of course, the assumptions used for lump sums to comply with 415 limits). 

Recently I worked on a fairly large terminating plan where the plan’s document defined AE as UP84 Mortality (pre- and post-retirement) along with 7% interest. Benefits commencing prior to NRA were determined using AE. Since nearly half of the participants were currently in pay status under many benefit forms and since many of those retirees had commenced benefits prior to NRA, it was clear that this AE definition was relevant to the benefits under the plan. Could the IRS or PBGC quarrel with this AE definition since both the mortality table and the interest rates are badly outdated? I don’t know the answer, but I know that these rates are generally within the deemed reasonable standard mortality and interest used in the IRS’ own regulations for determining non-discrimination in benefits. If it is deemed reasonable in that context, wouldn’t the IRS have a tough hill to climb if they wanted to claim that these assumptions were unreasonable for AE? And could the PBGC question the actuarial reductions used to determine the immediate benefits, whether a Qualified Joint and Survivor Annuity (QJSA) or a life annuity?

The benefit calculations for optional forms and pre- or post-NRA benefits are stunningly different when comparing these assumptions to a more “modern” definition of 5% interest and the 2017 applicable table (post-retirement only). For example, assuming $1,000/month payable at NRA 62 for a 45-year-old with a spouse age 43, the current 50% QJSA payable now would be:

  • UP 84 pre- and post-retirement at 7% = $199.72/mo.
  • 417(e) Applicable Mortality (post) at 5% = $325.05/mo.
If, for example, a $1,000/month life annuity benefit were delayed from NRA age 62 to age 67, the actuarially increased results are also considerably different:
  • UP 84 pre- and post-retirement at 7% = $1,760/mo.
  • 417(e) applicable mortality table (no pre-retirement mortality) at 5% = 1,443/mo.
This alarming disparity in the pre-NRA and post-NRA benefits shown here is due to the different definitions of actuarial equivalence noted above. Yet it does not appear to me that the large reductions in pre-NRA benefits violates Code Section 411 or other relevant Code Sections or regulations (nor does the larger actuarial increase in post-NRA benefits).

In the case of my terminating plan, this sort of benefit reduction from $1,000 down to under $200 for a 45-year-old participant may inherently encourage that participant (and any participants who aren’t close to their NRA) to elect a deferred annuity payable at 62. This is especially true in light of the fact that this particular plan did not forfeit benefits due to death. By waiting 17 years, a 45-year-old would receive over four times more monthly income as a QJSA and would not forfeit any benefits should he die prior to NRA. In the current interest rate environment, the actual cost of an annuity under these terms will be markedly higher than paying a lump sum from the plan. In the case of my terminating plan, fewer than 10% of the participants seem to be opting for just that, although I can imagine that percentage being higher if our RV (as described in the following sections) were done differently. Since the employer has agreed to contribute the full shortfall as part of the PBGC standard termination process even a few participants opting for a deferred annuity will likely cost them additional money, which will likely be noticed when the annuity quotes are finalized.

Relative Value Under Differing AE

There are many different approaches to determining RV based upon the IRS regulations from 2003. In the case of a plan where all of the optional forms of benefit (except lump sum) are based upon the actuarial equivalence defined in the plan, I most commonly use 100% as the RV between annuity options as of the same annuity starting date. For the lump sum option where 417(e) applies and results in the greatest lump sum amount, we usually determine the RV based upon a fraction. The numerator is the lump sum present value of the accrued benefit deferred to NRA, determined under Section 417(e), and the denominator is the present value of the actuarially reduced QJSA payable at the current date (assuming the participant is electing benefits to commence currently). Note that the current QJSA is determined under the plan’s AE while the present value of such QJSA is determined using 417(e) assumptions. Also note that in these calculations I am using pre- and post-retirement mortality in my 417(e) lump sum calculations. 

Using the same facts as above, the lump sum RVs produce wildly different results:

  • UP 84 pre- and post-retirement at 7% - RV of 157%
  • 417(e) applicable mortality (post-retirement only) at 5% - RV of 96.9%
The reason for the disparate results is that the numerator is based upon the same 417(e) assumptions and based upon the same $1,000/month deferred annuity. The denominator, however, is based upon completely different current age QJSAs due to the differing AEs in both plans.

This leads me to question my relative value methodology and whether a one-size-fits-all approach is appropriate.

Usefulness of Relative Value Calculations

In today’s interest rate environment, annuities have become quite expensive. Even using 417(e) assumptions to value the QJSA, which is permitted under a reasonable interpretation of the regulations, may produce misleading results. For example, in the case of the plan that uses 5%/applicable mortality AE assumptions, my RV is within 5 percentage points of the value of the QJSA, so as to imply that the two optional forms are roughly equal in value. But are they? I estimated that an individual who took the lump sum using 417(e) assumptions would fall short by about $35,000 if he or she attempted to purchase a QJSA annuity based upon the optional form shown. For purposes of estimating the current market cost of such an annuity, I assumed 2½% interest and the most recent 2017 applicable mortality table under 417(e).

At the same time, in the case of the plan that uses the 7%/UP84 pre- and post-retirement AE assumptions, my relative value implies a tremendous advantage in taking a lump sum since it seems to be worth over 50% more than the annuity, an anomaly due to the disparity between the actuarially reduced QJSA at current age and the 417(e) lump sum of the accrued benefit deferred to NRA. But I estimated that the actual cost of purchasing an immediate QJSA annuity would in fact be about 95% of the lump sum value, which is hardly the overwhelming advantage implied by the RV. And even that is deceiving because the annuity being purchased would be only about 60% of what it would have been had the plan used a more up-to-date definition of AE to determine the actuarially reduced QJSA.

So I return to my original points, but this time with some personal thoughts on creating a more rational system of actuarial equivalence and relative value:

1. Perhaps the IRS should revisit the definition of actuarial equivalence and define what are the allowable mortality tables, as well as defining an acceptable range of interest rates and/or empirical factors to use in determining actuarially adjusted benefits payable prior to and after normal retirement age. Tables such as GAM 1971 or UP 84 should be “retired” and replaced with something more rational in terms of today’s financial realities. Interest rates above 6% may no longer be realistic either. But be careful what you wish for. Such an analysis by IRS could result in a reworking of the admittedly outdated 401a4 Standard Tables and rates, with the results creating additional challenges for plans that require the General Tests (which is a large percentage of the DBs, CBs and PS plans in use for smaller employers). In addition, there would probably have to be some grandfathering of previous accrued benefits (at all array of possible ages, I assume). Needless to say, this could get complicated, and such a project would need to be weighed on a cost/benefit basis to see if it worth doing at all. 

2. The relative value approaches should be better defined with better examples. As I have shown above, my own approach to RV (which I believe is similar to what is used by many practitioners) falls far short of illuminating the payment of a lump sum compared to the value of an annuity (QJSA or life annuity). Perhaps we need to use some sort of current annuity costs to compare. I believe that PBGC’s immediate and deferred rates were supposed to mirror the costs of the current annuity market, although I am not certain if that is still the case. If it is, then perhaps using PBGC immediate and deferred annuity rates could provide more rational and useful disclosure.

But as far as the current rules that we are working under, unanswered questions remain and clarity is elusive. With apologies to Bob Dylan, the answers are still blowing in the wind, or perhaps circulating deep within the recesses of the Treasury Department or the ASPPA Government Affairs Committee.