Recent years have seen a growing consensus that employees need better tools for planning their retirement. This applies not only to the saving and investing phase, but also the drawdown phase. Retirees who receive their entire retirement benefit in a single lump-sum payment run a significant risk of “outliving their retirement assets.”
In the past, the solution to this problem was a defined benefit plan, which typically pays benefits in the form of a life or joint life annuity. As employers have sought greater predictability in their annual retirement plan expenses, however, there has been a pronounced shift away from defined benefit plans and toward defined contribution plans.
Although defined contribution plans can offer annuity options, they seldom do. In part, this is to avoid the administrative complexities posed by the qualified joint and survivor annuity (“QJSA”) and qualified preretirement survivor annuity (“QPSA”) rules, which impose intricate election and spousal consent procedures. Moreover, even plans that do offer annuity options rarely see retirees take advantage of them.
In February of 2010, the IRS and Department of Labor jointly issued a “request for information” on the subject of “lifetime income options.” In response to the numerous comments the agencies received, the IRS has now issued a package of guidance designed to encourage employers to offer more lifetime income options to their retirees. This package includes two separate sets of proposed regulations, along with two revenue rulings.
Qualified Longevity Annuity Contracts
One set of proposed regulations would create a partial exemption from the “minimum required distribution” (or “MRD”) rules. The MRD rules require that payment of benefits under an employer-sponsored retirement plan or traditional (non-Roth) IRA generally begin by age 70½, and then be paid over a specified period of time. This new partial exemption from the MRD rules would apply to “qualified longevity annuity contracts” (or “QLACs”).
The QLAC regulations would allow a participant in a defined contribution plan to use a portion of his or her account balance (generally, the lesser of 25% of the account or $100,000) to purchase a QLAC. Under a QLAC, annuity benefits would commence at a fairly late date (though no later than age 85) and be paid in the form of a single or joint life annuity. The key is that the amount used to purchase the QLAC would be disregarded when applying the MRD rules to the retiree’s account balance. This, in turn, would ensure that no portion of this amount must be paid to the retiree before the QLAC’s benefit commencement date in order to satisfy the MRD rules.
In the preamble to these proposed regulations, the IRS notes the following dual advantages of a QLAC:
- Purchasing longevity annuity contracts could help participants hedge the risk of drawing down their benefits too quickly and thereby outliving their retirement savings.
- Purchasing a longevity annuity contract would also help avoid the opposite concern that participants may live beneath their means in order to avoid outliving their retirement savings.
Under these regulations, QLACs could be offered under any defined contribution plan to which the MRD rules apply, including qualified 401(a) plans, 403(b) tax-sheltered annuities, governmental 457 plans, and traditional IRAs. At present, however, these QLAC regulations are only proposed. Moreover, the IRS has made clear that the existing MRD rules will continue to apply until these regulations are issued in final form.
Application of OJSA and OPSA Spousal Protections in Deferred Annuity Context
Many of the questions raised by deferred annuity contracts (such as the proposed QLACs) involve the application of the QJSA and QPSA notice, election, and spousal consent rules. Typically, any defined contribution plan that allows a participant to elect a life annuity form of payment must then comply with the full set of QJSA and QPSA rules. In Revenue Ruling 2012-3, however, the IRS explains how to limit the application of these rules to deferred annuity contracts.
The ruling considers three different factual scenarios. Under all three scenarios, a participant in a defined contribution plan may invest part or all of his or her account balance in a deferred annuity contract. Under that contract, payments are to commence at the later of the participant’s retirement or attainment of age 65, with the participant then allowed to elect among various annuity forms of payment.
Under Scenario One, a participant could also elect to receive the value of the contract in the form of a single lump-sum payment. This lump-sum option would not be available to a participant under Scenario Two. Under both of Scenarios One and Two, the participant’s surviving spouse (if any) would receive the entire value of the contract if the participant were to die before payments commence. Scenario Three then differs from Scenario Two only in that the participant could waive that spousal benefit (with the spouse’s written consent) at the time the contract is purchased.
In addressing each of these scenarios, the IRS concludes as follows:
- Under Scenario One, the participant’s ability to elect a lump-sum payment under the deferred annuity contract means that no annuity form of payment is actually elected at the time the contract is purchased. Accordingly, neither the QJSA nor the QPSA rules would apply at that time. The QJSA rules would apply during an election period immediately preceding the eventual annuity starting date. However, because neither the participant nor the spouse may waive the QPSA benefit, the plan need not comply with the QPSA rules.
- Under Scenario Two, the participant may not elect a lump-sum (or other non-annuity) form of payment. The purchase of the deferred annuity contract therefore constitutes the election of an annuity form of payment. For that reason, the QJSA rules would apply at the time the contract is purchased. As under Scenario One, however, the inability to waive the QPSA benefit means that the plan need not comply with the QPSA rules.
- Finally, the plan in Scenario Three would be required to comply with both the QJSA and QPSA rules at the time the participant invests in the deferred annuity contract. The QPSA rules would apply for the simple reason that – unlike under the other two scenarios – this contract does not otherwise guarantee a surviving spouse a benefit as valuable as the QPSA benefit.
By highlighting the salient factors in any QJSA or QPSA analysis of an investment in a deferred annuity contract, this ruling should eliminate some of the uncertainty otherwise associated with those contracts. Once the IRS finalizes its proposed QLAC regulations, those annuity contracts should therefore benefit from this ruling.
Split Distribution Options Under Defined Benefit Plans
Some defined benefit plans already permit retirees to receive all or a portion of their benefit in the form of a lump-sum payment. In converting the plan’s annuity form of payment into such a lump sum, the Tax Code requires the use of certain actuarial assumptions (known as the “417(e) assumptions”). Moreover, if only a portion of a benefit is payable as a lump sum, the remaining benefit – even if paid as an annuity – must also satisfy these 417(e) assumptions. In proposing the second set of regulations, the IRS has acknowledged that this administrative complexity may discourage employers from even offering such split distribution options.
Consistent with the goal of allowing participants to receive a portion of their benefit in a lump sum and a portion as an annuity, the IRS has proposed to simplify the rules to be followed by defined benefit plans that choose to offer split distribution options. The 417(e) assumptions would apply only to non-annuity payment forms (such as partial lump sums), while any annuity form of payment could be determined on the basis of the plan’s own actuarial assumptions. If these regulations are finalized as proposed, sponsors of defined benefit plans may want to consider offering a split distribution option.
Unfortunately, the preamble to these regulations cautions that any plan currently offering a split distribution option could not simply adopt this simplified approach to calculating annuities. Instead, such a plan would have to comply with the “anti-cutback” rules of Code Section 411(d)(6). These might require a “wear-away” approach, thereby further complicating the calculation of split distribution options.
Rolling Assets from a Defined Contribution Plan into a Defined Benefit Plan
The other recent ruling (Revenue Ruling 2012-4) addresses an option that is already available to plan sponsors. Under this option, participants in a defined contribution plan may be allowed to roll some or all of their account balance into a defined benefit plan sponsored by the same employer. That rollover amount would then be converted into an additional annuity benefit under the defined benefit plan. By rolling over only a portion of his or her account balance, such a participant could effectively receive a portion of that balance in the form of a lump sum and the remainder as an annuity.
This ruling points out, however, that two different sets of Tax Code constraints apply to a defined benefit plan when it converts a rollover amount into an annuity form of payment. On the one hand, the additional annuity benefit must be large enough to ensure that the conversion does not result in an impermissible “forfeiture” of the employee contributions attributable to the rollover. On the other hand, this annuity benefit must not be too large. If it is, then some portion of the benefit must be counted against the Tax Code Section 415 limitation on benefits payable under a defined benefit plan.
Fortunately, a plan may comply with both these nonforfeiture and Section 415 constraints by applying the same set of actuarial assumptions when converting a rollover amount into an annuity benefit. These are the 417(e) assumptions referenced above. Thus, any defined benefit plan that allows – or that might be amended to allow – participants to obtain an additional annuity benefit by transferring a rollover amount from a defined contribution plan should specify the use of these assumptions.
Although this revenue ruling applies only to rollovers made on or after January 1, 2013, the ruling notes that sponsors may also rely on its holdings with respect to rollovers made before that date.
Implications for Employers
Nothing in this recent package of guidance would require employers to offer additional distribution options under their plans. However, employers that wish to facilitate their retirees’ orderly drawdown of their retirement assets might consider adding one or more of these options. Although certainly not a panacea, they would appear to be a step in the right direction.