On February 3, 2012, the IRS issued a proposed regulation1 that would encourage the use of longevity annuity contracts under 401(k), 403(b), and other defined contribution retirement plans, as well as governmental 457(b) plans. The regulation would exempt certain such contracts from requirements of the Internal Revenue Code (the “Code”) that might otherwise prevent them from operating as intended.2 The regulation is one of several recent IRS pronouncements that are designed to help retirees deal with the risk of running out of money by facilitating their use of products that pay lifetime income benefits.
Longevity annuity contracts pay retirees a lifelong stream of income commencing at an advanced age, if the retiree lives to that age. Accordingly, they are a potentially valuable tool to help retirees protect themselves against the risk of exhausting their retirement savings while still alive.
Absent the relief proposed in the regulation, the use of using longevity annuity contracts in tax-advantaged retirement plans may create a problem under the “required minimum distribution” (“RMD”) rules in Code Section 401(a)(9). These rules require retirees to receive their plan benefits in installments after reaching the age of 70 ½, and the value of an annuity must be taken into account in determining the amount of RMD payments. As a participant makes withdrawals from his or her plan account in retirement, and depending on how much of the account value is attributable to the annuity contract, these rules could require contract distributions to commence earlier than the intended advanced age, thus defeating the purpose of the contract.
The regulation would provide relief by allowing longevity annuity contracts that meet certain requirements, referred to as “qualifying longevity annuity contracts” or “QLACs,” to be excluded in determining the amount of a retiree’s RMD payments prior to the commencement of annuity payments.3 QLACs eligible for this relief would be limited to non-variable contracts that satisfy certain reporting and disclosure obligations and certain other requirements, including that:
- Benefits must commence no later than the retiree’s attaining age 85;
- No cash surrender value or similar feature may be included;
- After the retiree’s death, no benefit other than a life annuity to a designated beneficiary may be provided;
- The total premiums paid for the contract cannot exceed the lesser of (i) $100,000 or (ii) 25% of the participant’s plan account balance on the date of the payment. On and after January 1, 2014, the $100,000 figure could be increased by cost-of-living (“COLA”) adjustments in $25,000 increments.
Industry response to the proposed relief has been very positive. However, there have been a number of public comments raising concerns about specific requirements.
Many of the comments relate to the premium limits. As drafted, the regulation provides that a contract fails to be a QLAC if and at the time those limits are exceeded. This would cause a QLAC to lose its favorable RMD treatment if, for example, the premiums paid exceeded 25% of the participant’s account balance due to a decrease in the account value between the time the contract is applied and paid for, or because of other in installments over time. Some commentators have suggested that the IRS provide a de minimus exception or other flexibility that would apply in such a circumstance, or “disqualify” a contract as a QLAC only with respect to the excess premium. Another commentator has suggested that the percentage limitation be increased to 35% or 40% percent to enable retirees with account balances of less than $400,000 to take advantage of the full $100,000 limitation, and that the dollar limitation should be increased to $150,000 or $200,000.
It has also been suggested that the COLA adjustment increments be decreased from $25,000 to a lower figure that would permit more frequent adjustments.
Commentators have also suggested that certain prohibitions in the regulation should be removed to encourage QLAC use. One commentator noted that the current low interest rate environment may discourage their purchase, and that permitting some use of variable contracts might be beneficial. Others have pointed out that the prohibition on including a cash surrender feature could discourage their use and that a “refund of premium” or similar feature would help address retiree concerns over becoming “locked in.”
We anticipate that the IRS will review these comments and perhaps make adjustments in response. In any event, we believe that a final regulation will be issued in the next six months or so and, as proposed, would generally apply to contracts purchased after the date of the final regulation and with respect to RMDs for years commencing on and after January 1, 2013. Upon issuance of the final regulation, defined contribution plan sponsors and participants will then determine whether use of QLACs is appropriate in their plans.