Near the end of 2016, the US Department of Treasury and the Internal Revenue Service (IRS) published two significant sets of proposed regulations on issues pertaining to defined benefit pension plans.
On December 29, 2016, Treasury and IRS issued proposed regulations that would update the mortality tables for single-employer defined benefit plans. Beginning in 2018, if finalized, the updated mortality tables are expected to increase plan funding liabilities and, by extension, Pension Benefit Guaranty Corporation (PBGC) variable rate premiums, as well as the value of lump sum distributions. Plan sponsors should be aware, though, that these new mortality assumptions may already be reflected in plan accounting results.
On November 25, 2016, Treasury and IRS issued proposed regulations that would update the minimum present value requirements applicable to certain distributions from defined benefit pension plans.
The following overview summarizes these proposed regulations and their expected impact on defined benefit pension plans. The changes made by these proposed regulations have been under consideration by Treasury and the IRS for some time and were anticipated by the retirement plan industry. Nevertheless, the future of these regulations is unclear in light of the regulatory freeze imposed by the Trump administration and the January 30, 2017, executive order requiring agencies to revoke two regulations for every new rule issued.
Proposed Regulations Updating Mortality Tables
Defined benefit pension plans apply mandated mortality tables to calculate the life expectancy of plan participants on the basis of age, sex and other factors. The plan’s mortality table is used to determine minimum funding requirements, which affect PBGC variable rate premium costs, and the minimum amount of lump sum distributions.
In October 2014, the Society of Actuaries released the RP-2014 Mortality Tables Report and the Mortality Improvement Scale MP-2014 Report, which contained new mortality assumptions recommended for valuing private-sector pension liabilities. Since then, the expectation has been that eventually the IRS would apply these assumptions to the mortality tables required for use by defined benefit pension plans.
Generally Applicable Mortality Tables
The proposed regulations would update the mortality assumptions for single-employer defined benefit plans. If finalized, for plan years beginning on or after January 1, 2018, the current RP-2000 Mortality Tables Report would be replaced with the RP-2014 Mortality Tables Report and the further updated Mortality Improvement Scale MP-2016 Report. Treasury and IRS expect to continue to take updated mortality improvement rates into account in years after 2018. The new mortality tables are generally expected to increase plan funding obligations, the value of lump sum distributions and the cost of PBGC premiums. In some cases, these increases could be significant (for example, an expected 3 to 5 percent increase in plan funding obligations).
Plan-Specific Substitute Mortality Tables
As required by the Bipartisan Budget Act of 2015, the proposed regulations would also simplify and liberalize the rules permitting a plan to utilize a substitute mortality table based on its own participant population, if the plan sponsor seeks approval from the IRS. To use a plan-specific substitute mortality table, a plan’s participant population must have a credible mortality experience. Current regulations provide that the standard for full credibility is 1,000 deaths for each gender within a two-to-five-year period. The proposed regulations would revise the standard to create a formula that takes into account the dispersion of benefits within the plan (i.e., individuals with higher benefit amounts would have a greater weight in the computation of the mortality rate for a particular age), which could result in a plan having full credibility based on fewer than 1,000 deaths for each gender.
In addition, under certain circumstances, the proposed regulations would permit a plan that has only partially credible mortality information to use a plan-specific substitute mortality table created using a weighted average formula based on the standard mortality table. Such plan would have to have a minimum of 100 deaths for each gender within a two-to-five-year period.
Considerations for Plan Sponsors
The proposed mortality table regulations likely would increase pension funding liabilities for many plan sponsors. In order to prepare for the possibility of increased funding liabilities, plan sponsors may wish to consider offering a lump-sum window or other de-risking options in 2017. Additionally, plan sponsors may want to engage their plan actuaries to determine the viability of a plan-specific mortality table under the simplified and liberalized proposed regulations. If viable, plan sponsors who wish to adopt a plan-specific mortality table should prepare to seek advance approval from the IRS.
Proposed Regulations on Minimum Present Value Requirements
The present value of a participant’s accrued benefit under a defined benefit pension plan must not be less than the amount calculated using the “applicable interest rate” and “applicable mortality table” defined in the Internal Revenue Code. The applicable mortality table would be affected by the new mortality assumptions discussed above. On September 9, 2016, Treasury and IRS issued final regulations addressing the minimum present value requirements for pension benefits payable partly as an annuity and partly in an accelerated form.
Following the issuance of those final regulations, Treasury and IRS issued additional proposed regulations on November 25, 2016, which would amend existing regulations to reflect the statutory changes made by the Pension Protection Act of 2006 and would make additional clarifying changes, including conforming changes to reflect the September 9, 2016, final regulations. The proposed regulations would make the following specific clarifications.
Treatment of Pre-Retirement Mortality in Lump Sum Distributions
The proposed regulations address whether a plan that provides a death benefit equal in value to the accrued benefit may apply a pre-retirement mortality discount for the probability of death when determining the amount of a lump sum distribution. Confusion over this issue has existed since a court held that a pre-retirement discount could not be used to compute the present value of a participant’s lump sum distribution under a cash balance plan if the death benefit under the plan was equal in value to the participant’s accrued benefit.
The proposed regulations would clarify that the probability of death under the applicable mortality table generally would be taken into account for purposes of determining the present value of a participant’s accrued benefit derived from employer contributions. This calculation would be made without regard to the death benefits provided under the plan, other than a death benefit that is part of the normal form of benefit or part of another optional form of benefit. However, a different rule applies when determining the present value of a participant’s accrued benefit derived from employee contributions. In that situation, the probability of death during the assumed deferral period (the period between the date of the present value determination and the assumed commencement date for the annuity attributable to contributions made by an employee) is not taken into account.
Social Security Level Income Options
A social security level income option is an optional form of benefit under which a participant’s accrued benefit is paid in the form of an annuity with larger payments in earlier years (before an assumed social security commencement age) to provide the participant with approximately level retirement income when the assumed social security payments are taken into account. The proposed regulations confirm that the minimum present value requirements apply to social security level income options.
Application of Required Assumptions to the Accrued Benefit
The present value of any optional form of benefit cannot be less than the present value of the normal retirement benefit. The proposed regulations would require that the present value of any optional form of benefit not be less than the present value of the accrued benefit payable at normal retirement age. Additionally, the proposed regulations provide an exception for an optional form of benefit payable after normal retirement age to the extent that a suspension of benefits applies.
Considerations for Plan Sponsors
Practitioners have requested comments on a number of issues raised in the proposed regulations, including the treatment of social security level income options and post-normal retirement age benefits. Nonetheless, plan sponsors should review their defined benefit pension plans to determine whether the calculations of certain optional forms of payment (for example, lump sum distributions and social security level income options) comply with the proposed minimum present value regulations. These regulations, although proposed, generally conform to previously enacted legislation and final regulatory action, and give plan sponsors a strong idea of the IRS’s position on these technical issues, subject to further adjustment in the final regulations.