IRS Announces Intention to Prohibit Lump-Sum Payout of In-Pay Annuities


Last week, the Internal Revenue Service issued Notice 2015-49 (the “Notice”) announcing that it intended to prohibit one type of common defined benefit plan “de-risking” strategy – offering a cash-out window during which retirees who are then receiving annuity payments can elect to receive a lump-sum payment in lieu of remaining annuity payments. The proposed amendments have not been published, but the Treasury Department and the IRS intend the revisions to apply as of July 9, 2015, except for certain cashout windows that had already been adopted or communicated as of that date. The amended regulations are not expected to prohibit other defined benefit de-risking strategies, such as offering a lump-sum option to those terminated plan participants who are not yet receiving benefits or contracting with a thirdparty insurance company to provide annuities to plan participants to satisfy a portion of outstanding liabilities.


In recent years, many companies have sought to remove (or reduce) tax-qualified defined benefit obligations from their balance sheets through various de-risking (or “risk transfer”) programs. Common strategies include (1) offering lump-sum distributions to retirees currently receiving annuity benefits, (2) offering lump-sum distributions to plan participants who are terminated and have vested but who have not commenced receiving annuity payments, and (3) implementing an annuity buyout through a thirdparty insurance company.

The Treasury Department, IRS, Department of Labor and the Pension Benefit Guaranty Corporation, which have traditionally favored life-time income payment options, have expressed concerns that certain defined benefit plan de-risking strategies shift the investment and longevity risks from the plan to the plan participants or otherwise erode ERISA protections (such as when the annuity payment obligation is shifted to a third-party insurer).


Tax-qualified defined benefit plans are required to offer plan participants benefits in the form of a life annuity (i.e., a single life annuity for unmarried participants and a joint and survivor annuity for married participants), though other forms of payment, including lump sums, are permitted.

The current regulations under Section 401(a)(9) of the Internal Revenue Code, which governs required minimum distributions from tax-qualified defined benefit plans, prohibit changes in the form or period of an annuity once payment of the annuity has commenced. The current Section 401(a)(9) regulations include an exception for annuity changes that increase benefits and therefore permit a defined benefit plan to offer a lump-sum cash-out window to retirees who are receiving annuity payments if the offer provides increased benefits. In recent years, the IRS has issued a number of private letter rulings to defined benefit plan sponsors approving proposals to offer such cash-out windows to retirees. As stated in the Notice, however, the Treasury Department and the IRS have now concluded that a cash-out of in-pay annuitants “would undermine” the intent of the regulation.

As a consequence, as described in the Notice, the expected amendments to the required minimum distribution regulations will provide that the types of permitted benefit increases will include only those that increase ongoing annuity payments and will not include those that cash out or otherwise accelerate annuity payments. The exception for changes to the annuity payment period provided for under the regulation is expected to be amended to prohibit acceleration of annuity payments, even if the plan amendment also increases annuity payments.


As set out in the Notice, the amendments to the Section 401(a)(9) regulations are expected to be effective as of July 9, 2015, but will not apply to retiree cash-out windows that were (1) adopted before July 9th, (2) communicated in writing to retirees before July 9th, (3) adopted pursuant to an agreement entered into before July 9th between a plan sponsor and an employee representative, or (4) covered by a private letter ruling or determination letter issued by the IRS before July 9th.


While the expected amendments to the Section 401(a)(9) regulations will eliminate one defined benefit de-risking strategy, the amended regulations are not expected to foreclose other risk transfer strategies, such as offering lump-sum payouts to terminated participants who are not yet receiving benefits or shifting annuity obligations to a third-party insurance company. In light of the impact that volatility of defined benefit obligations has on plan sponsors’ financial statements and funding requirements, we can expect efforts by plan sponsors to reduce those risks to continue.