The practice of offering lump-sum distributions has become increasingly popular among defined benefit plan sponsors looking to decrease volatility or other defined benefit plan risks. In some situations, plan sponsors offer the lump sum to participants in pay status as well as terminated vested participants who have not yet commenced payments. In late May 2014, the Internal Revenue Service (IRS) released a series of four private letter rulings concluding that defined benefit pension plan amendments allowing participants in pay status to elect, during a limited time period, lump-sum distributions of their remaining plan benefits were permissible under the required minimum distribution rules of the Internal Revenue Code (IRC).
The rulings follow two similar private letter rulings issued by the IRS in 2012, and highlight the fact that these types of arrangements require a range of considerations under the IRC and Title I of the Employee Retirement Income Security Act (ERISA), regardless of whether they are offered to terminated vested participants or participants in pay status.
The requesting plan sponsors all noted that they had experienced increased volatility in their pension plan obligations in recent years, which had made them less competitive in the global market. As a result, they wished to amend their plans to offer participants and beneficiaries in pay status a limited window of time in which they could elect to receive their remaining plan benefits in one lump-sum payment. Several of the requesting plan sponsors also noted that they would allow terminated vested participants to participate in the window, but did not request rulings with respect to those individuals.
The window period lump-sum option was structured in the 2012 rulings and the 2014 rulings as follows. The affected payees could keep their current form of payout, or elect any of the applicable new options made available by the plan amendment:
Click here to view table
Each requesting plan sponsor represented, among other things, that:
- Its methods for valuing the lump-sum distributions would comply with IRC Section 417(e) and that the window would not trigger any of the benefit restrictions described in IRC Section 436; and
- Applicable spousal consent requirements would be met. All elections would require spousal consent. In the event a participant had remarried since his or her initial annuity starting date, spousal consent would include, if applicable, the participant’s current and former spouses.
At issue in these rulings (as well as the IRS’s earlier 2012 rulings) was whether the proposed lump-sum distributions would violate the IRC’s required minimum distribution rules. The required minimum distribution rules provide that once a participant or beneficiary begins receiving lifetime annuity payments, his or her monthly payment amount may not increase and his or her payment period may not be modified except in specific, limited circumstances. One such circumstance is when a plan amendment provides for the payment of increased benefits. Although the addition of the lump sum-option would result in an increased payment amount and shortened payment period, the IRS concluded that the election to cash out the remainder of the annuity would be permissible because the lump-sum option was being offered pursuant to a plan amendment and only during a limited window period. The IRS also noted in PLR 201422031 that, as long as the portion of any lump-sum distribution attributable to that year’s required minimum distribution is not treated as an eligible rollover distribution, the lump-sum option itself would not trigger the excise tax under IRC Section 4974 for failure to take a required minimum distribution.
The 2014 rulings had been pending since as early as October or November 2012, and were issued on March 5, 6 and 7, 2014.
Similar to its 2012 rulings, the IRS noted that it was only expressing an opinion with respect to the required minimum distribution issue, and not with respect to any other potential tax consequences, or any implications under Title I of ERISA. The rulings emphasize the fact that there are a number of additional issues that plan sponsors and fiduciaries should consider in designing these types of programs, whether offered to participants in pay status or not. Some of these issues include:
- Spousal Consent – Lump-sum offers must comply with the same spousal consent rules that apply to initial benefit elections.
- QJSA Rules – In addition to the lump-sum option, the plan must still make qualified joint and survivor annuities and qualified optional survivor annuities available to participants.
- IRC Section 436 Benefit Restrictions – The plan’s adjusted funding target attainment percentage (AFTAP) cannot fall below 80%, because this would trigger restrictions on the plan’s ability to offer lump-sum distributions.
- IRC Section 415 Benefit Limitations – IRC Section 415 imposes limits on the amount of a participant’s plan benefit. For participants already in pay status, these limits must be satisfied on the participant’s initial annuity starting date, as well as the subsequent lump-sum payment date.
- IRC Section 417(e) Valuation Methods – IRC Section 417(e) contains specific rules regarding the interest rates that must be used in calculating lump-sum distributions.
- Eligibility for Window – The plan sponsor will have to decide who will be eligible to elect lump-sum distributions (e.g., terminated vested participants, participants in pay status, beneficiaries, or alternate payees). The lump-sum window must also satisfy certain nondiscrimination requirements.
- Disclosure of Lump Sum Consequences – Participants must receive sufficient information to understand the consequences of electing a lump-sum distribution and the value of the monthly annuity they are giving up. A plan sponsor and/or fiduciary might consider facilitating participants’ access to professional financial advice.
- Communication Timing – Plan fiduciaries must decide how far in advance participants should be notified of the lump-sum window.
- Length of Window – Plan fiduciaries will have to decide on an appropriate amount of time to allow participants to consider and elect the lump-sum option.
- Lost or Missing Participants – There may be participants who cannot be located for all or a portion of the election window.
- Coordination with Other Benefit Plans – Taking a lump-sum distribution may have an impact on long-term disability payment offsets for participants on disability or the ability of retirees to use pension annuity distributions to pay retiree medical premiums.