When employees covered under a defined benefit pension plan retire, they may be faced with an unenviable choice – if the plan allows participants to elect either a lump sum distribution or a joint and survivor annuity, they must decide whether they prefer the liquidity and portability of the lump sum, or the guaranteed lifetime income stream of the annuity. One solution to this “all-or-nothing” proposition is for the plan to offer “split” benefits payable partially in a lump sum (or other accelerated form) and partially in an annuity form. Unfortunately, a lack of clarity in existing guidance has discouraged some plan sponsors from offering this feature.
Specifically, current Treasury Regulations under Internal Revenue Code (Code) Section 417 require that the present value of benefits and distributions cannot be less than that determined by applying certain actuarial factors set forth in Section 417(e). This anti-abuse rule is referred to as the “Minimum Present Value” requirement. However, it does not apply to the amount of a distribution that is paid as an annual benefit which does not decrease during the life of the participant, such as a qualified joint and survivor annuity. Pension plans apply factors other than the statutory factors for this latter purpose.
Unfortunately, the current regulations do not provide clear guidance in cases where benefits are distributed partially as lump sums and partially as “non-decreasing” joint and survivor annuities. The IRS has publicly (although not through formal guidance) taken the position that the entire benefit is a single “distribution” that is wholly subject to the Minimum Present Value requirement. There are two practical problems with this result:
- First, it is counterintuitive (and, perhaps, inequitable) to apply the Minimum Present Value requirement to a partial annuity when it does not apply to a “full” survivor annuity. For example, consider a pension plan that offers a protected lump sum distribution form, which is merged into another plan where the lump sum is eliminated for future accruals. Under the IRS’ stated position, the annuity portion of a participant’s benefit (under the “acquiror” plan) would be subject to disparate treatment than would apply if the plans had not been merged but the accruals were otherwise the same.
- Second, applying the Minimum Present Value requirement to partial annuities when it does not apply to “full” annuities creates a significant administrative burden for plan sponsors and providers, mandating that they deal with another complex permutation in valuing optional benefit forms.
It is expected that partial annuity benefits would be a popular choice for participants when and if offered. To encourage plan sponsors to make them available, and thus avoid having participants elect full lump sums to the possible detriment of their retirement security, the IRS issued a proposed regulation (77 FR 5454, Feb. 3, 2012) to deal with these problems. The proposed regulation would allow pension plans to be amended to treat partial annuity and lump sum benefits as separate distributions under Code Section 417. This would avoid the problems noted above. This relief would be available to “bifurcated accrued benefits,” which are
- Separately determined portions of an accrued benefit, for which different distribution forms are available for the separate portions;
- Proportionate benefits for which (i) one form can be elected for a portion, with another form for the remainder (determined on a pro rata basis) or (ii) either form can be elected for the entire benefit; or
- Specified amounts distributed as lump sums with a separate election for the remainder, provided that the remainder cannot be less than the amount that would be paid if the entire benefit was distributable in a lump sum (applying the statutory factors under Code Section 417).
Industry response to the proposed regulation has been generally positive. However, there is a concern – noting the ambiguity in existing guidance, commentators have pointed out that some plans have historically treated partial lump sums and annuities as separate distributions. Thus, notwithstanding the IRS’ informal position, they have not applied the Minimum Present Value requirement to the annuity portions. This is particularly prevalent in the “merged plan” scenario noted above.
For this reason, commentators have requested clarification in the final regulation that it will not be interpreted as meaning that this approach was impermissible during prior periods. They have also suggested that the IRS indicate, even if only informally, that it will not challenge this interpretation prior to the final regulation’s effective date to the extent it was made in good faith.
We anticipate that the IRS will review this concern and may make adjustments in response. In any event, we believe that the final regulation will be issued in 2013 and, as proposed, would generally apply after that date. Upon the issuance of the final regulation, defined benefit plan sponsors will then be better able to determine whether offering partial annuity benefits would be helpful and appropriate.