ERIC Comments on Update to Minimum Present Value Requirements for Defined Benefit Plan Distributions

General Comments

As explained below, we are concerned that the “clarifying” changes in the proposed regulations are, in fact, both substantive and problematic. With certain exceptions, the proposed changes represent significant changes to long-standing guidance and well-established plan designs and related benefit determinations that have been in place for decades. It is particularly concerning to plan sponsors that the IRS can change the rules at this late date in a manner that potentially conflicts with well-established plan designs that over the years have been sanctioned by favorable IRS determination letters. These changes could call into question years of prior benefit determinations for retirees, many of whom are currently receiving annuity payments, and cause plans to provide different levels of benefits to similarly-situated retirees.

ERIC maintains that there is no compelling reason for most of the so-called clarifying changes. We recognize that the government has a general concern about the payment of pension benefits in the form of a lump sum.  However, the issuance of proposed regulations prior to discussion of the issues substantially raises the risks for plan sponsors. The characterization of the proposed changes as “clarifying” suggests a certain sense of finality and, even more concerning, a signal that plan sponsors should have heretofore been operating their plans in conformity with these changes.

We ask the IRS to also keep in mind that changes it may view as relatively minor or clarifying come with substantial costs to plan sponsors and their service providers. Administrative systems and benefit calculation programs need to be updated, plan documents need to be reviewed and potentially modified (largely without the possibility of the assurances of a favorable determination letter), and employee communications need to be prepared. Additional funding requirements and increased PBGC premiums also need to be considered.

Specific Recommendations

ERIC recommends, for the reasons set forth below, that the IRS adopt the following revisions to the proposed regulations:

• Treatment of Pre-Retirement Mortality – The regulations should not prohibit plans from taking pre-retirement mortality into account when determining the single sum value of employee contributions, and alternative methods for calculating the single sum value should be permissive rather than mandatory. Further, the regulations should permit, not require, plans to take pre-retirement mortality into account when determining the single sum value of the employer-derived accrued benefit and should allow plans to apply pre-retirement mortality in a consistent manner for all relevant purposes.
• Application of Section 417(e)(3) to Social Security Level Income Options – The regulations should not apply the minimum present value requirements to Social Security Level Income options.
• Post-Normal Retirement Age Adjustments under Section 417(e)(3) – The IRS should explain why it believes that changes to the existing language are necessary and the intended impact, and it should invite comments.
• Alternative Calculation of Subsidized Lump Sum — In response to the IRS request for comments, ERIC believes that alternative calculations are permissible when determining the lump sum value of a subsidized early retirement benefit, as long as the lump sum value is no less than the immediate value of the normal retirement benefit, determined in accordance with Section 417(e)(3).

ERIC believes that there is no reason to implement changes to the minimum present value requirements for employee contributions, or in the alternative, any changes should be permissive rather than mandatory. Plan sponsors have determination letters on plan designs with employee contributions and have been determining benefits in reliance on Rev. Rul. 89-60 guidance for the nearly 30 years since it was issued. This methodology has not led to any notable controversy that would suggest a substantial change in policy is necessary. Any change now would certainly call into question decades of benefit calculations, with potentially minimal benefit to affected participants.

• Application of Pre-Retirement Mortality to the Employer-Derived Accrued Benefit

The proposed regulations would provide that pre-retirement mortality is generally taken into account when determining the minimum present value of the employer-derived accrued benefit. We recommend that the IRS revise the regulation to explicitly state that this is a permissible plan design, and if implemented, would apply for all relevant purposes.

The Section 417(e)(3) calculations apply not just to voluntary lump sums but also to mandatory lump sum cash-outs under Section 417(e)(3)(1), application of the most valuable optional form of payment exception under Section 1.401(a)-20, Q&A-16, and application of substitution of annuity provisions under Section 1.430(d)-1(f). Because application of pre-retirement mortality results in a smaller lump sum than without, the regulations should give plan sponsors the option to take pre- retirement mortality into account for all relevant purposes.

• Application of Section 417(e)(3) to Social Security Level Income Options

The preamble to the proposed regulations acknowledges that questions have arisen regarding whether the minimum present value requirements of Section 417(e)(3) apply to a Social Security level income (“SSLI”) option. The proposed regulations would answer this in the affirmative by including an example, which would explain that SSLI options do not fit within the existing exceptions to the minimum present value requirements of Section 417(e)(3). Questions about the application of the minimum present value requirements to SSLI options are based on informal IRS guidance that is contrary to any reasonable reading of the statute.

Section 417 and its parallel provision, ERISA Section 205, generally provide that defined benefit plans and certain defined contribution plans must distribute benefits to a married participant in the form of a qualified joint and survivor annuity and to a single participant in the form of a single life annuity. Distributions may be made in other forms of benefit but generally only if the plan first obtains the participant’s consent and, in the case of a married participant, the spouse’s consent as well.

Section 417(e) and its parallel provision ERISA, Section 205(g), impose additional restrictions whenever a participant receives an “immediate distribution” of the “present value” of the qualified joint and survivor annuity (or single life annuity in the case of a single participant).  Distributions in this form are permitted as long as the present value is no less than it would be when calculated using the interest and mortality assumptions specified in Section 417(e).

A related provision in Section 411(a)(11), and the parallel ERISA Section 203(e), impose a similar requirement on an immediate distribution of the present value of a participant’s “nonforfeitable accrued benefit.” As interpreted by the courts and the IRS, the requirements of Sections 411(a)(11) and 417(e) and ERISA Sections 203(e) and 205(g) have come to mean that a covered defined benefit plan may not make a lump sum distribution unless the lump sum is at least equal to the present value (calculated using Section 417(e) statutory assumptions) of the participant’s vested single life annuity payable at normal retirement age.

For decades, many defined benefit plans have included an SSLI option. This option is an annuity that provides, as nearly as possible, level annuity payments to the participant for life when considering the retirement benefits under both the plan and Social Security.

The statutory issue raised by the proposed regulation is whether an SSLI option is an “immediate distribution” of the “present value” of the participant’s accrued benefit that must be calculated in accordance with the valuation requirements of Section 417(e). Under an SSLI option, annuity payments under the plan “step down” or decrease once a participant reaches Social Security retirement age, or in some cases might cease altogether, in recognition of the fact that the participant has begun receiving Social Security retirement benefits in addition to any annuity payments from the plan.

The conclusion in the proposed regulation that an SSLI option is subject to Section 417(e) is based solely on a provision in the existing regulations, which states that the Section 417(e) valuation requirements apply to every optional form of distribution from a covered plan unless the IRS provides an explicit exception. See Treas. Reg. §§ 1.411(a)-11(a)(1), 1.417(e)-1(d)(1) (emphasis added). In what can only be characterized as a bald deviation from the language of the statute, those same existing regulations flatly state that the valuation rules apply “regardless of whether the accrued benefit is immediately distributable.” Treas. Reg. § 1.411(a)-11(d). The existing regulations reached this conclusion, which is at odds with the statutory language, out of concern that plans might seek to avoid the valuation requirements by not making a single lump sum payment but instead, for example, splitting a lump sum in half and offering it in the form of two separate installments, one payable shortly after the other. From there, it was easy for the IRS to imagine the further ploy of splitting the lump sum into three or more installments payable over slightly longer periods of time. Regardless of what one thinks about the statutory basis for such an anti-avoidance rule, Social Security level income options could not have been devised to circumvent the 417(e) valuation requirements because they have existed since long before the valuation requirements in Section 417(e) even existed.

The existing regulations provide explicit exceptions from the valuation rules only for certain optional forms of distribution. See Treas. Reg. § 1.417(e)-1(d)(6). The first potentially relevant exception is for non-decreasing annuities – that is, annuities under which the monthly or other periodic payment does not decrease during the life of the participant. See Treas. Reg. § 1.417(e)- 1(d)(6)(i). The IRS has previously stated informally that an SSLI option is not covered by this exception because a Social Security leveling payment might result in a temporary annuity for a short period of time, thus “approaching a lump sum.” See 1996 Enrolled Actuaries IRS/Treasury, Q&A-22. This might occur, for example, if the annuity is sufficiently small (e.g., an employee retiring at age 63 with five years of service) that the annuity payment is reduced to zero once the participant reaches Social Security retirement age. The second potentially relevant exception is for annuities that decrease during the life of the participant solely because of the cessation of a “Social Security supplement.” See Treas. Reg. § 1.417(e)-1(d)(6)(ii)(B). The IRS has previously stated informally that an SSLI option is not covered by this exception either, presumably because an SSLI option is technically distinct from a Social Security supplement. See 1996 Enrolled Actuaries IRS/Treasury, Q&A-22.

Both of these informal IRS positions are inconsistent with its regulations governing the forms of distributions that are eligible for rollover to an IRA. Those regulations treat an SSLI option as a “series of substantially equal periodic payments” despite the step down in the monthly benefit at Social Security retirement age. Furthermore, the regulations treat an SSLI option identically to a Social Security supplement for this purpose.  See Treas. Reg. § 1.402(c)-2, Q&A-5(b).

Plan sponsors and administrators have reasonably relied for decades on the plain language of the statute and on numerous favorable determination letters to continue calculating Social Security level income options in accordance with the terms of their plans and without subjecting them to the Section 417(e) valuation assumptions.  Changing the rules at this late stage, more than 30 years after Section 417(e) was enacted, would unleash an unwarranted and costly administrative burden on defined benefit plans that they can ill-afford. If the IRS believes that changes to Section 417(e) are warranted, it should seek legislation to amend the language of the statute, but it should do so solely with respect to future accruals.

Post Normal Retirement Age Adjustments under Section 417(e)(3)

According to the preamble, the proposed regulations would “clarify” the current requirement that the present value of any optional form of benefit cannot be less than the value of the normal retirement benefit. The clarification would be made by replacing the foregoing reference to the “normal retirement benefit” with “accrued benefit payable at normal retirement age” and a reference to post-normal retirement age adjustments (i.e., an exception where the optional form is payable after normal retirement age and the suspension of benefits requirements are satisfied). Unlike the other proposed changes, the preamble gives no indication of why the IRS believes a change is needed and what impact such change might mean for plan benefit determinations.

The current reference to the “normal retirement benefit” without any reference to post-normal retirement age adjustments has remained unchanged since the regulations were promulgated in their original temporary form nearly 30 years ago. The proposed change would result in more questions than answers (e.g., whether plans would be required to provide post-normal retirement age increases that reflect interest and mortality, without regard to any  death benefit provided by the plan). Moreover, the IRS categorizes this change as “clarifying” but gives plan sponsors no reliance on the proposed regulations. This leaves plan sponsors in the untenable position of trying to guess what the proposed change is intended to clarify without the ability to make any changes to comply. For these reasons, if the IRS believes a change is necessary, clarifying or otherwise, it would be appropriate to have an explanation followed by the opportunity to comment.