Lump Sums under the Pension Protection Act of 2006

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1 Lump Sums under the Pension Protection Act of 2006 November 15, 2006 An article in the October 25th Wall Street Journal article entitled Changes in Defined-Benefit Plans Affect Many Highly-Paid Workers; Making Do With $200,000 Less has caught the attention of many plan sponsors. Below is a fuller discussion and analysis of changes in lump sum benefits under the new law that sponsors will find useful. We will address two distinct provisions under PPA related to lump sum payments: A reduction in the maximum lump sum payable for participants with benefits at or near IRS limits (effective in 2006), and A new basis for calculating minimum lump sums (phased in between 2008 and 2012). How do these provisions affect plan participants? The table below provides a quick summary of the two provisions. Table 1 PPA Change Effective Date Who s Affected? What Do We Know? What Are We Waiting For? Issues/ Decision Points Maximum Lump Sum 2006 A small fraction of employees with benefits limited by IRS rules (see Table 2) Everything but the status of 2006 payments prior to PPA Definitive retroactive guidance for 2006 Will SERP pick up reduction for eligible employees? Minimum Lump Sum phase-in All participants - Lump sums for plans with annuity formulas - Annuity benefits for hybrid formulas Estimated interest and mortality - Actual interest and mortality - Transition guidance New basis will produce smaller lump sums. Will plans: - adopt the new basis, - adopt a different

2 transition, or - continue with the current basis? Ideally, decisions will be made by the first half of 2007 What does the Maximum Lump Sum provision mean? This provision affects very few participants. Benefits lower than the amounts in the table below will not be affected by the IRS limits on benefit payments during 2006: Table 2 Age Annual Life Annuity Lump Sum Based on 5.5% 30 $23,500 $405, , , ,100 1,114, ,500 1,446, ,900 1,895, ,000 2,121, ,000 1,979,000 Second, the reduction in maximum lump sum benefits is not new maximum lump sums during 2004 and 2005 were also reduced due to the 5.5% interest rate minimum, but the reduction expired at the end of Under PPA, the reduction in maximum lump sum benefits has been made permanent. For benefits that are limited by IRS rules, the maximum lump sum is calculated using an interest rate no lower than 5.5%. (For benefits less than IRS limits, lump sums are based on 30-year Treasury yields, which have been below 5.5% for the past several years.) The 5.5% limitation can reduce lump sum benefits by 5-15%. Although the 5.5% is stated as applying for distributions in years following December 31, 2005,

3 PPA was not enacted until August 17, So, for the period between 1/1/2006 and 8/16/2006, operationally, the 5.5% limitation on lump sum payments did not exist. While it is not clear if the 5.5% limitation can or must be applied retroactively to the beginning of 2006, we have heard informally from the IRS that it would be difficult to require retroactive adjustments. We expect more definitive guidance on this in the near future. Finally, many participants who are affected by the 5.5% limitation also participate in supplemental (SERP) plans. Appropriate language in the SERP document can keep participants who are affected by the 5.5% limitation whole by automatically increasing the SERP lump sum by a corresponding amount. In order for a participant to be negatively affected by PPA during 2006, he or she would need to be (a) a rare participant whose benefit is reduced because of IRS limits who (b) received a benefit estimate prior to August 17, 2006, then (c) retired after August 17, 2006 and (d) was not covered by a SERP that would make up the shortfall. For most plans, this combination of circumstances likely occurs infrequently, if at all. What does the Minimum Lump Sum provision mean? PPA also changed both the interest rate and mortality table used to compute minimum lump sum benefits, beginning in 2008 and phased-in over five years. While we don t have final guidance on the assumptions required under PPA, there is information to make reasonable estimates of the impact of this change. The new minimum lump sum basis will use a lower mortality assumption (which will increase lump sums about 1%, if the mandated mortality assumption resembles IRS s proposed change for current liability ) and a new interest rate assumption a three-segment corporate bond yield curve rather than the 30-year Treasury bond that will generally reduce lump sums, possibly substantially. The impact of the new interest rate is based on several factors: (a) the age of the participant, (b) the shape of the yield curve (flat, steep, or inverted), (c) the yield spread between corporate and Treasury bonds, and (d) whether lump sums are based on immediate or deferred benefits (see appendix for more detail). The table below provides a range of estimated reductions in lump sums under PPA (ignoring the five year phase-in) based on actual interest rates between 1/1/1996 and 10/1/2006: Table 3 Age Based on Immediate Annuity Based on Deferred to 65 Annuity Average Reduction Range Average Reduction Range 30 15% % % % 12-3

4 % What factors should plan sponsors be considering? We have summarized below some items for plan sponsors to consider related to this issue: The current (10/1/2006) interest rate environment produces reductions similar to the average since 1996 (about at age 65 and 1 at age 55 for lump sums based on immediate annuities). PPA only requires that the yield curve be used to determine minimum lump sums required under law. Plan sponsors are free to use an alternative reasonable basis (such as the current, 30-year Treasury basis) provided the lump sum is at least as great as the minimum required, which is generally the case. Based on a similar law change in 1994, plans that adopt the PPA minimum may be able to avoid anti-cutback rules during implementation. Plan sponsors that pay more than the minimum in 2008 but wish to migrate to the PPA basis later may be required to grandfather the more generous basis. The five-year phase in of PPA reduces concerns that the new basis will accelerate retirements during For many plans, PPA minimum lump sums during 2008 may be only 1- lower. Such a fluctuation is less than what is routinely seen due to changing interest rates under current law. Plan sponsors that choose to continue paying benefits under the current basis may see a one-time increase in liabilities for funding purposes of about 5% due to PPA. This is because PPA requires that any subsidy in lump sum benefits be explicitly valued under the plan. (Prior to PPA, these subsidies were ignored in many pension funding calculations, specifically current liability. ) Participants covered by hybrid formulas generally will not see any impact on lump sum benefits, unless the plan had been paying additional amounts due to whipsaw. But annuity benefits will be higher than under current law by the amounts shown in the table above for plan sponsors that choose to adopt this PPA basis for purposes of determining annuities (although this conversion basis is not required). What needs to be done, and when? Plans have several months to evaluate options related to adopting the PPA lump sum basis. However, most plans will want to decide on a course in the first half of next year to leave enough time to make necessary changes to administrative systems and processes. Appendix: Three-Segment vs. 30- Treasury Rate In comparing the three-segment yield curve with the 30-year Treasury yield to determine lump sums, four variables are important: * * * Participant age. Older participants will see a smaller reduction in the required lump sum. Shape of the yield curve. When the yield curve is flat (i.e. short-term rates are near or above long-term rates), the reduction in lump sums will be greater. Conversely, when the

5 yield curve is steep (i.e. short-term rates much lower than long-term rates), the reduction in lump sums is less. Spread between corporate bond and Treasury yields. The larger the spread, the greater the reduction in lump sums using the yield curve. The plan s methodology for calculating lump sums. The majority of plans calculate lump sums as the value of the immediate life annuity, others as the value of a deferred (usually to 65) annuity. For the latter group, the yield curve will produce substantially lower lump sums. Below are the results of an historical analysis of the reduction in lump sums using our estimate of the PPA yield curve versus the 30- Treasury, focusing on three dates (plus a composite): 6/1/2000. The combination of a flat yield curve and a wide spread between corporates and Treasuries produce the largest drop in lump sum values under PPA rules during the period examined. 10/1/2003. A steep yield curve (very low short-term rates) coupled with a narrow spread between corporates and Treasuries generates the smallest decrease under PPA versus current rules. 10/1/2006, the most recent date available, and Average over the entire period, 1/1/ /1/2006 Estimated Impact of PPA Minimum Lump Sum Basis Based on Historical Interest Rates 6/1/2000 Interest Rates (Flat yield curve, large spread) 10/1/2003 Interest Rates (Steep yield curve, small spread) Interest Rate 30- Treasury Interest Rate 30- Treasury Impact on lump sums: Immediate Def. to 65 Impact on lump sums: Immediate Def. to (2) (6) 30 (11%) (45%) 50 (2) (4) 50 (7%) (21%) 55 (1) (3) 55 (5%) (13%) 60 (1) (23%) 60 () (7%) 65 (1) (1) 65 () () In terest Rate 10/1/2006 Interest Rates (Flat yield curve, small spread) 30- Treasury Interest Rate Composite, (Avg. yield curve, avg. spread) 30- Treasury Impact on lump sums: Immediate Def. to 65 Impact on lump sums: Immediate Def. to (15%) (4) 30 (15%) (49%) 50 (11%) (23%) 50 (1) (27%) 55 (1) (17%) 55 (1) (19%) 60 () (11%) 60 () (1) 65 () () 65 () ()

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