Preventing Disastrous DB Distributions Sunday, April 28, 2013

Transcription

1 Preventing Disastrous DB Distributions Sunday, April 28, 2013 David B. Farber, ASA, COPA, EA, MSPA Defined Benefit Distributions Participant must elect form of benefit prior to payment from plan Types of forms of benefit Life annuity Life annuity with a certain period Joint and Survivor annuity Annual installments over a set period of time Lump sum Married participants must generally obtain spousal consent in order to receive the benefit in a form other than a qualified joint and survivor annuity 1

2 Accrued Benefits Benefits to be distributed are generally a function of the accrued benefit. The accrued benefit is defined in the plan document, and is generally either earned on a unit benefit basis, or earned on a pro-rata basis (often referred to as fractional accrual). Accrued Benefits A unit benefit accrual is typically based on either a percentage of salary or a flat dollar amount An example of a percentage of salary accrual is 1% of salary per year. Salary can be each individual year s salary, final year s salary (the past year), or an average salary over a specified period of time. An example of a flat dollar accrual is $50 (payable monthly) per year of service. 2

3 Accrued Benefits A pro-rata accrual is typically based on the expected benefit payable at the normal retirement age As an example, suppose that a participant has an expected normal retirement benefit of $1,000, payable monthly beginning at age 65. The participant (currently age 50) was hired at age 40, and entered the defined benefit plan at age 45. Pro-rata accrual is typically either based upon total years of service or total years of plan participation, as defined in the plan document. The accrued benefit based on years of service is: $1,000 (10/25) = $400 The accrued benefit based on years of participation is: $1,000 (5/20) = $250 Equivalent Benefits Optional forms of benefit are determined based upon the plan provisions that describe how to convert the benefit from the normal form of benefit to the elected optional form Conversion could be a simple factor. For example: Normal form of benefit is a life annuity of $2,000 per month Optional form of benefit is a life annuity with the first 10 years of payments guaranteed, equal to 92% of the life annuity The life annuity with the first 10 years guaranteed for this participant is equal to $1,840 per month (92% of $2,000) 3

4 Equivalent Benefits Conversion could be based upon actuarial equivalence. Conversion uses present value of an annual annuity of $1, payable monthly, for normal form of benefit and optional form of benefit elected This is often referred to as an Annuity Purchase Rate (APR) Multiply benefit in normal form by APR for normal form, and then divide the result by the APR for the optional form of benefit elected, resulting in the actuarially equivalent benefit Equivalent Benefits Example of conversion using actuarial equivalence. Normal form of benefit for a participant age 65 is a life annuity of $2,000 per month Optional form of benefit is a life annuity with the first 5 years of payments guaranteed, actuarially equivalent to the normal form Plan equivalence is based upon 5% interest and the applicable mortality table under PPA The APR for the annual benefit, payable monthly, at age 65 is 12.05; the APR in the optional form is Life annuity with the first 5 years guaranteed for this participant is equal to $1,972 per month ($2, ) 4

5 Qualified Joint and Survivor Annuity Payment of benefit continues to spouse upon death of participant Spousal benefit must be no less than 50% and no more than 100% of the benefit paid while the participant was still alive Plan must specify the percentage for the qualified joint and survivor annuity (QJSA) If the plan only allows for 1 joint and survivor annuity option, then that is deemed to be the QJSA If the plan allows for more than one joint and survivor annuity option, then the most valuable option must be the QJSA Qualified Joint and Survivor Annuity Spousal consent for an optional form of benefit that is not a QJSA is not required if the participant has been married for less than one year as of the date of distribution. For an annuity, the date of distribution is the date that the payments begin. Spousal consent is in the form of a waiver signed within 180 days of the annuity starting date, stating that the spouse agrees to waive the right to the QJSA 5

6 Qualified Joint and Survivor Annuity A Qualified Optional Survivor Annuity (QOSA) is a second option for married participants The QOSA is a joint and survivor annuity with a different survivor percentage from the QJSA The amount of the QOSA depends upon the QJSA percentage If the QJSA percent is less than 75%, then the QOSA percent is equal to 75%. If the QJSA percent is greater than or equal to 75%, then the QOSA percent is equal to 50%. An election of the QOSA does not require spousal consent if it is actuarially equivalent to the QJSA Lump Sum Defined A lump sum distribution is a one-time payment to a plan participant that is actuarially equivalent (equal in value) to the benefit that would otherwise be payable from a defined benefit plan A lump sum is an optional form of benefit it is not required to be an option offered by the plan Generally the plan participant must elect to receive the lump sum form of benefit from the plan IRC section 411(a)(11)(A) allows a defined benefit plan to have an option under which the plan can force a participant with a lump sum value of their vested accrued benefit of no more than $5,000 to receive their benefit as a lump sum (including married participants without spousal consent!) 6

7 Lump Sum Defined The lump sum is determined based upon actuarial assumptions and methods stated in the plan document The lump sum must be at least as large as required under IRC 417(e)(3) The lump sum cannot exceed the maximum lump sum allowed under IRC 415(b) Lump sum payments may not be allowed for certain highly compensated employees Lump sum payments may be restricted for under-funded plans Plan lump sum determination Uses actuarial assumptions defined in plan document Plan actuarial assumptions could utilize IRC 430(h)(2) segment interest rates Segment 1 rate applies to benefit payments made within the next 5 years from the current valuation date Segment 2 rate applies to benefit payments made after the next 5 years but not more than 20 years from the current valuation date Segment 3 rate applies to benefit payments made after the next 20 years from the current valuation date For example, if the valuation date is 1/1/2013, then the segment 2 rate would take effect for payments starting 1/1/2018 and the segment 3 rate would take effect for payments starting 1/1/2033 7

8 Plan lump sum determination Example 1 Participant Smith has a vested accrued benefit of $1,000 per month payable at age 65 Smith is currently age 50 Plan lump sum equivalence assumptions: 5% interest rate PPA mortality table, post-retirement only APR at age 65 is Lump sum value of benefit at age 65 is $144,648 $1, = $144,648 Lump sum value at age 50, discounting at 5% interest per year from age 65 to age 50, is $69,578 $144, = $69,578 Plan lump sum determination Example 2 Same as example 1, except that the mortality is used both preretirement and post-retirement Lump sum value of benefit at age 65 is $144,648 Lump sum value at age 50, discounting at 5% interest per year from age 65 to age 50 and adjusting for mortality during that same period, is $65,797 $144,648 (D65/D50) = $144,648 (389,263/855,753) = $65,797 8

9 Plan lump sum determination Example 3 Same as example 1 except for the following plan lump sum equivalence assumptions: PPA 24-month segment rates in effect on first day of year of lump sum determination (rates published in December of prior year) PPA mortality table, post-retirement only Lump sum value of benefit at age 50 is $52,151 Note that interest rates used were (3.14%, 5.90%, 6.45%), the 3 segment rates in order from 1 to 3 The first payment at age 65 would be in 15 years, so the segment 2 rate of 5.90% was used to determine the present value of the payments from ages 65 to 70 The payments beginning at age 70 would be in 20 years, so the segment 3 rate of 6.45% was used to determine the present value of the payments from age 70 and later Plan lump sum determination Example 3 (continued) -- Detail of lump sum calculation Present value factor from segment 2 rate of 5.90% {[N65(12) N70(12)]/D65} Interest discount from age 65 to age 50 {[2,499,807 1,549,714)/223,517} = Present value factor from segment 3 rate of 6.45% (N70(12)]/D65) Interest discount from age 65 to age 50 (1,038,205/159,617) = Lump sum value of benefit at age 50 is $52,151 $1, ( ) = $52,151 9

10 IRC 417(e)(3) Lump Sums IRC 417(e)(3) requires a minimum lump sum value to be paid (if a lump sum is elected) determined using specific actuarial assumptions, referred to as the applicable interest rate and the applicable mortality table The applicable interest rate and mortality have been based upon IRC 430(h) interest and mortality assumptions since 2008 The applicable interest rate is determined as defined in the plan document by a stability period and a look-back month IRC 417(e)(3) Lump Sums The stability period can be a month, a quarter or a year The stability period defines how often the interest rate changes for purposes of IRC 417(e)(3). For example, if the stability period was defined to be each quarter, then a different interest rate would be used to determine the lump sum depending upon which quarter of the year the participant was to receive the lump sum payment. 10

11 IRC 417(e)(3) Lump Sums The look-back month is any of the 5 months preceding the beginning of the stability period The look-back month defines which applicable interest rate is to be used for purposes of IRC 417(e)(3). For example, if the look-back month was defined to be 3 months, then the applicable segment rates determined in October, 2012 would apply for a stability period beginning on 1/1/2013. Transition rules applied for years prior to 2012 with regard to determination of the segment rates for IRC 417(e)(3). IRC 417(e)(3) Lump Sums The applicable mortality table is the table in effect on the first day of the stability period This is effectively the calendar year in which the stability period begins Example: For a stability period that begins on 10/1/2012 and ends on 9/30/2013, the 2012 published mortality table would be the applicable mortality table for all lump sums paid during that one-year period 11

12 IRC 417(e)(3) Lump Sums Treasury regulation 1.417(e)-1(d)(1) states that the present value under IRC 417(e)(3) must be valued using the same method as is used under the plan s actuarial equivalence. It is not clear under PPA, which changed the applicable mortality table beginning in 2008, whether this regulation still applies. Under the regulation, if the plan does not use pre-retirement mortality to determine the lump sum (as in example 1), then the IRC 417(e)(3) lump sum would also be valued without the use of pre-retirement mortality. There has been some comment with regard to the changes under PPA such that it may be a requirement to use pre-retirement mortality for the IRC 417(e)(3) lump sum regardless of the plan definition. IRC 417(e)(3) Lump Sums Example 4 Participant Smith has a vested accrued benefit of $1,000 per month payable at age 65 Smith is currently age 50 Plan lump sum equivalence assumptions: 5% interest rate PPA mortality table, pre-retirement and post-retirement Stability period: Calendar year Look-back month: 2 months Lump sum payment date: 1/1 IRC 417(e)(3) segment rates based upon stability period and look-back month: (2.16%, 4.77%, 6.05%) 12

13 IRC 417(e)(3) Lump Sums Example 4 (continued) Lump sum value at age 50, using plan assumptions as in example 2, is $65,797 Lump sum value, using the IRC 417(e)(3) segment rates, is $56,613 Note that the segment 2 interest rate of 4.77% was used to value payments from ages 65 until 70, and the segment 3 interest rate of 6.05% was used to value payments from age 70 and later The lump sum payable to Smith is equal to the greater of the plan lump sum of $65,797 or the IRC 417(e)(3) lump sum of $56,613. This is the plan lump sum of $65,797. IRC 417(e)(3) Lump Sums IRC 411(d)(6) anti-cutback consideration The plan definition of the stability period and the look-back month are considered part of the accrued benefit of the participant, and generally cannot be changed in such a way as to reduce the value of the accrued benefit. A special rule applies such that if the stability period and/or the look-back month is changed in the plan document, then the IRC 417(e)(3) value of the accrued benefit is protected for 1 year from the amendment. The lump sum value during that one-year period is based upon either the interest rate that would have been used under the old plan provisions, or the interest rate that would be used under the new plan provisions Changes in the mortality table (as required by law) from year to year are deemed to not be a violation of the anti-cutback rules. 13

14 IRC 417(e)(3) Lump Sums Example 5 Participant Smith elects to receive a lump sum distribution on 5/1/2013 The stability period of the plan is the calendar year Prior to 2013, the look-back month was 4 months On 1/1/2013, the plan was amended to change the look-back month to 1 month The IRC 417(e)(3) lump sum value of Smith s accrued benefit using the plan provisions in effect on 5/1/2013 is $186,000. The IRC 417(e)(3) lump sum value of Smith s accrued benefit using the plan provisions in effect prior to 2013 is $188,000. Smith s IRC 417(e)(3) lump sum value is the greater of the two, which is $188,000. Maximum Lump Sum under IRC 415(b) IRC 415(b)(2)(E)(ii) states that any benefit paid in a form of benefit that falls under the requirements of IRC 417(e)(3) such as a lump sum may not exceed the maximum lump sum value as specified under IRC 415 The maximum lump sum payable under IRC 415(b)(E)(ii) is equal to the smallest of the following (using the maximum IRC 415(b) annuity as the retirement benefit): The lump sum value using 5.5% interest and the applicable mortality table 105% of the lump sum value determined using the assumptions required under IRC 417(e)(3) The lump sum value using the plan lump sum assumptions 14

15 Maximum Lump Sum under IRC 415(b) If the employer has no more than 100 employees (within the controlled group of the employer) who earned at least $5,000 in the prior year, then the IRC 415(b) maximum lump sum is determined without regard to 105% of the lump sum value determined using the assumptions required under IRC 417(e)(3) Maximum Lump Sum under IRC 415(b) Example 6 Participant Smith, age 65, elects to receive a lump sum distribution on 1/1/2013 The plan vested accrued benefit is $10,000 per month, payable beginning at age 65 as a life annuity The IRC 415(b) limit for Smith is $10,500 per month, payable beginning at age 65 as a life annuity The employer has more than 100 full time employees, each earning more than $5,000 per year 15

16 Maximum Lump Sum under IRC 415(b) Example 6 (continued) The following lump sum values are determined for Smith: (1) Value of plan benefit using plan equivalence = $1,446,484 (2) Value of plan benefit using IRC 417(e)(3) equivalence = $1,473,740 (3) Value of IRC 415(b) benefit using 5.5% interest and applicable mortality table = $1,456,147 (4) 105% of value of IRC 415(b) benefit using IRC 417(e)(3) equivalence = $1,624,798 (5) Value of IRC 415(b) benefit using plan equivalence = $1,518,808 Maximum Lump Sum under IRC 415(b) Example 6 (continued) Without regard to IRC 415(b), the lump sum payable to Smith is $1,473,740 (the greater of (1) and (2)) The maximum lump sum payable under IRC 415(b), the lump sum payable to Smith is $1,456,147 (the smallest of (3), (4) and (5)) The lump sum that is to be paid to Smith is $1,456,147 (the lump sum limited by IRC 415(b)) 16

17 Restrictions for top paid HCEs Restricted employees cannot be paid a lump sum (or any other IRC 417(e)(3) form of benefit) unless certain conditions are satisfied A restricted employee is one of the highest 25-paid HCEs of the employer (consider the entire controlled group) The high-25 list is re-determined each year To determine whether an employee is on the high-25 list, consider the highest salary that they were paid in any year Former employees can be on the HCE list Restrictions for top paid HCEs A restricted employee can be paid a lump sum if they provide security (in the form of an escrow account) of at least 125% of the lump sum (Revenue Ruling 92-76) There is no restriction on the payment of the lump sum if at least one of the following is true The lump sum value does not exceed $5,000 The lump sum value does not exceed 1% of the total current liability of the plan prior to the distribution The market value of assets immediately after the distribution is at least 110% of the total current liability immediately after the distribution 17

18 Restrictions for top paid HCEs If an employee is restricted, and does not satisfy an exemption, then their benefit must be paid as an annuity The employee can subsequently be paid the remaining lump sum if either of the following becomes true: The employee is no longer one of the top 25 paid HCEs The lump sum value satisfies one of the rules allowing it to be paid Restrictions for top paid HCEs Current liability is based upon the applicable mortality table and the 30-year Treasury rate Since current liability is generally not used under PPA, it is not clear what, if anything, should now be substituted for current liability in determining whether there is a restriction in lump sum payments. Although there have been no changes in the regulations under PPA, common practice is to use the funding target (the present value of the prior year accruals valued using funding interest and mortality) instead of current liability 18

19 Restrictions for top paid HCEs Example 7 Lump sum values of accrued benefit for restricted employee Smith: Plan lump sum = $950,000 IRC 417(e)(3) lump sum = $1,000,000 IRC 415(b) maximum lump sum = $1,200,000 Current liabilities: Smith: $900,000 All other participants: $4,630,000 Market value of assets = $6,000,000 Restrictions for top paid HCEs Example 7 (continued) The overall lump sum payable to Smith is $1,000,000 The market value of assets after the lump sum distribution to Smith is $5,000,000 ($6,000,000 - $1,000,000) The current liability of the plan after the lump sum distribution to Smith is $4,630, % of current liability after the lump sum distribution to Smith is $5,093,000 ($4,630, ) The lump sum payment to Smith is restricted because after the proposed distribution, the market value of the assets would be more than 110% of the current liability 19

20 Restrictions for top paid HCEs Example 7 (continued) Options for Smith: Receive benefit as an annuity Set up escrow account of $1,250,000 (125% of $1,000,000) in order to receive the lump sum of $1,000,000 Prohibited Lump Sum Payments under IRC 436(d) Adjusted funding target attainment percentage (AFTAP) is a ratio representing the percentage of the liabilities of the plan that are currently funded Generally, the AFTAP is the ratio of the plan assets (actuarial value of assets) to the plan liabilities (funding target) If the plan has purchased annuities for any NHCEs within the past 2 years, then the amounts used to purchase the annuities are added to both the assets and liabilities for purposes of the AFTAP The actuarial value of assets is generally reduced by the funding balances (funding standard carryover balance and pre-funding balance) If the AFTAP of the plan is less than 60%, then lump sum payments cannot be made (unless no more than $5,000) 20

21 Prohibited Lump Sum Payments under IRC 436(d) If the AFTAP is less than 80% and at least 60%, then a limited lump sum payment can be made Lump sum payment is limited to the smaller of: 50% of the lump sum that could be paid if not for the restriction of IRC 436(d) The present value of the Pension Benefit Guaranty Corporation (PBGC) maximum guaranteeable benefit valued using IRC 417(e)(3) assumptions, with a look-back month of 5 months Participant options for balance of benefit Receive as an annuity Defer receipt of the balance until a time when the plan is no longer subject to restrictions (as long as this does not violate other qualification requirements, such as minimum required distributions under IRC 401(a)(9) Prohibited Lump Sum Payments under IRC 436(d) Example 8 Lump sum values of accrued benefit for restricted employee Smith: Plan lump sum = $950,000 IRC 417(e)(3) lump sum = $1,000,000 IRC 415(b) maximum lump sum = $800,000 Present value of PBGC maximum guaranteeable benefit = $430,000 The AFTAP for the plan is 70% 21

22 Prohibited Lump Sum Payments under IRC 436(d) Example 8 (continued) The maximum lump sum payment that Smith can receive (without regard to the IRC 436(d) restriction) is $800,000 (since the lump sum is limited under IRC 415(b)) The restricted lump sum payment under IRC 436(d) is equal to the smaller of: $400,000 (50% of $800,000), or $430,000 Smith s lump sum payment must be limited to $400,000 Benefit Elections A participant must receive notification of the benefit distribution rights at least 30 days and not more than 180 days prior to the date that the annuity payments can begin The notification must include the following: Explanation of QJSA rules Information concerning optional forms of benefit available, including the relative value of the benefits under each option If the benefit is not paid within the 180-day period, a new notice must be distributed 22

23 Preventing Disastrous DB Distributions Any Questions? Please David Farber at: Thank you for attending this session. 23