ADVISORY EMPLOYEE BENEFITS February 9, 2012

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1 ADVISORY EMPLOYEE BENEFITS February 9, 2012 NEW GUIDANCE ON LIFETIME INCOME PAYMENT OPTIONS On February 2, 2012, the Treasury Department and IRS released a package of guidance on lifetime income payment options for tax-qualified retirement plans and IRAs. The guidance addresses four topics that Treasury and the IRS believe have affected the availability of lifetime income options and the take-up rate among participants: 1. Spousal Annuity Requirements. Defined contribution plans that satisfy certain conditions are not subject to ERISA s spousal annuity requirements (i.e., the QJSA and QPSA ). A new Revenue Ruling clarifies that offering an optional annuity will not, in itself, make a plan subject to the spousal annuity requirements, except to the extent that a participant elects the annuity. 2. Rollovers to Defined Benefit Plans. An efficient way to convert an account balance to an annuity is to roll it over to a defined benefit plan. A new Revenue Ruling sets forth rules for defined benefit plans that accept rollovers. Employers who sponsor defined benefit plans that already accept rollovers (e.g., flooroffset arrangements) should review their plans carefully to assess the impact of this guidance. 3. Split Payment Options (Partial Lump Sum). Treasury and the IRS believe that more participants would elect annuities if they could receive part of their benefits in a lump sum. A split payment option (part lump sum and part annuity) would offer the advantages of a lump sum, with the safety net of an annuity in case the participant outlives his or her savings. A proposed regulation includes guidance on how to calculate benefits In This Advisory... New guidance on lifetime income payment options addresses four topics: How ERISA s spousal annuity rules apply to profit-sharing plans that allow payment in an annuity; Technical requirements for defined benefit plans that accept rollovers; How to calculate benefits when part of a benefit is paid in a lump sum and the rest is paid in an annuity; and Minimum required distribution rules for deferred annuities. under a split payment option. Sponsors of plans that already have split payment options should review their plans to assess the impact of this guidance. 4. Deferred Annuities. Another way to reduce the risk of outliving one s savings is to buy a deferred annuity that starts paying at an advanced age (e.g., 80 or 85). A proposed regulation would change the minimum required distribution rules to better accommodate deferred annuities under defined contribution plans. Each topic is discussed below. BEIJING BRUSSELS LONDON NEW YORK SAN DIEGO SAN FRANCISCO SILICON VALLEY WASHINGTON

2 SPOUSAL ANNUITY REQUIREMENTS ERISA and the Internal Revenue Code require defined benefit and money purchase plans to provide two spousal death benefits: (1) a qualified joint and survivor annuity ( QJSA ) and (2) a qualified preretirement survivor annuity ( QPSA ). The QJSA is an annuity in which (a) the participant receives a monthly benefit for the rest of his or her life, and (b) if the participant dies before his or her spouse, the surviving spouse receives a monthly benefit for the rest of his or her life. Spousal consent is required for payment in a form other than a QJSA; and plans allowing other payment forms must satisfy disclosure requirements. The QPSA is a death benefit that is paid to the participant s surviving spouse if the participant dies before starting his or her retirement benefit. The QPSA is paid in the form of an annuity for the rest of the surviving spouse s life. Profit-sharing plans (which include most defined contribution plans other than money purchase plans) are generally exempt from the QJSA and QPSA requirements if -- The participant does not elect a life annuity; and Any balance that is not paid before the participant s death is payable to his or her surviving spouse. Revenue Ruling clarifies that if a profit-sharing plan is otherwise exempt from the QJSA and QPSA requirements, offering an annuity option will not cause the plan to be subject to the QJSA and QPSA requirements--except to the extent that a participant irrevocably elects to receive an annuity. If a participant elects to receive an annuity, the QJSA and QPSA requirements will apply only for that participant. For example: Suppose that a profit-sharing plan allows participants to invest all or part of their account balances in an annuity contract, and participants who invest in the contract are allowed to exchange out of the contract at any time. If a participant dies before payments start, his or her account balance (including the amount invested in the annuity contract) is payable to his or her surviving spouse. Under these facts, the QJSA requirement will apply only to amounts that a participant elects to receive as an annuity; and the QPSA requirement will not apply unless the participant dies after electing the annuity and before the payment start date. In contrast, if (a) participants are not allowed to exchange out of the annuity contract and (b) amounts invested in the contract must be paid in an annuity, the QJSA and QPSA requirements will apply to all amounts invested in the annuity contract. This new guidance is effective immediately. ROLLOVERS TO DEFINED BENEFIT PLANS Defined benefit plans typically pay annuities at a lower cost than an insurance company. If an employer maintains both a defined contribution plan and a defined benefit plan, participants in the defined contribution plan can get favorable annuities by rolling over their balances to the defined benefit plan. Revenue Ruling sets forth the following technical requirements for defined benefit plans that accept rollovers: The assumptions used to convert the amount rolled over to an annuity must be at least as favorable to the participant as the assumptions prescribed by Section 417(e) of the Internal Revenue Code (i.e., the assumptions required for calculating lump sums). 2

3 If the assumptions are more favorable than the Section 417(e) assumptions, the added value will be treated as a new accrual under the defined benefit plan that is subject to the limit on benefits under Section 415 of the Internal Revenue Code. Also, the guidance states that if the assumptions are not reasonable, the added value will be subject to nondiscrimination testing. If payment of the amount rolled over does not start immediately, the plan must add interest to the amount rolled over at 120% of the federal mid-term rate; and the annuity that the participant eventually receives must include the value of the interest. The guidance also suggests that special death benefits must be provided. The new requirements could affect many floor-offset arrangements and other defined benefit plans that already accept rollovers. Employers should review their plans carefully to assess the impact of the new requirements. The new requirements are effective for rollovers on and after January 1, SPLIT PAYMENT OPTIONS Treasury and the IRS believe that more participants would elect annuities if they could receive part of their benefits in a lump sum. A split payment option (part lump sum and part annuity) would offer the advantages of a lump sum (e.g., an opportunity to invest a large amount of money and benefit from investment gains), with the safety net of an annuity in case the participant outlives his or her savings. In the preamble to a new proposed regulation, Treasury and the IRS identify what they believe to be a hindrance to offering split payment options: if a defined benefit plan offers a split payment option, the Section 417(e) actuarial assumptions that apply for calculating lump sums (or more favorable assumptions) must be used to calculate both the lump sum and the residual annuity benefit. The discussion implies that this view might extend to benefits that consist of multiple parts, where only one part is payable in a lump sum. Sponsors of defined benefit plans under which part of the benefit may be paid in a lump sum and the rest in an annuity should consider the implications of the views expressed in the preamble. The proposed regulation sets forth a more simple rule: if a defined benefit plan offers a split payment option, the Section 417(e) assumptions will apply only to the part of the benefit that is paid in a lump sum. For most cash balance and pension equity plans, the lump sum can be equal to the account balance; this means that the Section 417(e) assumptions generally will not be required for split benefits paid from those plans. The proposal contemplates three approaches for calculating split benefits: Separate Benefits ( A+B ). If a participant s benefit consists of two (or more) parts (Part A + Part B), and the lumpsum option is available for only part of the participant s benefit, the lump sum and non-lump sum parts can be calculated separately. For example, suppose that a participant s benefit consists of a precash balance benefit and a cash balance benefit, and the lump-sum option is available only for the cash balance benefit. In this scenario, the lump sum can generally be equal to the cash balance, and the annuity part can be calculated separately using the plan s assumptions. Proportionate Approach. If a participant may elect to receive part of a benefit in a lump sum and the rest in an annuity, the benefit must be calculated as follows: 3

4 First, calculate the amount that would be paid if the entire benefit were paid in a lump sum, using Section 417(e) assumptions. For a cash balance or pension equity plan, the lump sum will generally be equal to the account balance. Multiply that amount by the percentage that the participant elected to receive in a lump sum. For example, if the actuarial present value of the participant s benefit is $100,000 and the participant elects to receive 25% of his or her benefit in a lump sum, the amount of the lump-sum payment is $25,000. Next, calculate the amount that would be payable if the entire benefit were paid in the annuity form that the participant elects, using the plan s assumptions. Multiply that amount by the percentage that the participant elected to receive in the annuity form. Dollar Amount. A plan may allow participants to elect to receive a specified dollar amount in a lump sum. The proportioning principles described above would apply for calculating the part of the benefit that is not paid in a lump sum. Plan sponsors may not rely on the proposed regulation until it is finalized. As proposed, the final regulation will apply prospectively only. Also, the proposed regulation states that if a plan already has a split payment option, any change to follow the new rules will be subject to the anti-cutback rule. DEFERRED ANNUITIES Another way to combine the advantages of a lump sum with the safety net of an annuity is to allow participants to set aside part of their retirement savings in a deferred annuity. Under this approach, participants can manage their savings for a fixed period-- e.g., until age 80 or 85--and then receive an annuity. Existing minimum required distribution rules restrict deferred annuities. In some circumstances, the minimum required distribution rules can force participants to receive the amount set aside before they reach the designated age--draining their safety net. A new proposed regulation addresses this concern by introducing a qualified longevity annuity contract ( QLAC ) for defined contribution plans. If a participant sets aside part of his or her account balance to buy a QLAC, the amount set aside will not be taken into account for purposes of calculating the participant s minimum required distributions. The proposed rule applies only for defined contribution plans. To qualify as a QLAC, the following conditions must be satisfied: The amount that a participant sets aside for the QLAC may not exceed the lesser of $100,000 (indexed) or 25% of the participant s account balance. The $100,000 limit is cumulative: amounts set aside for a QLAC under another plan count toward the $100,000 limit. Administrators may rely on the participant s representation regarding the amount set aside in another plan. Annuity payments must start by age 85 (indexed as mortality changes). The contract must not make available a commutation benefit, cash surrender right, or similar feature. Payments after the participant s death must not exceed a specified amount. This condition is based on existing incidental death benefit rules (but the details are not the same as under existing rules). 4

5 Companies that issue QLACs must satisfy certain disclosure and reporting requirements. The proposed regulation does not address how to apply ERISA s spousal protections to QLACs. For example, if a participant dies after purchasing a QLAC and before QLAC payments start, it is not clear whether the amount invested in the QLAC must be paid to the participant s surviving spouse, or whether all or part of the purchase price can be forfeited. The proposed regulation will be effective prospectively, after it is finalized. Plan sponsors may not rely on the proposed regulation before it is finalized. MEMBERS OF COVINGTON S EMPLOYEE BENEFITS & EXECUTIVE COMPENSATION GROUP John Vine jvine@cov.com Mary DeYoung mdeyoung@cov.com Scott Macey smacey@cov.com William Woolston wwoolston@cov.com Amy Moore anmoore@cov.com Kathryn Johnson kjohnson@cov.com Richard Shea rshea@cov.com Jenna Wallace jwallace@cov.com Julie Edmond jedmond@cov.com Mike Chittenden mchittenden@cov.com Michael Francese mfrancese@cov.com Christen Sewell csewell@cov.com Robert Newman rnewman@cov.com Megan Doyle mdoyle@cov.com Seth Safra ssafra@cov.com Spencer Walters swalters@cov.com Kendra Roberson kroberson@cov.com Grace Ristuccia* gristuccia@cov.com Katherine Mineka kmineka@cov.com Kathryn Capone kcapone@cov.com * Admitted in VA, but not in DC; supervised by principals of the firm. Not a lawyer; Senior Benefits Advisor The lawyers in Covington & Burling LLP s Employee Benefits & Executive Compensation Group play a leading role in advising and representing employers on employee benefits and executive compensation matters. We frequently appear before Congress, federal agencies, and federal courts to resolve major issues of law, policy, and finance. Our employee benefits practice covers all types of benefit arrangements, including retirement plans, welfare plans, fringe benefits, equity and incentive compensation, and programs for executives and directors Covington & Burling LLP. All rights reserved. 5