Special Report: New Guidance On Retirement Plan Lifetime Income Options

Executive Summary

The Treasury Department released guidance last week to encourage the use of annuity options in defined contribution and other retirement plans. This guidance is intended to encourage the availability of lifetime retirement income for participants in these plans. Although the guidance removes certain regulatory barriers and clarifies uncertainties in the law, it fails to address certain important legal and administrative issues that need to be considered before implementing these options.

New Guidance on Retirement Plan Lifetime Income Options Answers Some Questions, But Still Leaves Many Others Open

On February 2, 2012, the Internal Revenue Service ("IRS") and U.S. Department of Treasury ("Treasury Department") announced a much-anticipated guidance package intended to encourage the use of full and partial lifetime annuity options in defined benefit and defined contribution retirement plans. The package comes in the form of two proposed IRS regulations, which were published in the Federal Register on February 3, and two revenue rulings, which are set to be published in the Internal Revenue Bulletin on February 21. The guidance is the first step in a joint initiative between the Treasury Department and the U.S. Department of Labor ("DOL") to help increase savings and retirement income and to provide incentives for retirees to move away from the current trend of taking lump-sum retirement plan distributions instead of annuity distributions. The Treasury Department also issued a Fact Sheet that, among other things, describes how the current trend has resulted in the increased risk of Americans outliving their assets in retirement.

The new guidance removes certain regulatory impediments to offering lifetime annuity options and is intended to give retirement plan sponsors and fiduciaries greater certainty in administering their plans, as further explained below. At the same time, however, there are a number of issues that were not addressed by the guidance and need to be considered before plan sponsors take advantage of these new options.

Offering Partial Annuities in Defined Benefit Plans

One of the stated goals of the guidance is to make it easier for defined benefit retirement plans to offer combined retirement options, such as the option for plan participants to receive a portion of their benefits in the form of a lifetime stream of payments and the remaining portion in the form of a lump-sum cash payment. To encourage this option, the proposed IRS regulations would make it easier for defined benefit pension plans to calculate the value of a partial annuity form of benefit when it is offered in conjunction with a lump-sum benefit.

Current Regulatory Requirements. By way of background, Section 417(e) of the Internal Revenue Code ("Code") and the regulations thereunder generally mandate the method that tax-qualified defined benefit plans must use to calculate the present value of all optional forms of benefit. The present value of an accrued benefit and the amount of certain optional forms of benefit, including lump-sums, must not be less than the amount calculated using specified interest rates and mortality assumptions (this is commonly referred to as the "minimum present value requirement"). However, there is an exception in the regulations for annuity forms of payment – the value of different annuity options under a plan may be calculated by converting one type of annuity into another using the plan's regular conversion factors, rather than the more complicated minimum present value factors. Under current regulations, a defined benefit plan that offers a combined retirement option (i.e., a partial annuity and lump-sum option) is required to use the more complicated minimum present value factors for valuing the lump-sum portion and the partial annuity portion of the benefit.

New Proposed Regulations. The new proposed Section 417(e) regulations would provide an exception to the minimum present value requirement and allow plans offering a combined retirement option to use the simpler conversion factors for valuing the annuity portion of a benefit. Although the lump-sum portion of the benefit must still be calculated using the minimum present value factors, the Treasury Department hopes that by easing the burden of calculating combined retirement options, more plans will offer these options.

The new proposed Section 417(e) regulations would apply to distributions with annuity starting dates in plan years beginning after the publication date of final regulations. It is important to note that these proposed regulations would apply only to those defined benefit plans that choose to allow for bifurcated distribution options. Plans that previously provided partial lump-sum distribution options would be required to comply with the Code's anti-cutback provisions if they are amended to take advantage of the simplified conversion provisions in the regulation. Taxpayers wishing to comment on these proposed regulations have until May 3, 2012 to submit comments.

Offering Longevity Annuities in Defined Contribution Plans

Another stated Treasury Department goal is to address the concern for retirees outliving their retirement savings. To respond to this risk, the IRS issued proposed regulations that facilitate the use of qualified longevity annuity contracts ("QLACs") in certain types of defined contribution plans (described below) by modifying the current required minimum distribution ("RMD") rules under Code Section 401(a)(9). The theory underlying QLACs is to provide...