Remember the Nuances of Determining Lump Sum Benefits

Sometimes when one walks through the woods, they can be quite thick. In fact, one can get lost in them if one is not careful. In an Oct. 21 session at the ASPPA Annual Conference, James E. Holland, Chief Research Actuary for Cheiron and former manager of the Employee Plans Division of the IRS Tax-Exempt and Government Entities Office, discussed the trees in the thick forest of rules concerning defined benefit lump sum issues.

Central to this effort are the following sections of the federal Internal Revenue Code:

• 401(a)(4)

• 401(a)(9)

• 411(a)(13)

• 415(b)

• 417(a)

• 417(e)(3)

• 436

“In the defined benefit context, any one of these things will affect you. A well-designed plan will address all of these,” said Holland. He noted that there is no particular requirement that is pre-eminent; the interaction of the requirements, however, is key.

There are complications concerning the application of these provisions, according to Holland. Among them:

• The Section 401(a)(9) rule under which an annuity commences, but the participant wants to change to a lump sum upon retirement. “They [the IRS] know unmistakably that we as a group are concerned about this issue,” Holland said, he but was not hopeful regarding the prospects for that being addressed, adding, “I don’t think it any intent to change that.”

• The rule under Section 411(a)(13), which was added by the Pension Protection Act of 2006 (PPA), that requires that optional forms of benefit be the actuarial equivalent (using reasonable assumptions) of the hypothetical account or accumulated percentage of pay. “Of course, ‘reasonable assumptions’ are not defined,” Holland noted.

• The rules under Section 417(e)(3), which predate the PPA and have not been undated for purposes of Section 411(a)(10); regarding these, Holland says the IRS is “going to have to update the figures and levels on which determinations are made.”

Testing under Section 415 can be problematic. Holland said; “the trick is to design the plan to watch out” for exceeding what it permits. “Beware,” he warned, “if you are helping write the plan document, you need to get it right.” He further cautioned, “Remember, lawsuits can arise over the application of Section 415. Ask yourself, ‘Could this have been avoided without proper communication?’” A final note of caution: “Lawsuits tend to be expensive,” he warned.

Also be careful regarding hybrid design, Holland said. “You can’t just pick an interest rate,” Holland noted. “My working hypothesis is always if I can think of a crazy situation in which facts won’t work, the world out there will come up with something even crazier. Be careful of what is going into plan design — it’s the law of unintended consequences,” he suggested.

Holland zeroed in on two matters in addressing communication as it applies to handling lump sums: the definition of qualified joint survivor annuity (QJSA), and underfunding:

QJSA

• Consider what the eventual goal is.

• If the objective is to pay out a lump sum, why bother to provide a QJSA?

• At the design stage, think about what the goal is.

Underfunding

• Talk to the plan sponsor first.

• You’re doing the calculation, but you may not be the person communicating with the plan sponsor.

• Communications in this case can be “almost a bottomless pit.” Ask yourself where the communication is going to be, and who is going to communicate with whom.

Professionals Matter

Remember your central role and its importance, Holland said. “Folks like you who take the time to understand the rules sometimes don’t get the credit that you should,” he observed.