Since the issuance of the final regulations under § 417(e)(3) of the Internal Revenue Code in 1988, practitioners have been critical of the interpretation taken by the IRS in situations where a benefit was being paid partly in single-sum and partly in an annuity form. The IRS has regarded that situation (and similar situations) as one optional form that is subject to the rules of § 417(e)(3). On Sept. 9, 2016, the IRS officially modified its view, and issued revisions to the regulations. This article describes the modification.
Background
Section 417(e)(3) of the Code and § 1.417(e)-1(d) of the regulations require the use of the “applicable interest rate” and the “applicable mortality table” to determine the amount of single-sum distributions and the amount payable in other forms of benefit subject to that section. In general, these rules require that:
• “A defined benefit plan must provide that the present value of any accrued benefit and the amount (subject to sections 411(c)(3) and 415) of any distribution, including a single sum, must not be less than the amount calculated using the applicable interest rate… and the applicable mortality table…” (§ 1.417(e)-1(d)(1), first sentence; emphasis added)
• “The present value of any optional form of benefit cannot be less than the present value of the normal retirement benefit determined in accordance with the preceding sentence.” (§ 1.417(e)-1(d)(1), second sentence, emphasis added)
Section 1.417(e)-1(d)(6) of the regulations defines forms that are not subject to the requirements of § 1.417(e)-1(d). The requirements do not apply to “the amount of a distribution paid in the form of an annual benefit that:
• Does not decrease during the life of the participant, or, in the case of a QPSA, the life of the participant’s spouse; or
• Decreases during the life of the participant merely because of: (a) the death of the survivor annuitant (but only if the reduction is to a level not below 50% of the annual benefit payable before the death of the survivor annuitant); or (b) the cessation or reduction of Social Security supplements or qualified disability benefit …”
Under the above sections, the IRS has viewed the payment of a benefit partly in the form of a single sum and partly in another form (say a QJSA) as one form that is not exempt from the requirements. The consequences of this interpretation are best seen by an example.
Example
Assume a calendar year plan has a normal retirement age of 65. A participant has a single life annuity benefit (normal form) of $10,000 a month at age 65, and a spouse who is age 62. The plan provides a QJSA with 100% provided to the surviving spouse, and that the QJSA is the actuarial equivalent using 5% interest and the current applicable mortality table under § 417(e). Further, assume that the plan specifies the segment interest rates from the November prior to the beginning of the plan year as the applicable interest rate (which are 1.76%, 4.15%, and 5.13%, respectively for 2016; that is the November 2015 rates). (These are the segment interest rates used in the examples in the regulations.) If the participant wanted to take a single sum based upon $2,500 and the remainder as a $7,500 QJSA, the plan could not simply provide the present value of $2,500 using the § 417(e)(3) rates, and then apply the applicable mortality table and 5% to determine the QJSA. Instead, the amount payable as a QJSA would have to be determined, at a minimum, using the applicable interest rate and the applicable mortality table. The comparison is seen in the following table:
Benefit Amount per IRS View Amount Plan Preferred to Pay
$2,500 payable $393,252 $393,252
as single sum
$7,500 payable $6,273 $6,251
as QJSA
The plan would have preferred to pay out $6,251 as a monthly QJSA but the regulations required that $6,273 be paid ($22 more). Now some would say that is small, but now consider what the result is if the plan used a different mortality table. Using the mortality table from Revenue Ruling 2001-62 results in a preferred QJSA benefit of $6,161, and the “extra” required to satisfy the § 417(e)(3) regulations is $112.
While critics of the regulations understood the need to prevent obvious abuses (consider 99% of the benefit paid as a single sum and 1% an annuity), the inability to separately treat benefits accrued under prior formulas made it difficult to merge in plans, change equivalency definitions, or grandfather benefits upon changing a formula.
The IRS recognized the issues and about 10 years ago indicated that consideration was being given to revising the regulations. In fact, to close observers, the modification has been expected since the issuance of the current regulations under § 415(b) in 2007. Those regulations clarified that where benefits are paid partially in the form of a QJSA and partially in some other form, the exclusion of the survivor portion of the QJSA applies even though another portion of the benefit is paid in another form. Now the § 417(e)(3) regulations have been revised as well. (In a little fairness to the IRS, we should note that the issuance of Pension Protection Act of 2006 regulations and related guidance took some priority over the past 10 years.)
Revised Regulations
Desiring to do more to promote annuities, the IRS amended the regulations to permit the bifurcation of benefits. A new § 1.417(e)-1(d)(7) has been added, which expressly allows a plan to provide for the bifurcation of benefits. There are two methods and some operational rules (and seven examples).
Explicit Bifurcation
The first method is an explicit plan-specified bifurcation (see § 1.417(e)-1(d)(7)(ii)(A) of the regulations) (referred to below as “explicit bifurcation”). Under explicit bifurcation, a plan can provide that the § 417(e)(3) regulations apply to a specified portion of a participant’s accrued benefit “as if that portion were the participant’s entire accrued benefit.” Using the above example, the plan could specify that 25% of the accrued benefit ($2,500) could be paid as a single sum and treated separately. Thus, the plan can reach its desired result as illustrated in the table, which means the QJSA amount would be $6,251.
Aside from allowing a portion of the accrued benefit to be paid as a single sum and a portion as an annuity, explicit bifurcation can be used in other circumstances. This method allows a plan to treat benefits accrued before and after a specified date differently. The method facilitates the conversion to a cash balance plan, for example, or the change in benefit formulas.
A key requirement is that the plan needs to provide for the separate treatment. Apparently, the plan can provide that the percentage paid as a single sum is chosen by the participant. See Example 1 in § 1.417(e)-1(d)(7)(v). However, it is not necessary that a plan specify a percentage, but the portion of the benefit. For example, upon conversion to a cash balance formula, the plan can specify that the cash balance portion be distributed in a single sum and the prior accrued benefit as an annuity. See Example 4 in § 1.417(e)-1(d)(7)(v). Also, a plan can specify that the accrued benefit as of a certain date is payable as a single sum and the remainder as an annuity, which is considered a specified portion of the benefit. See Example 7 in § 1.417(e)-1(d)(7)(v).
Distribution of a Specified Amount
The second method applies if the plan provides for the distribution of a single sum payment that is not based upon a specified portion of the accrued benefit as defined in explicit bifurcation. In that case, the portion of the accrued benefit that is not settled by the single sum distribution (that is, the remaining portion of the accrued benefit) must not be less than the excess of the total accrued benefit expressed in the normal form commencing at normal retirement age (or current age, if later) over the annuity payable in the normal form that is actuarially equivalent to the single-sum payment using the applicable interest rate and the applicable mortality table. The second method is much like the method under the regulations prior to revision. However, once the remaining normal retirement benefit is determined, that annuity can be paid in any optional annuity form under the plan using plan assumptions.
One application of the second method is to the payment of a single sum equal to employee contributions plus interest, which is not a specified portion of the accrued benefit. See Example 2 in § 1.417(e)-1(d)(7)(v). Another application is if the plan specifies an amount such as $10,000 payable as a single sum. See Example 6 in § 1.417(e)-1(d)(7)(v).
Operational Rules
The revised regulations provide for certain rules of operation. One of these rules allows repeated application to a bifurcated benefit, so that the bifurcation can again be applied to bifurcate the remaining accrued benefit. As illustrated in Example 5 (which is a variation on Example 4) in § 1.417(e)-1(d)(7)(v), a plan can permit a participant to elect a percentage of the cash balance account as the single sum payment, while requiring that the prior accrued benefit be paid as an annuity.
The operational rules require the use of explicit bifurcation in certain instances. If a plan is going to protect payment of a portion of the accrued benefit in an optional form subject to the § 417(e)(3) rules so as to meet the anti-cutback rule of § 411(d)(6), then the plan must use explicit bifurcation and specify the portion of the accrued benefit. See § 1.417(e)-1(d)(7)(iv)(C)(1).
An Unexpected Result
If a plan provides that a single-sum distribution is available to settle a participant’s entire accrued benefit, then in order to provide for a distribution of a single sum payment that settles a portion of the accrued benefit, the plan must use explicit bifurcation. See § 1.417(e)-1(d)(7)(iv)(C)(2). This seemingly straightforward statement is anything but clear when you look at Example 3 in § 1.417(e)-1(d)(7)(v). Example 3 illustrates a plan that provides for the payment of a single sum that is the present value of the early retirement benefit (but not less than the present value of the accrued benefit payable at normal retirement age).
Example 3 follows Example 2 and assumes a single sum equal to the employee contributions plus interest. Do not ignore this example on the idea that most private sector plans do not provide for employee contributions. Substitute a set amount such as $32,000 (the amount in the example) if you need to. The amount of the accrued benefit that is settled is the portion equal to the single sum payment (the $32,000 paid) divided by the present value of the early retirement benefit (which is $197,532 based upon an early retirement benefit at age 60 that has a 25% reduction from age 65). So, the remaining benefit is based upon the remaining amount of the single sum of the entire early retirement benefit that could have been paid. You do not get this understanding from simply reading the explicit bifurcation method.
Note that in Example 2 the payment of the amount of employee contributions plus interest was not considered a specified portion of the accrued benefit, and the second method has to be used. However, the additional fact of the availability of the payment of the entire accrued benefit payable as a single sum requires different treatment, the use of the explicit method, and the determination of the pro-rata portion of the benefit compared to the single-sum value of the entire early retirement benefit.
Section 411(d)(6) Relief
The revised regulation applies to distributions with annuity starting dates in plan years beginning on or after Jan. 1, 2017; however, taxpayers may elect to apply the new rules to earlier periods. Because the new rule can reduce the amount of the residual benefit (using the table above as an example, from $6,273 to $6,251) the revised regulation provides limited relief from the anti-cutback rule of section 411(d)(6). If the revised rules are applied for a plan year beginning before Jan. 1, 2017, then there will not be a violation of § 411(d)(6) merely because the plan is amended on or before Dec. 31, 2017, to provide that the rules of the revised regulation are applied to distributions with annuity starting dates on or after the later of the adoption date or effective date of the amendment. (This is the definition in § 1.411(d)-3(g)(4) of the applicable amendment date, which is the reference in the actual regulation.) This appears to mean that a plan has until the end of 2017 to make amendments to use the revised rules for existing accrued benefits without any § 411(d)(6) issues.
What the final regulations do not provide is a model amendment or a recognition that a plan will not be able to get a determination letter for the amendment to reflect the new regulations. Also, most pre-approved plans have been submitted for the next cycle of opinion letter and do not have provisions reflecting the revised regulations. Even if plan sponsors can add language to the pre-approved plans now, it will likely be after 2017 that employers will adopt the latest pre-approved plans. This would seem to be after the Dec. 31, 2017, deadline for § 411(d)(6) relief. Perhaps the IRS will address this in subsequent guidance.
Conclusion
The changes to the § 417(e)(3) regulations are a welcome modification that makes intuitive sense to plan sponsors and practitioners. However, it appears that adopters of pre-approved plans may not be able to take full advantage of the new rules without further guidance.
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