IRS Shuts Down Pension Plan De-Risking Technique of Offering Lump Sums to Retirees in Pay Status

6 min

In an unexpected development, the Internal Revenue Service (IRS) recently issued Notice 2015-49, which essentially prohibits qualified defined benefit pension plans from offering retirees who are in pay status an option to convert their annuities into immediate lump sums. The notice refers to these offers as "lump sum risk-transferring programs."

Over the past few years, many plan sponsors have made or considered these types of offers as one technique for "de-risking" their qualified pension plans. A lump sum distribution in this context effectively transfers the longevity risk and investment risk from the pension plan to the retirees. In addition, the retirees are no longer considered to be participants in the plan for ERISA purposes, and the plan sponsor no longer needs to pay Pension Benefit Guaranty Corporation (PBGC) premiums with respect to those retirees.

Notice 2015-49

The notice announces that the IRS intends to amend the required minimum distribution regulations under section 401(a)(9) of the Internal Revenue Code of 1986, as amended (the Code), to provide that qualified defined benefit pension plans generally are no longer permitted to replace any joint and survivor, single life, or other annuity currently being paid with a lump sum payment or other accelerated form of distribution. The IRS indicated that it intends that the future amendments will apply retroactively as of July 9, 2015, the date the notice was issued, except with respect to certain accelerations that were already in process before that date (discussed further below).

The required minimum distribution rules under Code section 401(a)(9) generally provide that a participant's benefits under a qualified retirement plan must begin to be distributed no later than the participant's required beginning date, which is generally defined as April 1 of the calendar year following the later of: (i) the calendar year in which the employee attains age 70-1/2, or (ii) the calendar year in which the participant retires (subject to a special rule for owners of more than 5% of the plan sponsor).

The required minimum distribution rules also require that any distributions other than lump sums commencing on a participant's required beginning date must be paid in the form of periodic annuity payments for the participant's life (or the joint lives of the participant and his or her beneficiary) or over a period certain that is no longer than a period permitted under the applicable regulations. The required minimum distribution rules generally prohibit any changes in the period or form of the distribution after it has commenced, except in a narrow set of circumstances specified in the regulations, such as in the case of retirement (i.e., for participants who commenced benefits while still employed), death, or plan termination.

The current regulations also permit increases in annuity payments, to pay increased benefits that result from a plan amendment. The IRS issued at least 10 private letter rulings in 2012 and 2014 that interpreted this exception to apply to plan amendments that were adopted to implement lump sum risk-transferring programs. Private letter rulings cannot be relied upon or cited as authority by taxpayers other than the taxpayers to whom the rulings were issued.

In direct contrast to these private letter rulings, Notice 2015-49 explains that the IRS intends to propose amendments to the required minimum distribution regulations to provide that the types of permitted benefit increases allowed under the "plan amendment" exception would include only those that increase the ongoing annuity payments, and do not include those that accelerate the annuity payments themselves – that is, annuities can no longer be converted to lump sums under the plan amendment exception.

Effective Date

The IRS intends that the new regulations will apply as of July 9, 2015 (the date the notice was issued). However, the notice provides further that the changes are not expected to apply to lump sum risk-transferring programs that fall within one of the following four categories (referred to hereinafter as "Pre-Notice Accelerations"):

  1. a program adopted (or specifically authorized by a board, committee, or similar body with authority to amend the plan) prior to July 9, 2015;
  2. a program with respect to which a private letter ruling or determination letter was issued by the IRS prior to July 9, 2015;
  3. a program with respect to which a written communication to affected plan participants stating an explicit and definite intent to implement the lump sum risk-transferring program was received by those participants prior to July 9, 2015; or
  4. a program adopted pursuant to an agreement between the plan sponsor and an employee representative (with which the plan sponsor has entered into a collective bargaining agreement) specifically authorizing implementation of such a program that was entered into and was binding prior to July 9, 2015.

Implications for Plan Sponsors

If you have been considering or are in the process of implementing a lump sum risk-transferring program, you should consider the extent to which, if any, you may fall within one of the four categories of Pre-Notice Accelerations. If you find that you do, you may be able to continue to pursue or implement the lump sum risk-transferring program.

If not, you should consider the extent to which you may be able to continue to offer a similar type of lump sum program. For example, it appears that plan sponsors should still be able to offer lump sums to certain participants who are not currently in pay status (e.g., participants who have terminated employment with vested benefits, but who have not commenced distributions). In addition, the notice is not clear on whether the new regulations would apply only to retirees who have reached their required beginning date (i.e., generally the later of age 70-1/2 or retirement) or whether the new regulations would apply to all participants in pay status (i.e., even those who have not reached their required beginning date). The notice is also not clear on whether lump sums can continue to be offered to any retirees in pay status in connection with the formal termination of a plan, which is another exception under the current Code section 401(a)(9) regulations in addition to the plan amendment exception.

There are also other de-risking techniques that defined benefit pension plan sponsors may want to consider (and that were not addressed in the notice), including, but not limited to:

  • Liability-Driven Investing – aligning a plan's investments with the duration of its liabilities;
  • Freezing the plan with respect to eligibility or future benefit accruals;
  • Formally terminating the entire plan or only a portion of the plan (e.g., a spin-off termination); and
  • An annuity buy-out or buy-in – purchasing annuities from an insurance company to provide all or a portion of the accrued benefits under the plan.

The members of Venable's Employee Benefits and Executive Compensation group routinely advise clients on qualified retirement plan matters, including de-risking strategies, and would be happy to discuss any questions or concerns relating to your plan.