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Lifetime Income Options For 401(k) Plans New Treasury Regulations Open the Door for Plan Sponsors

By: Sam Henson, J.D.

A guaranteed source of lifetime income has long been the selling point for defined benefit plans. To provide that guarantee, defined benefit plan sponsors may use a variety of products and investment strategies, including insured annuity products designed to protect against the volatility of the market and address increased longevity. As employers move away from defined benefit plans in favor of the significant savings associated with defined contribution retirement plans, participants lose the guarantee of a lifetime benefit. After the economic downturn of 2008 struck a blow to the account balances of participants approaching retirement age, many are facing the stark reality of outliving their account balance. Participants want the certainty of knowing what stream of income they will have in retirement, and that it will last.

If certainty is what defined contribution participants

want, then why not offer lifetime income?

The government also asked that very question two years ago. The Department of the Treasury, the Internal Revenue Service (IRS) and the Department of Labor (DoL) issued a “Request for Information” on a variety of issues focused on increasing the use of lifetime income options in defined contribution plans. After reviewing nearly 800 comments from across the retirement industry, the government has taken action. The President’s Council on Economic Advisors’ recent report, “Supporting Retirement for American Families,” highlighted the risks facing workers from increased reliance on defined contribution plans and longer life expectancies and the role new guidance may play in dealing with such risks. Along with regulatory reforms, defined contribution plan sponsors now have initial guidance on how to offer lifetime income options in their plans.

Second Quarter 2012 • The Key

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Treasury Releases Three Pieces of Lifetime Income Guidance for 401(k) Plans

1. Outline of Deferred Annuity Options in a 401(k)

In Revenue Ruling 2012-3, the IRS outlines the rules in which a 401(k) plan can offer a deferred annuity contract as an investment option. Participants may purchase a deferred annuity contract payable at the later of the date the participant retires or reaches 65. The rule also clarified that amounts may be transferred to other investments at any time. Participants have the option of selecting various life annuity forms or a lump sum cash payment at retirement. The automatic form of income is a straight life annuity for single participants and a 50 percent joint and survivor annuity for married participants. For any option other than 50 to 100 percent joint and survivor annuity, spousal consent is still required. If the participant dies before the annuity beginning date, a death benefit is payable to the surviving spouse or beneficiary. A plan can also offer a fixed deferred annuity contract. Under this option, a participant may not transfer amounts out of the contract to a different investment and a lump sum cash payment is not available.

2. Outline for Partially Annuitizing Defined Contribution Accounts Through a Defined Benefit Plan

In Revenue Ruling 2012-4, the IRS sets a general framework to allow a rollover from a defined contribution plan into a defined benefit plan to be converted into annuity payments. The new guidance now gives plan sponsors of both a defined contribution plan and a defined benefit plan a way to provide annuity benefits at a significant cost savings without increasing the complexity of the defined contribution plan.

The Revenue Ruling views a rollover from the defined contribution plan as a “mandatory employee contribution” to the defined benefit plan. The rollover amount is then subject to the vesting, qualified joint and survivor annuity, qualified preretirement survivor annuity and benefit limit rules required by mandatory employee contributions. Plan sponsors may incorporate this ruling into their administration immediately. To take advantage of the new guidance, an employer would need to cover the same participants in both plans. The defined contribution plan would allow an employee who terminates after age 55 and has 10 years of service to roll his defined contribution balance into the defined benefit plan, thereby allowing him to annuitize his benefit under both plans. If the defined benefit plan terminates, the additional benefit being purchased will be subject to the Pension Benefit Guaranty Corporation (PBGC) termination insurance program, including limits on guaranteed benefits.

The big focus in defined benefit plans has been to insulate the plan sponsor against asset volatility and longevity risk by implementing derisking strategies that cash out inactive participants and emphasize liability driven investments. The ability to make use of this rule and its annuity strategy is not likely to reach the level of popularity as derisking, but it should be discussed with sponsors.

3. Using Longevity Annuities

A longevity annuity is simply an insurance product that provides a guaranteed source of income starting at an advanced age (80 or older). Unlike traditional deferred annuity products, with longevity products, you cannot realize a benefit prior to attaining the specified age. The point of these products is to provide protection

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Lifetime Income Options for 401(k) Plans (continued)

against outliving your defined contribution plan assets. The reason that most plans have not made use of these products is because the current regulatory framework restricts their usefulness. The Minimum Required Distribution (MRD) rules required defined contribution participants to begin taking a distribution from their plan when they reach 70 ½. The MRD rules also required the distribution amount to be calculated by dividing the existing account balance by the life expectancy of the individual. Under the current rule, the value of a longevity annuity would have to be included in the calculation resulting in a MRD from a contract that does not allow a distribution. The failure to properly include the longevity annuity in the calculation could result in a 50 percent excise tax on participants for underreported amounts, reporting penalties to the employer and potential plan disqualification.

To address this regulatory hurdle, the IRS has proposed a regulatory amendment that provides limited relief from the MRD requirements. Before annuitization, the value of a longevity annuity contract can now be excluded from the account balance used for the MRD, so long as the contract meets the “qualifying longevity annuity contract” (QLAC) rules. To be a QLAC, the annuity premium cannot cost more than 25 percent of the account balance or $100,000, whichever is less, and the payout begins by age 85. To lessen the cost of the QLAC, it could be offered with a fixed annuity, starting at an advanced age with no acceleration of commencement. Most importantly, the value of the QLAC would not be taken into account for MRD calculation purposes. The regulation is only in the proposed stage at this time. It will apply to MRDs beginning on or after January 1, 2013. The next steps in the process are public comments ending in May, hearings in June and finalization of the rule by the end of the year.

Looking Ahead

The new IRS regulations provide only the first of many steps that will need to occur in order to realize lifetime income options in defined contribution plans. These guidance steps remove some of the more obvious hurdles to the implementation of annuity options, and more is to come. The Department of Labor has indicated it will emphasize lifetime income goals by releasing rules requiring benefit statements to disclose the estimated amount of lifetime income that could be provided with the participant’s current account balance. By removing regulatory obstacles to longevity contracts, the government has shown its willingness to not only encourage lifetime income options for defined contribution plans, but to actually take action in assisting plan sponsors in the execution.

It remains to be seen whether these regulatory changes will result in a great deal of interest to 401(k) plans. Lifetime annuity products have been on the market for years, in addition hybrid annuity products providing both a guaranteed lifetime income stream and the ability to invest in the market are also starting to emerge. Lifetime income is not a cure-all, but plan sponsors should understand that participants have significant risk in outliving their plan accounts, and lifetime income options are worth considering as a viable component in plan design.

SAMUEL HENSON, J.D.Senior ERISA CounselLockton Retirement Services816.751.2245 | shenson@lockton.com