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Los Angeles Advanced Pension Conference 2016

Workshop 2

IRC Section 415 and Multiple Annuity Starting Dates

Richard A. Block, ASA, FSPA, MAAA

Block Consulting Actuaries, Inc.

Michael B. Preston, FSPA, MAAA

Preston Actuarial Services, Inc.

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Basic Assumptions

Unless otherwise noted:

Actuarial equivalency is the 1994GAR Unisex projected to 2002 with a 5% interest rate. No pre-retirement mortality.

§417(e) Segment Rates are 1.76%/4.15%/5.13%

NRA is age 65

Plan Year/Limitation Year are the Calendar Year

All calculations are for the 2016 Limitation Year

No forfeiture on death. Normal form is life annuity.

Individuals in the examples have 10 years of service and participation in the plan and average compensation is enough to justify the maximum benefit

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§415 Limits• Defined Benefit Pension Plans must limit payouts to

the lesser of:

– An age adjusted annual dollar amount that is increased

for the Cost of Living (2016 limit is $210,000)

• Phased in over 10 years of participation

– 100% of a participant’s average of the three highest

consecutive years

• Phased in over 10 years of service

• Limitations apply to life annuity or QJSA benefits

– Other forms of payment must be reduced actuarially

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§411(a) Issues

• 411(a) generally requires that the benefit payable in an optional form

be equivalent to the accrued benefit

• The regulations point out conflicts between §411(a) and §415

• Tom’s §415 average compensation is $120,000. He is at the plan’s

Normal Retirement Age with a $10,000 monthly benefit. If the plan

does not provide for suspension of benefits, then Tom must start

receiving benefits even if not retired.

• Since Tom’s benefit cannot be actuarially increased, if Tom does not

commence benefit payments, the value of his benefit declines and the

plan will violate §411

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Grandfathered Benefits

• Benefits as of the day before the first

limitation year beginning after June

30, 2007 are grandfathered provided:– The terms of the plan complied with prior

guidance and

– The terms of the plan were adopted and

in effect by April 4, 2007

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Grandfathered Benefits

As of 12/31/07, Norman is 65 years old and

his §415 average compensation is $400,000

without regard to the §401(a)(17) limits. His

annual accrued benefit is equal to $180,000. If

the §401(a)(17) limits were recognized, his

§415 average compensation would be

$150,000.

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Grandfathered Benefits

On 1/1/16, Norman’s actuarially adjusted benefit is

equal to: $180,000 x 12.2524 / 9.7333 x 1.05^8 =

$334,771. The benefit payable is $334,771.

Although the actuarially adjusted benefit exceeds his

high 3 year average when limited to the §401(a)(17)

limit, Norman’s 12/31/07 accrued benefit is

grandfathered including optional forms, early and late

retirement benefits

Note: actuarial factors are annual APRs because the plan

provides for annual payments

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§415 Payment Form

• §415 Limits are based on an annual benefit

payable monthly– Dollar limit actuarial adjustments under age 62

result in smaller benefits.

– Dollar limit actuarial adjustments over age 65

result in larger benefits until you hit the wall at

around age 68

– Lump Sums are less

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Maximum Lump Sums• For distributions after December 31, 2005 plan

lump sums are the greater of 1(a) or 1(b) but not

greater than (2) or (3).

• (1) the rates under the plan • 1(a) is the plan’s conversion rates

• 1(b) is the 417(e) conversion rates, if applicable

• (2) the conversion rate using 5½% & the

Applicable Mortality Table (AMT)

• (3) the rate that provides a benefit of 105% of

the value using the applicable interest rate &

mortality assumptions. If the employer would be

eligible to set up a SIMPLE, this limit does not

apply

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Maximum Lump SumsMike has accrued the maximum dollar benefit. He

is 65 years old at 1/1/16, the NRA under the plan.

His monthly accrued benefit is $17,500 payable

now and he wants to take a lump sum settlement.

Plan rates are 6%/6% 94GAR

(1) Plan Rate APR-130.39

(2) 5½% Life Annuity and applicable mortality

APR -140.03

(3) §417(e) Life Annuity Rate APR -157.30

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Maximum Lump Sums

Lump Sum is the lesser of {Greater of (1)(a) or (1)(b)}, (2) and (3):

(1) (a) $17,500 x 130.39 = $2,281,825(b) $17,500 x 157.30 =$2,752,750

(2) $17,500 x 140.03 = $2,450,525(3) $17,500 x 157.30 x 105% = $2,890,388

The plan may pay Mike a lump sum equal to $2,450,525.

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Maximum Lump Sums-Hybrid Plan

Annie’s account balance at 1/1/16 is $2,281,825.

Crediting rate is 6%. Actuarial equivalency is 6%/6%

94GAR. Annie’s accrued monthly benefit at 1/1/16,

her 65th birthday, is $17,500 payable now. Annie wants

a lump sum settlement.

Her lump sum is the lesser of (1a), (2) and (3):

(1a) $17,500 x 130.39 = $2,281,825

(2) $17,500 x 140.03 = $2,450,525

(3) $17,500 x 157.30 x 105% = $2,890,388

Annie’s lump sum is limited to $2,281,825

Hybrid plans are not subject to §417(e)(3), therefore in

this case, the maximum benefit is converted using a

6% interest rate

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Maximum Lump Sums

Kurt is age 46 with 4 years in the plan and 10 years of employment

Normal Form of Payment is a fully subsidized 100% Joint & Survivor Benefit. Actuarial equivalency is 5%/5% 94GAR. Lump sum is actuarial equivalent of normal form. Sponsor is eligible to set up a SIMPLE.

Accrued Monthly Benefit payable at age 46 is $1,774.55 §415 Dollar Limit at age 46 is $6,238.51 x 4/10 = $2,495.40

(1) Plan Rate APR Normal Form-213.17(2) §417(e) Rate APR Normal Form-226.85(3) 5½% APR Life Annuity Form- 189.41

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Maximum Lump Sums

Kurt’s Lump Sum is the lesser of {the greater

of (1a) or (1b)} and (2):

(1a) $1,774.55 x 213.17 = $378,281

(1b) $1,774.55 x 226.85 = $402,557

(2) $ 2,495.40 x 189.41 = $472,654

Kurt’s lump sum equals $402,557

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Annuity PaymentsBenefits to which §417(e)(3) does not apply

Optional form is the lesser of the benefit under the plan or the actuarial equivalent of §415 limit using 5% and applicable mortality

•Rick is age 75 and wants to retire with a 10 Certain & Life (C&L) benefit•Plan factor for 10 C&L benefit is 98% of the life annuity normal form•§415 Average Monthly Pay is $3,500.00•Rick’s accrued monthly benefit is $3,450.00

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Annuity PaymentsBenefits to which §417(e)(3) does not apply

• 10 C&L benefit $3,450.00 x .98 =$3,381.00

• 415 limitation for optional form.

– APRs using 5% & AMT• APR life annuity 106.18

• APR 10 C&L 120.06

– Maximum 10 C&L annuity benefit

$3,500.00 x 106.18/120.06 = $3,095.37

• Rick’s 10 C&L benefit is limited to $3,095.37

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Benefits Payable before Age 62Benefit commencing before age 62 is the age 62 §415

limitation reduced by the plan factors for early

retirement or the actuarial equivalent of the age 62

§415 limitation using 5% and the AMT whichever

produces the smaller benefit.

Art is 55 years old. The plan’s Normal Retirement Age

is 62. Benefits payable earlier than NRA are reduced

by .25% for each month earlier than NRA. Art’s

accrued benefit payable at NRA is $17,000 a month.

Art wants to retire. What is his monthly benefit?

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Benefits Payable before Age 62

Art’s benefit at age 55 is: $17,000 x (1-(.0025 x ((62-55)x12))) = $13,430

The §415 dollar monthly limit reduced from age 62 to age 55 is $17,500 x 156.87 / 179.40 x 1.05^-7 = $10,881.86

Art’s monthly benefit is limited to $10,881.86

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Benefits Payable before Age 62What if the plan’s NRA is age 65?

Art’s benefit at age 55 is: $17,000 x (1-(.0025 x ((65-55)x12))) = $11,900

The §415 dollar monthly limit reduced from age 65 to age 55 is $17,500 x 146.11 / 179.40 x 1.05^-10 = $8,749.89

Art’s monthly benefit is limited to $8,749.89

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Benefits Payable after Age 65

Benefit commencing after age 65 is

the age 65 §415 limitation increased

by the plan factors for late retirement

or the actuarial equivalent of the age

65 §415 limitation using 5% and the

AMT whichever produces the smaller

benefit.

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Benefits Payable After Age 65David is 67 years old. The plan’s Normal Retirement Age is

65. Benefits payable later than NRA are increased by .8%

for each month later than NRA. David’s accrued benefit

payable at NRA is $17,000 a month.

David wants to retire. What is his monthly benefit? David’s

benefit at age 67 is: $17,000 x (1+(.008 x ((67-65)x12))) =

$20,264

The §415 monthly dollar limit increased from age 65 to age

67 is $17,500 x 146.11 / 138.66 x 1.05^2 = $20,330

David’s monthly benefit is limited to $20,264

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415 Benefits at Unbirthdays• 415 Limit based on age in years and

completed months• Lump Sum conversion factors are also

based on age in years and completed months

• May a plan use age nearest or attained age at distribution date? Only if it provides for a smaller benefit than the §415 benefit based on fractional age

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415 Benefits at Unbirthdays• Allowable Methods?

– Linear Interpolation of limits at integral ages

– Linear Interpolation of APRs with a compound interest discount to actual age

– Mortality table built using constant force of mortality between integral ages

– Any other reasonable method

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§415 Average Compensation

• Breaks in service/gaps are ignored for average

compensation

• Less than 3 years of service-Average is based on years

and fractions of a year but not less than one year.

• Assume LY is the calendar year. Judy was hired on

7/1/13 and terminates on 12/31/14. Total pay is $60,000

(2013) and $120,000 (2014)

• §415 Average pay for Judy is $120,000 at 12/31/14

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§415 Average Compensation

• Let’s revisit Judy’s employment history. Judy was hired on 7/1/13

and terminated on 12/31/14.

• Total pay is $60,000 (2013) and $120,000 (2014).

• Judy is now re-hired on 1/1/16 and receives $500,000 for her 2016

services.

• After paying Judy, employer files chapter 7 and Judy is again

unemployed as of 12/31/16

• §415 average pay for Judy is ($60,000 + $120,000 + $265,000)/2.5

= $178,000

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Compensation

•Amounts paid while on active duty or during a period

of disability may be generally included

•Severance and other post-employment pay. Generally

only amounts paid no later than

• 2½ months after termination or

•The end of the limitation year that includes the

termination date and

• The amounts would have been includible if paid

prior to termination

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Application of §401(a)(17)

• Regulation limits benefits to the lesser of:

– Age 65 dollar limit (actuarially decreased before

age 62 and increased after age 65) and,

– High 3 year pay where each year is limited to the

§401(a)(17) limit

– Interesting public policy basis. Value of the §415

limitations decline after approximately age 68

• 2007 accrued benefit grandfathered

– The document supported that interpretation

– The plan conformed with prior guidance AND

– The provisions were adopted and in effect by April

4, 2007

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100% Average Compensation Limit

• Pat is age 70, Years of Participation-7, Years of Service-8, Pay is $300,000 for all years.

• §415 age 70 annual dollar limit is $308,276

• §401(a)(17) Average is $260,000 (average of $255,000, $260,000 and $265,000)

• Dollar limit: $308,276 x 7/10 = $215,793

• % limit: $260,000 x 8/10 = $208,000

• Benefit payable: $208,000

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Maximum Lump Sums Reflecting the §401(a)(17) Limits

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De Minimis Benefit

• $10,000 may be paid in any form

– Phased in over 10 years service

– Must never have participated in any DC plan

maintained by employer. Is participation in a §401(k)

only plan considered a DC plan for this purpose?

• Normal form must be least valuable form under the plan

– Or plan must limit the normal form such that the

least valuable form does not violate the $10,000 limit

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De Minimis Benefit

• Assume a $10,000 10 C&L benefit and an $11,000

life only benefit are actuarially equivalent

• Plan can provide a $10,000 benefit with 10C&L as

the normal form

– Plan cannot permit an optional form of life

annuity

• Paying $11,000 would violate §415

• Paying $10,000 as a life annuity would be an

impermissible forfeiture under §411

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De Minimis Benefit

– Plan could limit normal form benefit

– If max 10 C&L under the plan was $9,090.90, the

equivalent life only benefit would be $10,000 satisfying

§415

– Clarifies long held IRS position that the $10,000 de

minimis benefit cannot be paid as a lump sum

– Lump sum would be limited to the greater of $10,000 or

the lump sum value of the 100% of pay limit

– If that result is less than the PVAB of the de minimis

annuity, it is an impermissible forfeiture

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Timing of COLAs

Cannot give COLA to someone completely paid out in a prior limitation

year and who does not accrue an additional benefit

Kevin was age 65 on 12/31/12 and received an in-service lump sum

distribution of his accrued benefit, the §415 limit.

At the time of his distribution, Kevin had 10 years of participation and

the benefit formula does not recognize service in excess of 10 years

Is Kevin’s 2013 benefit increased by the 2013 COLA? No. However, if

Kevin still had an accrued benefit or accrues a benefit then he is entitled

to the 2013 COLA.

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COLAs on §415 Average Compensation

• Larry retired in 2000 and takes an annual benefit of

$20,000 starting at age 65. §415 pay is $25,000

• 7 years later, the employer would like to increase

Larry’s benefit

• Post retirement COLAs brings his average pay limit

to $30,314 (Note: slightly different than $25,000 *

$180,000/$160,000 as actual COLA’s used)

• Since Larry has been receiving a benefit that is not

subject to §417(e)(3) and his annuity is less than his

adjusted high 3 year average, his benefit may be

increased to $30,314

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Funding of §415 COLA

• Although §415 increases are considered

plan amendments for certain purposes, Cost of

living increases in the §415 dollar limits are

not treated as amendments for §404

• Therefore, the Cushion always includes the

current §415 dollar limit

• See 2002 Gray Book Q&A 3.

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Multiple Annuity Starting Dates (MASDs)

• Applies when there are multiple distributions which count against

the §415 limit

• Examples

– Prior plans

– §401(a)(9) payments

– §415 COLA adjustments to benefits in pay status

– Rehires

– Payments to alternate payees

– Top 25 restrictions under §1.401(a)(4)-5

– Participants in multi-employer and single employer plans

– Lump sums to retirees at plan termination

– Bifurcated benefits resulting from §436 restrictions

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Multiple Annuity Starting Dates

(MASDs)

• MASD when participant changes benefit

form

• New ASD for §§ 417 & 415

• Revised income stream must comply

with §§ 417 & 415

• §415 regulations have deferred guidance

but §401(a)(9) regulations did not

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Multiple Annuity Starting Dates (MASDs)

• §415 Regulations–Reserved– In the preamble: “The benefit payable at each

annuity starting date must comply with §415 when aggregated with all past payments.”

–The problem is the §415 regulations introduce the concept of MASDs but give no guidance on what you do with them!

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Multiple Annuity Starting DatesMary Ann is 63 years old as of 12/31/12. The plan calls for a pay

credit equal to the present value of 10% of the §415 dollar limit

in each year. NRA under the plan is age 62. The plan allows for

in-service distributions on or after NRA. Actuarial Equivalency is

5½/5½ 94GAR.

APRs: 63-142.27 64-139.04

After one year of participation, Mary Ann’s 2012 accrued benefit

is the maximum benefit. She took a lump sum settlement of that

benefit on 12/31/12 ($1,666.67 x 142.27=$237,117).

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Multiple Annuity Starting Dates

What is the benefit Mary Ann can accrue

and receive in 2013?

Since she was paid her entire benefit on

12/31/12, she may only receive a 2013

pay credit equal to $1,708.33 x 139.04 =

$237,526

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MASDs-§401(a)(9) Regulations

• Overview of the §401(a)(9)/ §415 regulations on

MASD. The questions to be answered are:

– Does the original income stream comply with

§415 as of the 1st ASD?

– Does the income stream as modified comply

with §415 as of the 1st ASD?

– Does each modification of the income comply

with §415 at the later ASD?

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MASDs-§401(a)(9) Regulations• Specific methodology:

– Value revised the annuity stream using §415 interest rates.

If the payment stream is based on a life contingency then

must use the applicable mortality table

– For payment patterns that are subject to §417(e)(3) must

use 5½% interest

– Discount payments to the 1st ASD

– Convert the discounted payments to a life annuity starting

at the ASD

– Compare the resultant annuity with §415 limit as of the

ASD

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MASDs• James’ §415 average compensation is

$140,000

• His monthly accrued benefit at age 70 is

$10,000

• $10,000 monthly benefit commences at

age 70 as a life annuity

• At age 75, in 2016, the plan terminates

and James elects a $1,144,500 lump sum

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MASDs

• James’ revised benefit form at the 1st ASD is a life

annuity for 5 years followed by a lump sum of the

remaining payments at the 6th year.

• Since the revised income stream was based on life

contingencies and the modified pattern must

discount for interest and the AMT

• Since the revised benefit form was not payable for

James’ life, then must value the revised income

stream at 5½%

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MASDs

PaymentYear

Annual Amount

DiscountedValue at age

70*

1 through 5 $ 120,000 $ 507,204

6th 1,144,500 797,323

Total $1,744,500 $1,304,527

*Discounted at 5½% and the Applicable Mortality Table

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MASDs• James’ revised benefit stream is subject to §417(e)(3) &

therefore §415 calculation must use 5½%

• At 1st ASD: §415 annual benefit (payable monthly) derived from

present value of revised income stream is $ 1,304,527

/ 122.46 x 12 = $127,836

• At 2nd ASD benefit provided by lump sum at age 75: $1,144,500/

102.97 x 12 = $133,376

• Since $127,836 & $133,376 are less than James’ §415 average

compensation of $140,000, the plan may pay lump sum

• If James’ §415 average compensation was less than $133,376,

the payment of the lump sum at age 75 would violate §415

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MASDs• Howie’s §415 average compensation is

$200,000

• His accrued monthly benefit at age 70 is

$10,000 ($120,000 a year payable monthly)

• At age 70, Howie elects a 31 year certain

benefit with 4.99% annual increases

• At age 75, Howie elects a $1,144,500 lump

sum

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MASDs

• Howie’s revised benefit form at his 1st ASD is 5

year certain payout for 5 years followed by a lump

sum settlement of the remaining payments at the 6th

year.

• Since the revised income stream was NOT based on

a life contingency and the modified pattern was not

payable for the life of the participant, then must

value the revised income stream at 5½% without

mortality.

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MASDsPayment

YearAnnual Amount

Discounted Value at age 70*

1 $ 42,172 $ 42,172

2 44,276 41,968

3 46,486 41,765

4 48,805 41,563

5 51,241 41,362

6 1,201,930 906,629

Total $1,377,480 $1,115,459

*Discounted with 5½% and no mortality

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MASDs

• Howie’s revised benefit stream is subject to §417(e)(3) &

therefore §415 calculation must use 5½%

• At 1st ASD his §415 annual benefit (payable monthly) derived

from present value of revised income stream is $1,084,528 /

122.46 x 12 = $106,277

• At 2nd ASD, his §415 annual benefit (payable monthly) derived

from present value of revise income stream is $1,115,459 /

102.97 x 12 = $160,527

• Since $106,277 & $129,994 are less than Howie’s §415 average

compensation of $200,000, the plan may pay Howie the lump

sum

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Issues with the §401(a)(9) Regulations on MASDs

• The regulations were published June 15, 2004 it

does not recognize the changes in the §415 limits

brought on by PFEA and PPA

• The regulation’s position is if an income stream is

changed and the change results in a reduction in

the present value of a benefit stream due to the

imposition of the §415 limits then that reduction

is an impermissible cutback under §411

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Issues with the §401(a)(9) Regulations

on MASDs

• Regulations have not been rescinded

• Regulations do not address situations where

the participant is continuing to accrue

benefits

• Regulations do not address changes in

compensation

• Regulations do not address increases in the

§415 limits

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IRS Notice 99-44-Catch Up

• Mark’s §415 dollar limit is $205,000. Assume no increases in

future dollar limits. He starts a $15,000 monthly benefit

commencing at age 62 as a life annuity

• At age 71, sponsor wishes to increase Mark’s benefit to the

maximum available

• Under the Notice, $17,083.33-$15,000=$2,083.33 is accumulated

from age 62 to age 71 with 5% interest and the AMT or $25,011.

• The $25,011 is then converted into an annuity at age 71,

$300,135/122.99 = $2,440.

• Mark’s monthly benefit may be increased prospectively from

$15,000 to $19,523. Regulations require the compliance with §415

at the 2nd ASD. Therefore, Mark’s benefit is limited to $17,083.33

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IRS Notice 99-44

• Notice issued before final §415 regulations• Notice was issued to describe the effect of the

elimination of section §415(e)• Notice introduces the concept of a “catch up”• Notice implies once a benefit is paid, the §415 dollar

limit is fixed at that age. Thus an individual who received $1 benefit at age 30 is limited to a benefit of less than $1,928 35 years later!

• The authors believe the concept of the catch up and the requirement that the dollar limit is fixed at the 1st

ASD are good reasons to believe the guidance is obsolete

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MASD Example• With multiple annuity starting dates, increases in

§415 limits, in compensation and in mortality

tables, how does one calculate benefits available at

later ASDs?

• Rather than calculate the discounted value of

distributions to the 1st ASD, the authors suggest a

different approach. Accumulate the benefits to the

last ASD and test §415 limits at that point. Of

course, §415 limits should have been tested at the

previous ASDs.

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MASD Example• Facts-Plan 1

– Sponsor terminates defined benefit plan & distributes lump sum of $600,000 to Kirk at age 50.

– Plan rates are 5%/5% 94GAR– 415 lump sum rates are 5.12%/5.12% 94GAR

• Facts Plan 2– Sponsor terminates defined benefit plan & distributes lump sum

of $700,000 to Kirk at age 55 – Plan rates are 5%/5% 94GAR– 415 lump sum rates are 5.50%/5.50% 2010 Applicable Mortality

Table

• Facts Plan 3– Sponsor wants to set up a new plan – Normal Retirement Age is 62– Plan rates are 5%/5% Applicable Mortality Table– 415 lump sum rates are 5.50%/5.50% Applicable Mortality Table– What is the maximum benefit that may be provided under Plan 3

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MASD Example

• Plan 1-Distribution at age 50

– Equivalent 415 monthly accrued benefit is determined under the plan provisions and the 415 provisions at the time of the distribution. Therefore, using 94GAR at 5.12%, the equivalent month benefit provided by the $600,000 lump sum is $600,000/185.91 = $3,227

– Under § 415(g), all defined plans of an employer are required to be aggregated. Therefore, the actuarially adjusted benefit at age 62 will use the current §415 factors of 5% and the AMT. Actuarial equivalent benefit at age 62 is $3,227 * 192.76 / 156.87 * 1.05^12 = $7,121

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MASD Example

• Plan 2-Distribution at age 55–§415 factors will use the 2013 AMT at

5½%. Equivalent monthly accrued benefit

provided by the $700,000 lump sum

$700,000/169.43 = $4,131

–Actuarial equivalent benefit at age 62

using the 2016 AMT and 5½% is

$4,131*179.40/156.87 *1.05^7 = $6,648

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MASD Example

• Plan 3-Expected Benefit at age 62– Maximum before recognition of prior plans: $17,500

– Net Monthly Benefit available in Plan 3: $17,500 -

$7,121 – $6,648

– Plan may provide Kirk with a $3,731 monthly benefit

payable at age 62

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MASD Example

• Alternate Approaches–Convert the prior plan distributions using

the current AMT and 5½%

–Actuarially increase the prior plans’

benefits by 5½% and the AMT