Effective September 9, 2016, the Department of Treasury (Treasury) and Internal Revenue Service (IRS) issued final regulations addressing the minimum present value requirements for pension benefits payable partly as an annuity and partly in an accelerated form, usually a lump sum. These final regulations under the Internal Revenue Code (Code) Section 417(e) aim to encourage pension plans to make partial annuities available to participants who can now elect only lump sums. With these regulations, Treasury and IRS take another step to promote lifetime income alternatives for retirement plan participants.
Like the proposed regulations issued in 2012 that we previously discussed here, the final regulations provide that the minimum present value requirements of Code Section 417(e) apply only to the accelerated or lump sum portion of the benefit. These final regulations should be reviewed by sponsors of pension plans that already provide for bifurcated benefits, because plan amendments may be needed. If a pension plan is newly amended to provide for bifurcated benefits, the amendments should take the final regulations into account.
Under Code section 417(e) and Reg. § 1.417(e)–1(d)(1), a pension plan must meet minimum present value requirements. The present value of any accrued benefit and the amount of any distribution, including a lump sum, must not be less than the amount calculated using the “applicable interest rate” and “applicable mortality table,” both described at Reg. §1.417(e)-1(d). The 2012 explanation of the proposed regulations asserted that under current law both the accelerated (lump sum) and annuity portions of a bifurcated distribution are subject to the minimum present value requirements of Code section 417(e)(3). The final regulations are consistent with the proposed regulations in creating an exception under which the minimum present value requirements apply only to the accelerated or lump sum portion, not the entire accrued benefit.
Bifurcated Accrued Benefits
The final regulations describe two different approaches, depending on a plan’s terms. Under “explicit bifurcation,” if a pension plan provides an accelerated payment or lump sum as a specified portion of a participant’s accrued benefit, the minimum present value requirements apply only to the accelerated or lump sum portion.
For example, consider a pension plan that pays 25 percent of a participant’s accrued benefit as a lump sum at retirement. Under the final regulations, the lump sum amount would be determined using the Code section 417(e) interest and mortality factors, while the amount of the annuity could be determined using the plan’s assumptions.
The second approach (“implicit bifurcation”) applies if a lump sum payment is a specified dollar amount rather than a portion of a participant’s accrued benefit. In that case, the residual annuity amount (payable in the normal form at normal retirement) cannot be less than the excess of: (1) the participant’s total accrued benefit expressed in that annuity form, over (2) the annuity in that form which is actuarially equivalent to the lump sum payment applying the Code section 417(e) interest and mortality factors.
For example, consider a contributory pension plan under which a participant’s contributions with interest are paid as a lump sum. That lump sum amount is first converted to an annuity payable in the normal form at normal retirement using the Code section 417(e) interest and mortality factors. This annuity amount is then subtracted from the participant’s total accrued benefit, expressed in the normal annuity form at normal retirement. The difference is the minimum amount payable as an annuity in the plan’s normal form at normal retirement. Plans that allow lump sum payments of specified dollar amounts should be reviewed for consistency with this minimum annuity requirement.
The regulations include seven examples to illustrate the application of these rules.
The final regulations require explicit bifurcation where a plan is amended to eliminate an optional form of benefit but retains the optional form for benefits already accrued, or if a participant can elect to receive all of the accrued benefit as a lump sum.
If different factors are used to calculate different portions of an accrued benefit attributable to an early retirement benefit, a retirement-type subsidy, an optional form of benefit, or an ancillary benefit, and if the plan provides for an accelerated distribution of only part or parts of the accrued benefit, the plan must specify the parts to which the accelerated distribution applies.
For example, if a plan had one set of early retirement factors that applied to a participant’s accrued benefit as of December 31, 2005, but a different set of factors for benefits accrued after that date, and the plan provides for a lump sum distribution that settles only a portion of the accrued benefit, then plan must include language that specifies which portion of the benefit is settled by that distribution.
The final regulations apply to bifurcated benefits with the same starting date, and the rules can be applied to bifurcate accrued benefits more than once.
Limited Anti-Cutback Relief
The final regulations provide a limited exception to the anti-cutback rule of Code section 411(d)(6) for pension plans that use the Code section 417(e) interest and mortality factors in calculating distributions if, under the final regulations, these factors are not required to be used. Plan sponsors can adopt amendments to reflect the final regulations for plan years beginning before January 1, 2017, even if the amendments reduce benefits. For anti-cutback relief, the deadline for adopting amendments is December 31, 2017.
The final regulations are effective September 9, 2016, and apply to distributions starting in plan years beginning after 2016. The regulations can be applied to any earlier period, subject to the deadline above for anti-cutback relief.
Sponsors of defined benefit pension plans with bifurcated benefits should review their plans to determine whether benefits are calculated in accordance with the final regulations. Some plans with bifurcated benefits should be amended for consistency with the final regulations. Amendments can apply retroactively, subject to the December 31, 2017, deadline for amendments which reduce benefits. Treasury and IRS have simplified the calculation of bifurcated benefits, thereby encouraging plan sponsors to consider amending their pension plans to make partial annuities available to participants.