1/13/2016. Basic Assumptions. Los Angeles Advanced Pension Conference Workshop 2. IRC Section 415 and Multiple Annuity Starting Dates

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1 - 0 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. 1 Unless otherwise noted: Basic Assumptions 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 2 1

2 415 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 3 411(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 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,

3 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, Grandfathered Benefits On 1/1/16, Norman s actuarially adjusted benefit is equal to: $180,000 x / 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 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 8 3

4 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 9 Maximum Lump Sums Mike 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 (2) 5½% Life Annuity and applicable mortality APR (3) 417(e) Life Annuity Rate APR Maximum Lump Sums Lump Sum is the lesser of {Greater of (1)(a) or (1)(b)}, (2) and (3): (1) (a) $17,500 x = $2,281,825 (b) $17,500 x =$2,752,750 (2) $17,500 x = $2,450,525 (3) $17,500 x x 105% = $2,890,388 The plan may pay Mike a lump sum equal to $2,450,

5 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 65 th 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 = $2,281,825 (2) $17,500 x = $2,450,525 (3) $17,500 x 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 12 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, Dollar Limit at age 46 is $6, x 4/10 = $2, (1) Plan Rate APR Normal Form (2) 417(e) Rate APR Normal Form (3) 5½% APR Life Annuity Form Maximum Lump Sums Kurt s Lump Sum is the lesser of {the greater of (1a) or (1b)} and (2): (1a) $1, x = $378,281 (1b) $1, x = $402,557 (2) $ 2, x = $472,654 Kurt s lump sum equals $402,

6 Annuity Payments Benefits 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, Rick s accrued monthly benefit is $3, Annuity Payments Benefits to which 417(e)(3) does not apply 10 C&L benefit $3, x.98 =$3, limitation for optional form. APRs using 5% & AMT APR life annuity APR 10 C&L Maximum 10 C&L annuity benefit $3, x / = $3, Rick s 10 C&L benefit is limited to $3, Benefits Payable before Age 62 Benefit commencing before age 62 is the age limitation reduced by the plan factors for early retirement or the actuarial equivalent of the age 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? 17 6

7 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 / x 1.05^-7 = $10, Art s monthly benefit is limited to $10, Benefits Payable before Age 62 What 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 / x 1.05^- 10 = $8, Art s monthly benefit is limited to $8, Benefits Payable after Age 65 Benefit commencing after age 65 is the age limitation increased by the plan factors for late retirement or the actuarial equivalent of the age limitation using 5% and the AMT whichever produces the smaller benefit. 20 7

8 Benefits Payable After Age 65 David 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 / x 1.05^2 = $20,330 David s monthly benefit is limited to $20, 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 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 23 8

9 415 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/ 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/ average pay for Judy is ($60,000 + $120,000 + $265,000)/2.5 = $178, 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 26 9

10 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 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, % 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, (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, Maximum Lump Sums Reflecting the 401(a)(17) Limits 29 10

11 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 30 De Minimis Benefit Assume a $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 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 32 11

12 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. 33 COLAs on 415 Average Compensation Larry retired in 2000 and takes an annual benefit of $20,000 starting at age 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, 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

13 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 36 Multiple Annuity Starting Dates (MASDs) MASD when participant changes benefit form New ASD for 417 & 415 Revised income stream must comply with 417 & regulations have deferred guidance but 401(a)(9) regulations did not 37 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! 38 13

14 Multiple Annuity Starting Dates Mary 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: 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, x =$237,117). 39 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, x = $237, 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 1 st ASD? Does the income stream as modified comply with 415 as of the 1 st ASD? Does each modification of the income comply with 415 at the later ASD? 41 14

15 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 1 st ASD Convert the discounted payments to a life annuity starting at the ASD Compare the resultant annuity with 415 limit as of the ASD 42 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 43 MASDs James revised benefit form at the 1 st ASD is a life annuity for 5 years followed by a lump sum of the remaining payments at the 6 th 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% 44 15

16 MASDs Payment Year Annual Amount Discounted Value at age 70* 1 through 5 $ 120,000 $ 507,204 6 th 1,144, ,323 Total $1,744,500 $1,304,527 *Discounted at 5½% and the Applicable Mortality Table 45 MASDs James revised benefit stream is subject to 417(e)(3) & therefore 415 calculation must use 5½% At 1 st ASD: 415 annual benefit (payable monthly) derived from present value of revised income stream is $ 1,304,527 / x 12 = $127,836 At 2 nd ASD benefit provided by lump sum at age 75: $1,144,500/ 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 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 47 16

17 MASDs Howie s revised benefit form at his 1 st ASD is 5 year certain payout for 5 years followed by a lump sum settlement of the remaining payments at the 6 th 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. 48 Payment Year MASDs Annual Amount Discounted Value at age 70* 1 $ 42,172 $ 42, ,276 41, ,486 41, ,805 41, ,241 41, ,201, ,629 Total $1,377,480 $1,115,459 *Discounted with 5½% and no mortality 49 MASDs Howie s revised benefit stream is subject to 417(e)(3) & therefore 415 calculation must use 5½% At 1 st ASD his 415 annual benefit (payable monthly) derived from present value of revised income stream is $1,084,528 / x 12 = $106,277 At 2 nd ASD, his 415 annual benefit (payable monthly) derived from present value of revise income stream is $1,115,459 / 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 50 17

18 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 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 52 IRS Notice 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, $15,000=$2, 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/ = $2,440. Mark s monthly benefit may be increased prospectively from $15,000 to $19,523. Regulations require the compliance with 415 at the 2 nd ASD. Therefore, Mark s benefit is limited to $17,

19 IRS Notice 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, years later! The authors believe the concept of the catch up and the requirement that the dollar limit is fixed at the 1 st ASD are good reasons to believe the guidance is obsolete 54 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 1 st 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. 55 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

20 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/ = $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 * / * 1.05^12 = $7, MASD Example Plan 2-Distribution at age factors will use the 2013 AMT at 5½%. Equivalent monthly accrued benefit provided by the $700,000 lump sum $700,000/ = $4,131 Actuarial equivalent benefit at age 62 using the 2016 AMT and 5½% is $4,131*179.40/ *1.05^7 = $6, 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

21 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 60 21