DB Distributions - Addressing the Common Questions. Daniel Liss, EA, CEO, Economic Growth Pension Services, Inc.

Transcription

1 DB Distributions - Addressing the Common Questions Daniel Liss, EA, CEO, Economic Growth Pension Services, Inc. 1

2 Daniel Liss, EA, CEO, Economic Growth Pension Services, Inc. Daniel began working at EGPS in 2003, where he spent several years learning the pension administration business from the many highly qualified pension specialists and actuaries. He qualified as an enrolled actuary in He has been a member of the Society of Pension Actuaries since He became C.E.O. in November He loves leading the team of experienced actuaries, administrators and salespeople, and constantly developing and improving the client service experience. He lectures regularly on pension topics such as wealth accumulation in pension and 401(k) plans, overfunded plans, and defined benefit/cash balance issues, and is qualified to give CPE credits to CPAs. 2

3 DB Distribution Annuities Why do we need annuities? IRS requirement that DB plans payout their benefits in the form of an annuity Treas.Reg (a)-1(b)(1)(i) Normally (especially for rank and file) we take advantage of the exception that terminees can be paid in other forms e.g., a lump sum 3

4 DB Distribution Annuities For decades, plans have been required to offer a survivor annuity Under the Retirement Equity Act of 1984, the rules were satisfied by a life annuity on the participant, then a survivor annuity not less than half of what the participant was getting on the participant s spouse. This annuity was called the Qualified Joint & Survivor Annuity, or QJSA 4

5 DB Distribution Annuities PPA (August, 2006) enacted new QOSA (qualified optional survivor annuity) rules Basic effect is to require the plan to offer two different J & S annuities If you have one survivor annuity, with the survivor portion less than 75% of the participant s annuity, then the QOSA is J & 75% S But if the survivor portion is 75% or more, the QOSA is J & 50% S Why??? 5

6 DB Distribution Annuities Survivor annuities are important in small plans because the J & S can be subsidized i.e. a participant due $15,000/month life annuity can receive $15,000/month for BOTH lives, even though that exceeds the actuarial equivalent More money for the owners! As a rough example, an owner with maximum comp/service/participation can expect a lump sum of about $2.4m 6

7 DB Distribution Annuities But the 100% J & S could pay out as much as $3.6m Still think your plan is overfunded? Warning: if participant receives a lump sum in this case, it can be based on the life annuity only 7

8 DB Distribution Annuities Participant can also receive if plan allows a $10,000/year life annuity IRC 415(b)(2)(4) 415 allows this even if the dollar limit is less (e.g., commencement at age 25) or the comp limit is less (salary of a dollar a year) just need 10 years of service You CANNOT convert this to a lump sum Participant could not have been in a DC plan with the same employer (obsolete statute but still on the books) [415(e)] 8

9 DB Distribution Annuities For Required Minimum Distributions, special considerations apply most important is the ability to incorporate a COLA in the annuity This lowers payments in earlier years, but increases them in later years The COLA must be less than 5% per year, or a consumer price index may be used 9

10 DB Distribution Annuities Other tools to lower payments include offering a full survivor annuity, and offering guaranteed payments (payments which run even after both annuitants pass on) 10

11 Annuities, Annuities Everywhere So, you took over a plan which offered the following optional forms of benefit: Survivor annuities: J & 100%S, J & 50%S, J & 75%S, J & 25%S C & C (certain & continuous) annuities: 60 payments guaranteed, 120 payments guaranteed, and 240 payments guaranteed 11

12 Annuities, Annuities Everywhere Annuity certain: entire benefit paid out over ten years Can you amend the plan to remove these bothersome optional forms? Yes, but IRC sec. 411(d)(6)(B) says you have to preserve whatever was available/accrued ( $1,250/mo for life with 120 payments guaranteed ) on the date of the amendment 12

13 Annuities, Annuities Everywhere Some optional forms in benefits are not protected And increases in benefits are NOT subject to this preservation So, if benefit goes from $1,500/mo accrued to $2,500, you still have to offer $1,250/mo 10 C & C and the rest of the benefit in whatever from would now be allowable and disclose this in the relative value disclosures 13

14 Annuities, Annuities Everywhere It s tempting to ignore this when the old annuity values get swamped by new accruals and have less and less economic meaning Big plans spend a lot of time and money keeping track of these things 14

15 Annuities, Annuities Everywhere The 411(d)(6) regulations allow some things to be discontinued For instance, if plan has 3 or more survivor annuities you can go down to the two required Death benefits (typically, insured death benefits) are normally not protected Removal to comply with regulation changes is allowed 15

16 Annuity to Lump Sum Take the case of Sam. Sam is 35 years old and has been both an employee and participant for more than ten years Benefit is 100% of pay, and Sam is fully accrued, With his pay having always been $75,000, his accrued benefit is therefore $6,250/mo at NRA, here age

17 Annuity to Lump Sum Step 1: Take the accrued benefit, expressed as an annuity (usually as a life annuity) payable commencing at the plan s normal retirement age (typically 62-65) here $6,250/mo. Look up the annuity purchase rate at the plan s normal retirement age you must match the normal form of the annuity benefit! 17

18 Annuity to Lump Sum Step 1: Take the accrued benefit, expressed as an annuity (usually as a life annuity) payable commencing at the plan s normal retirement age (typically 62-65) here $6,250/mo. Look up the annuity purchase rate at the plan s normal retirement age you must match the normal form of the annuity benefit! 18

19 Annuity to Lump Sum Assumptions are 8% pre- and post-, mortality IA71 table for males, post-retirement only So, APR at age 62 is , meaning to buy a $1 annuity commencing age 62 will cost $ at plan rates (note that this is highly unrealistic these days) 19

20 Annuity to Lump Sum For this step, use the plan s stated actuarial equivalence (post-retirement) Beware: if the actuarial equivalence floats (i.e., changes with time), your life just got a lot more exciting Multiply by the accrued benefit - $6,250 x 111,311 = $695,694 (as of age 62 at plan rates) 20

21 Annuity to Lump Sum Discount back to today (previous result) x (1+ plan s preretirement actuarial interest rate) ^ (-number of years to today) For Sam, it s $695,694 x (1.08) ^ (35-62) = $87,092 Result is your tentative lump sum, almost guaranteed to be the wrong answer 21

22 Annuity to Lump Sum Discount back to today (previous result) x (1+ plan s preretirement actuarial interest rate) ^ (-number of years to today) For Sam, it s $695,694 x (1.08) ^ (35-62) = $87,092 Result is your tentative lump sum, almost guaranteed to be the wrong answer 22

23 Annuity to Lump Sum Discount back to today (previous result) x (1+ plan s preretirement actuarial interest rate) ^ (-number of years to today) For Sam, it s $695,694 x (1.08) ^ (35-62) = $87,092 Result is your tentative lump sum, almost guaranteed to be the wrong answer 23

24 Annuity to Lump Sum Next step: Start over Take the accrued benefit, of $6,250/mo This time, you must use the 417(e) segment rates (here s a handy link to finding them: and the applicable mortality table ( 15E is what Datair calls it; your vendor may have a different name) 24

25 Annuity to Lump Sum Each payment must be discounted back by the appropriate segment rate (if the payment is to be made in the next five years, use the first segment rate; otherwise, if it is to be made in first twenty years, use the second segment rate; otherwise use the third segment rate). You must also multiply each payment by the probability that it will get paid (basically, a bunch of px s) 25

26 Annuity to Lump Sum Each payment must be discounted back by the appropriate segment rate (if the payment is to be made in the next five years, use the first segment rate; otherwise, if it is to be made in first twenty years, use the second segment rate; otherwise use the third segment rate). You must also multiply each payment by the probability that it will get paid (basically, a bunch of px s) 26

27 Annuity to Lump Sum I used 2015 assumptions here segment rates 1.48/3.77/4.79. The main takeaways: 1) Payments are going to be dominated be the third segment rate (which controls payments 20+ years from now; remember Sam is 27 years from retirement) These rates are FAR lower than the plan rates, so the lump sums are going to be a LOT higher 27

28 Annuity to Lump Sum So, in this example, you can treat it as a single APR with the 2015 Applicable Table at 4.79%, or So, the lump sum at retirement is that times the annuity, or $997,

29 Annuity to Lump Sum To get the current value at age 35, discount back 27 years at 4.79% (again, we re lucky that everything falls into segment 3) $997,806 x ^ -27 = $282,219 If you get the idea that man should be replaced by machine here, you re probably right 29

30 Annuity to Lump Sum The greater of the lump sums determined in steps 1 & 2 is the amount due the participant However, for participants at/near the 415 limit, you must make an additional calculation: discount the lump sum back/forward to age 62 (or as late as 65) at 5.5%, using the applicable mortality table, and make sure that result doesn t exceed the 415 life annuity limit 30

31 Annuity to Lump Sum To test 415, first convert the annuity (at plan rates) to an age 35 annuity: Dollar limit: $17,500 (415 $ limit at age 62) x 1.08 ^ -27 x APR at 62/APR at 35 [ / ], or $1,672.07/mo., payable at age 35 Comp limit is never reduced: $6,250/mo. 31

32 Annuity to Lump Sum Annuity equivalent is the lesser of the two, $1, You get the PVAB of this annuity by multiplying the annuity by the immediate (age 35) APR using 415 assumptions, i.e. 5.5% and the Applicable Table, or So, 415 limit is $341,040 32

33 Annuity to Lump Sum We left some money on the table We could raise Sam s payout by amending plan s actuarial equivalence What would this cost for other employees? 33

34 Why Did The Numbers Change? The client s plan is frozen - how and when do payout numbers change? Passage of time: this is the biggie. The closer participant gets to retirement, the smaller the discount factors, and the present values get larger and larger Changes in assumptions: the plan could be amended, of course, but 417(e) changes from year to year (maybe more frequently; check your plan document) 34

35 Why Did The Numbers Change? The client s plan is frozen - how and when do payout numbers change? Passage of time: this is the biggie. The closer participant gets to retirement, the smaller the discount factors, and the present values get larger and larger Changes in assumptions: the plan could be amended, of course, but 417(e) changes from year to year (maybe more frequently; check your plan document) 35

36 Why Did The Numbers Change? Iron law of actuarial math: lower rates = higher PVs! Also, the mortality table improves every year, which increases lump sums a few percent If your plan is top heavy participant may have additional accruals = higher PVs 36

37 Frozen Plans Even if the plan is frozen, depending upon the type of freeze, increases in compensation may increase benefits Changes in assumptions will usually change the lump sum remember that segment rates and 417(e) mortality change every year (maybe more often) Passage of time will increase the benefits (think of it like a bank account accruing interest) 37

38 An Example Tale of Two Participants: Plan formula: 100% of pay, life only NRA: 62 Joe has average salary of $210,000, ten years of participation, age 57 Sam has salary of $75,000, ten YOP, age 35 38

39 An Example Actuarial equivalence: Plan factors: 8% pre- and post-mortality Mortality table: IA71M 417(e) factors: Segment rates: 1.48/3.77/4.79% Mortality: 2015 Applicable Mortality Table (unisex) 39

40 An Example 1) Name 2) Salary 3) Accrued Benefit 4) Plan factors LS 5) 417(e) Lump Sum 6) 415 Limit 7) Lump Sum Joe 210,000 $17,500 $1.325m 2.409m 1.812m $1.812m Sam 75,000 $6,250 $87k $282k $341k $282k 40

41 An Example The proper lump sum is: greater of 4) or 5), but not more than 6) So, Joe gets 415 haircut, but not Sam 41

42 More on Lump Sums Note that cash balance plans have a partial exemption from 417(e) Upshot is these plans pay out the hypothetical balance (which is the PVAB of the plan s annuity benefit) Basically these plans shoot the arrow and then draw the target, i.e. first they calculate how much they want the PVABs to increase by (the contribution credit ) 42

43 More on Lump Sums Then they accrue just enough to make that the increase in PVABs But (to not worry about 417(e)) the plan must either a) not be top heavy; b) TH allocation made into another plan (and you should know how to pair a CB plan with a profit sharing plan); or c) TH must be small enough that it s swamped by the CB 43

44 More on Lump Sums But, remember: CB plans are DB plans; so annuity options are always available Small plan participants never seem to elect them anyways 44

45 Terminating Plans How do you settle liabilities in a terminating DB plan? One way is to walk over to XYZ Life Insurance Co. and give a check Big plans do this all time, but it can be very expensive maybe 25% over what the plan budgeted for 45

46 Terminating Plans Another option is to convince the participants to take lump sums In small plans, the participants do not need much convincing What if you have a holdout? You have 2 choices: buy an annuity or self fund 46

47 Terminating Plans Self funding is cheaper But the plan must stay in existence (and be amended for law changes, file 5500s, etc.) until the holdout dies What if (in a terminating or ongoing plan) there are participants already receiving annuities? 47

48 Terminating Plans It would often be in the sponsor s interest (and perhaps the participant as well) to stop the annuity and take a lump sum The term used is de-risking, since the plan dumps longevity/investment return risk on the participant Apparently, the IRS does not like this practice They issued a Notice ( ) announcing their intent to crack down on this risk transfer 48

49 Terminating Plans But existing plans will probably not be affected Also, since they intend to amend the 401(a)(9) regs, possibly participants not receiving RMDs might be unaffected You can probably do it now, even though they intend to publish retroactive regulations 49