A New Theory of Relativity: Treasury Publishes Final Regulations on Disclosure of Relative Values of Optional Forms of Benefit

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1 Legal Alert: A New Theory of Relativity: Treasury Publishes Final Regulations on Disclosure of Relative Values of Optional Forms of Benefit January 15, 2004 The Treasury Department s final regulations may not change the course of scientific history, but the new rules regarding disclosure of relative values of optional forms of benefit are significant in their own way for defined benefit plans. The Treasury Department issued proposed regulations in this area on October 7, 2002, which we summarized in a previous Legal Alert. The final regulations, issued on December 17, 2003 at Treas. Reg (a)(3)-1, adopt the proposed regulations with very few changes. This Legal Alert summarizes both the key aspects of the final regulations and differences from the proposed regulations and discusses the steps that plans affected by the regulations may need to take. This Legal Alert also includes a short discussion of procedural changes and plan amendments that some plans may need to make, effective January 1, 2004, to address certain situations in which a participant has a retroactive annuity starting date. Background Under section 401(a)(11) of the Internal Revenue Code ( Code ), the default form of distribution for defined benefit, money purchase, and certain other defined contribution plans is required to be a qualified joint and survivor annuity ( QJSA ). These plans can, and most plans do, permit participants to elect other forms of distribution, such as other types of annuity distributions or a lump sum. If a plan offers other forms of benefit, however, the participant must receive a notice explaining, among other things, the financial impact of a decision to waive a QJSA and the relative values of alternative forms of benefit. See Treas. Reg (a)- 11(c)(3) and 1.401(a)-20, Q&A-36, for the rules as they existed before the final regulations described in this Legal Alert revised and consolidated the rules. Plan administrators have historically used a variety of methods to disclose the relative values of alternative forms of benefit. For plans offering a lump sum payment alternative, notices under many such plans have simply stated the monthly dollar amount of the QJSA and the total value of the lump sum, without any comparison of the two in the same form. Because a QJSA is often subsidized when compared to the equivalent lump sum amount, members of Congress and others expressed concerns that participants were making lump sum elections without understanding the significant value they were losing. This article is for informational purposes and is not intended to constitute legal advise.

2 In response to these concerns, the October 2002 proposed regulations required the value of the QJSA and other forms of benefit to be presented in a manner that provides a meaningful comparison of the relative economic values of the forms of benefit without the participant having to make his or her own calculations using interest or mortality assumptions. The proposed regulations also consolidated all of the rules regarding the form and content of the QJSA and qualified pre-retirement survivor annuity ( QPSA ) elections. Thus, rules from Treas. Reg (a)-11(c)(3) and 1.401(a)-20, Q&A-36 have been revised and restated at Treas. Reg (a)(3)-1. The Final Regulations, Including Significant Changes General Rules. The final regulations retain the general rule of the proposed regulations that, as part of the QJSA notice provided to participants, a defined benefit plan must show the relative value of each optional form of benefit compared to the value of the QJSA. A plan can do this by, for example, (1) expressing the actuarial present value of the optional form of benefit as a percentage of the actuarial present value of the QJSA, (2) stating the actuarial present value of both the QJSA and the optional form of benefit, or (3) expressing the optional form of benefit as an actuarially equivalent annuity payable at the same time and under the same conditions as the QJSA. Generally, relative values can be calculated using reasonable actuarial assumptions, but certain forms of distribution, such as lump sums, must be calculated using prescribed assumptions. The proposed regulations required that the interest rate used to develop the comparisons be disclosed in the QJSA notice; the final regulations retain this rule and also specify that the other actuarial assumptions (e.g., life expectancy assumptions) used in the calculations must be provided to participants upon request. Under the proposed regulations, optional forms of benefit were required to be compared to the QJSA for the participant. Commentators noted that this would result in different comparisons for married participants (for whom the QJSA is generally defined to be a joint and 50% survivor annuity) and unmarried participants (for whom the QJSA is generally defined to be a single life annuity). The final regulations permit plans to compare the relative values of optional forms to the QJSA on a uniform basis, regardless of whether the participant is married, provided that the joint and survivor or single life annuity benefit options to which other optional forms are compared are the same for married and unmarried participants. For example, for a plan in which the QJSA for married participants is a joint and 50% survivor annuity and for unmarried participants is a single life annuity (and each of these forms is available to all participants on the same terms), the plan could compare all other optional forms of benefit to the joint and 50% survivor annuity for both married and unmarried participants. This article is for informational purposes and is not intended to constitute legal advise. 2

3 Simplifying Rules. As under the proposed regulations, the final regulations permit plans in which the QJSA and all other optional forms of benefit are actuarially equivalent to simply state that the optional forms of benefit are approximately equal in value to the QJSA. The final regulations also retain the rule permitting plans to describe forms of benefit with an actuarial present value of at least 95 percent of the QJSA for a married participant as approximately equal in value to the QJSA. In addition, a plan that is comparing the value of optional forms of benefit to the value of a QJSA that is a single life annuity may describe forms of benefit with an actuarial present value of at least 95 percent of the single life annuity but not more than percent of the single life annuity as approximately equal in value to the single life annuity. These rules will allow many plans to avoid presenting all the detailed relative value information that the final regulations otherwise require. Two additional simplifying rules were carried over from the proposed regulations. The final regulations allow banding or grouping of optional forms of benefit with actuarial values within five percentage points for purposes of disclosing their relative value. In addition, the rules permit the use of estimates of relative values or charts showing comparisons of optional forms of benefits at representative ages. If estimates or charts are used, however, the plan must provide more precise calculations upon a participant s request. Miscellaneous Items. Under Treas. Reg (a)-20, Q&A-16, the QJSA for married participants must be at least as valuable as any other optional form of benefit under the plan. It may be the case for some plans that under one set of reasonable actuarial assumptions, the plan satisfies this requirement, but under the set of reasonable actuarial assumptions used to provide the relative value comparisons for the QJSA notice, the QJSA may not appear to be as valuable under certain scenarios. The preamble to the final regulations clarifies that there is no implication that such a plan would fail to satisfy the requirements of Q&A-16. The preamble notes that the regulations do not include model notice language on relative value comparisons. However, the regulations numerous detailed examples of how comparisons can be presented to participants can serve as a starting point in preparing notices. The preamble also states that the IRS and Treasury Department are continuing to consider the extent to which QJSA and QPSA notices can be provided electronically, and that the IRS and Treasury Department anticipate issuing general guidance regarding electronic notices for qualified retirement plans. The relative value regulations are applicable only to defined benefit plans. Money purchase plans and certain other defined contribution plans subject to the QJSA and QPSA rules must, of course, comply with the other rules governing QJSA and QPSA notices set forth in the final regulations. As under the proposed regulations, the final regulations restate and consolidate existing guidance for such notices, with no significant changes. This article is for informational purposes and is not intended to constitute legal advise. 3

4 Effective Date Albert Einstein s theory of relativity was retroactively effective to the beginning of time; the theory of relativity described in the final regulations is only effective prospectively. Specifically, the final regulations are applicable to QJSA explanations relating to distributions with annuity starting dates on or after October 1, 2004, and to QPSA explanations provided on or after July 1, In the case of a retroactive annuity starting date under Code section 417(a)(7), the date of commencement of payments is substituted for the annuity starting date in applying the effective date provision. Next Steps Although the regulations are not effective until mid- to late-2004, many employers will want to start preparing to implement the regulations as soon as possible. Some of the significant actions that plan sponsors should be taking in response to these final regulations are as follows: Determine whether any defined benefit plans offer lump sum distributions or optional forms of benefit that are not actuarially equivalent to the QJSA. o If all optional forms offered under a plan are not actuarially equivalent to the QJSA, determine whether the optional forms can be considered actuarially equivalent by satisfying the 95% or 95%/102.5% thresholds described above. o If a plan does not offer a lump sum payment alternative and the optional forms of benefit offered under the plan are actuarially equivalent (or are considered actuarially equivalent) to the QJSA, a statement will need to be added to the QJSA notice to reflect this information, but little else will likely need to be done. If a plan offers a lump sum payment alternative or the other optional forms of benefit are not actuarially equivalent to the QJSA, the plan sponsor will need to modify its administrative procedures and the QJSA notice to satisfy the final regulations. o The plan sponsor should determine how the required comparisons will be presented, i.e., on the basis of a QJSA or a single life annuity, using individualized comparisons or generally applicable charts, etcetera. o The plan sponsor will need to have an actuary perform calculations to provide for banding, if appropriate. o The QJSA notice should be modified to reflect the relative value comparison and other required information. o The IRS is considering issuing guidance under Code section 411(d)(6) that would give plan sponsors additional flexibility to modify optional forms of benefit, potentially simplifying compliance with the relative value regulations. Until any This article is for informational purposes and is not intended to constitute legal advise. 4

5 guidance is issued, however, plan sponsors will generally need to prepare for compliance with the relative value regulations based on their existing forms of benefit. Retroactive Annuity Starting Date Regulations This summer, the IRS finalized regulations under Code section 417(a)(7) regarding plans that permit benefits to commence with annuity starting dates ( ASDs ) that occur before the QJSA notice is provided, referred to as retroactive annuity starting dates ( RASDs ). The regulations are effective January 1, Among other things, these rules require that interest must be paid on back payments in RASD situations and that participants and spouses must affirmatively consent to the RASD. On their face, the statute and regulations appear to be directed at plans that specifically permit a participant to elect an ASD that is in the past (i.e., a participant could make an election on June 1, 2004 to commence a pension with an ASD of January 1, 2004). However, the regulations define an RASD in a way that actually affects many, if not all, pension plans. As noted above, an RASD is defined as any ASD occurring before the QJSA notice is provided. Therefore, these two common scenarios would be considered RASDs subject to the requirements of the regulations: Plan allows participant to call and request benefit commencement up until the day or week before the requested ASD despite the fact that, in these situations, the plan is not able to provide the QJSA notice before the ASD (i.e., participant calls on September 28, 2004 to request a pension with an ASD of October 1, 2004, and the plan provides the QJSA notice on October 2, 2004). Plan provides for pensions to commence at age 65 with no ability for terminated, vested participants to elect a late (i.e. post-65) ASD, and the participant is missing or otherwise fails to elect to have benefits commence at age 65. In these situations, a plan would need to satisfy the requirements of the RASD regulations, including paying interest on back payments and obtaining participant and spousal consent to the RASD. Procedures and notices would need to be modified to accomplish this, and certain plan amendments would likely be necessary. Alternatively, it may be possible in some situations to make plan design changes (including appropriate plan amendments) to avoid the RASD scenarios entirely. Given the January 1, 2004 effective date of the RASD regulations, plan sponsors who have not considered these issues should do so promptly to be sure they are in compliance with the regulations for any RASDs occurring in This article is for informational purposes and is not intended to constitute legal advise. 5

6 !!! Please contact any of the following members of our Employee Benefits and Executive Compensation practice if you have questions concerning the relative value regulations or the retroactive annuity starting date regulations. George H. Bostick Adam B. Cohen Ian A. Herbert David J. Kritz Carol T. McClarnon Alice Murtos Robert J. Neis W. Mark Smith William J. Walderman Carol A. Weiser Walter H. Wingfield This article is for informational purposes and is not intended to constitute legal advise. 6