[author: Veronica A. Silva]

The Internal Revenue Service and the Treasury Department recently released new guidance that aims to increase the availability of annuities and other lifetime income options as forms of payment under defined contribution and defined benefit retirement plans. The guidance was issued to encourage plan sponsors to offer these lifetime income options in addition to lump sum payments that are particularly prevalent in defined contribution plans. The guidance is also aimed at helping with the issue of many retirees either outliving or underutilizing their retirement savings. This alert briefly describes these changes.

Defined Contribution Plans

Applying Survivor Annuity Rules to Deferred Annuity Contracts – Revenue Ruling 2012-3 deals with the application of the spousal consent rules (qualified joint and survivor annuity or “QJSA” and qualified pre-retirement survivor annuity or “QPSA”) to a defined contribution plan that offers a deferred annuity contract as investment option which is accounted for separately from other investment options offered under the plan. Although spousal consent does not come into play for purposes of the purchase of the deferred annuity contract, the ruling clarifies how the QJSA and QPSA rules apply once the participant has invested in the deferred annuity contract by using three scenarios distinguished by the features of the particular deferred annuity contract. In all three examples, the portion of a participant’s account balance which is invested in options other than the deferred annuity is not subject to the spousal consent rules because the deferred annuity is accounted for separately from the rest of the individual’s account.

Qualified Longevity Annuities – The Treasury Department issued proposed regulations to address certain legal impediments to the offering of longevity annuities as a distribution option under a defined contribution plan. Longevity annuities provide retirees with a guaranteed stream of income for life beginning at an advanced age. Participants can purchase these types of annuities with a small portion of their account balance and therefore insure against outliving their retirement savings. Before these new regulations, offering longevity annuities inside a defined contribution plan would generally have violated the required minimum distribution (RMD) rules of Code Section 401(a)(9). The regulations tackle the limitations imposed by the RMD rules by creating qualified longevity annuity contracts (QLACs) and providing that amounts invested in QLACs are excluded for purposes of the RMD rules. In order to qualify as a QLAC, the longevity annuity must meet certain specific requirements, including premium limits, a commencement date of no later than age 85, a death benefit for surviving spouses, being explicitly designated as a QLAC, and not having a cash refund feature. The proposed regulations would apply to contracts purchased on or after the publication date of the final regulations.

Rollovers to Defined Benefit Plans – Revenue Ruling 2012-4 provides guidance to employers who are willing to allow rollovers from their defined contribution plans into their defined benefit plans (including cash balance plans) with the ultimate goal of giving participants the opportunity to purchase additional annuity benefits under the defined benefit plan. Although these kinds of rollovers were not specifically prohibited in the past, there was very little supporting guidance available. The lack of specific guidance acted as a deterrent for allowing these types of rollovers. The guidance uses a model defined contribution plan to which joint survivor annuity rules do not apply and which does not permit after-tax contributions. The annuity which becomes available under the defined benefit plan is the actuarial equivalent to the lump sum contribution rolled over from the defined contribution plan. In order to address issues raised by other defined benefit plan rules (e.g., Code Section 415(b) annual limit, Code Section 411(c) employee contributions being non-forfeitable), the IRS stated that the rollover does not violate such other rules if the defined benefit plan converts the rollover amount to an actuarially equivalent annuity by using the applicable interest rate and applicable mortality table under Code Section 417(e). Consequently, the benefit attributable to the rollover amount is treated as non-forfeitable and would not count toward the annual benefit limit under Code Section 415(b). The ruling applies prospectively to rollovers that are made on or after January 1, 2013.

Defined Benefit Plans

Partial Annuities – The Treasury Department issued proposed regulations to encourage defined benefit plan participants to elect partial annuity options (in plans where partial annuities are available) rather than full lump sums. Until now, defined benefit plans that allowed partial annuity distributions were required to calculate the annuity and lump sum portions based on the interest rates and mortality assumptions of Code Section 417(e) (known as the “minimum present value requirement”) which was a significant administrative burden for these plans. To encourage plans to offer partial annuity options, the proposed regulations allow plans to calculate the annuity portion of the benefit with the plan’s own actuarial assumptions, which makes the annuity calculation considerably easier (the lump sum portion must still be calculated with the statutory assumptions, however). The proposed regulations apply only to those defined benefit plans that wish to allow partial annuity options. Plans that already permit partial annuity distributions need to be mindful of the anti-cutback provisions of the Code if they take advantage of the new provisions. Note that there are a number of unanswered questions with respect to these proposed regulations, and the final regulations may end up being significantly different as a result.

Plan Sponsor Considerations

Retirement plan sponsors are likely to welcome the new guidance because it provides more flexibility in the types of distribution options that can be offered to participants. However, the guidance on qualified longevity annuities and partial annuities is not yet final. Until final regulations are issued on these two topics, plan sponsors should consider how the new rules would apply to their particular plans and analyze whether the current distribution options offered under their plans should be broadened to include additional lifetime income options. Finally, plan sponsors will be wise to consult with counsel prior to implementing these new distribution options because any changes to their plan design may raise issues which they will find unanswered by the current guidance.