Talk of annuities within 401(k) plans is becoming more common, but employers remain reluctant to move full steam ahead despite new guidance from the Internal Revenue Service and Department of Treasury issued in February.
"The way I look at much of this guidance is that it almost whets your appetite for more," says Paul Hamburger, partner and head of the Washington, DC employee benefits, executive compensation and ERISA litigation practice center with Proskauer. "It's incomplete; it's the beginning of a dialogue."
The guidance contains four pieces altogether: two proposed regulations and two revenue rulings. The proposed regulations are subject to change until they're finalized, while the revenue rulings are a reflection of what the law is today.
"This is a great first step," says Jack Abraham, principal and benefits practice lead with PricewaterhouseCoopers.
In general, the guidance is designed to make it easier for 401(k) and defined benefit plan sponsors to offer annuity options within their plans. But there are still several administrative hurdles.
"People are skittish about it, so I wonder how much they'll really take advantage of it," says Hamburger. "You need to go into it with your eyes open and understand the regulatory hurdles that need to be addressed before you say to your vendor, 'Okay, this is a great idea. Let's start offering annuities.'"
In a nutshell, the guidance includes:
* Proposed regulations that exempt qualified longevity annuity contracts from current required minimum distribution rules.
* Proposed regulations to permit DB plans to distribute benefits as part lump sum and part annuity on more favorable terms than is now permitted.
* A revenue ruling that provides rules for obtaining annuity distributions for the rolled-over amounts from DC plans to DB plans.
* A revenue ruling that addresses how to apply the qualified joint and survivor annuity and qualified pre-retirement annuity rules to a profit-sharing plan that offers deferred annuities.
Longevity annuities
QLACs, or qualified longevity annuity contracts, are a type of longevity annuity that starts paying out at a predetermined age some time in the future. They're a way to protect against longevity risk, or the risk of outliving your savings. When an employee retires at age 65, for example, he could put a portion of his savings in a QLAC that would allow the money to grow, tax-deferred, and provide a large payout on a monthly basis when the former employee reaches age 85.
"It should be looked at as an insurance policy against living too long, which is the biggest problem employees without fixed-income annuities have in retirement," says Abraham.
One of the biggest challenges with longevity annuities is that people tend to underestimate their life expectancy and therefore don't think the products are right for them. But Abraham suggests "everyone who owns a house of relative value is going to buy fire coverage. The probability of a fire is virtually zero. The probability of hitting age 85 is about 50%. This is probably very good insurance."
Educational hurdles aside, the proposed regulations on QLACs present other issues as well. Under current retirement plan regulations, retirees must begin taking their money out by age 701/2. The proposed regulations say that the portion of money in a QLAC would not be subject to the 701/2 rule.
"The immediate concern for many plan administrators will be, 'How do I find that person 20 years from now? What if 20 years from now I've sold the company?'" says Hamburger. "Lots of things can happen in 20 years with this money sitting in an annuity contract in the plan. How exactly are plan administrators going to deal with that?"
The response to that concern, he continues, is to distribute the annuity contract at the same time as you give the employee their balance. Then it's a distribution. But that option also has unknown implications. "Will the annuities be able to be managed that way?" says Hamburger. "Will that have tax consequences? Will they be rolled over into an IRA?"
A hidden issue with QLACs that plan administrators might not think of involves domestic partners. Many plans today cover domestic partners as primary beneficiaries. Federal law, meanwhile, doesn't recognize same-sex domestic partners as spouses.
"What happens if the retiree dies between the time he leaves the company at, say, age 60 and the time the payout starts at age 80?" says Hamburger. "The guidance provides a different answer depending on whether the beneficiary is a spouse - which for the purposes of federal law means opposite-sex spouse - or a nonspouse designated beneficiary, which would include children but also same-sex domestic partners. And it's a less advantageous rule for nonspouses."
Part lump sum, part annuity
The second piece of proposed regulations makes it easier for retirees to split their pension and get a partial lump sum and a partial annuity out of the same DB plan. "Today, theoretically, you can do that, but it becomes a difficult actuarial calculation and that discourages plans from offering it," says Hamburger. "The [new] rules would say, 'We will allow you to use simplified actuarial assumptions to calculate that broken-off piece.' That could be helpful."
In this case, though, the guidance doesn't address what might happen in a merger or acquisition. For example, Company A buys Company B. And Company B's plan has these features, but Company A doesn't want them. Can Company A get rid of them?
"At what point are these things distribution options as opposed to investment options that can be eliminated?" asks Hamburger. "And how can they be eliminated when they're in the plan? Because you may need to do that if you terminate a plan or merge two plans."
One of the revenue rulings allows employees to roll over part of their DC accounts into the employer's DB plan, assuming one still exists. For employees, this means a couple of things. "One, they can retire earlier than they might have otherwise thought because their guaranteed payment might be bigger than what they'd planned for," explains Abraham. "Two, generally those annuities are going to be less expensive than the insurance company annuities."
And while Abraham believes this process can be structured so it doesn't create additional risks for the employer, Hamburger cautions: "If you use more favorable factors than what the IRS told you to use and that yields an annuity amount that is bigger than what would have been provided by the IRS factors, that additional piece of the annuity will be treated as a benefit increase and will be subject to all the regulatory testing rules that apply."
If, on the other hand, "you are less favorable, so that the annuity is smaller than what the law would otherwise require, you've disqualified the plan," he says. "You can't do too much, and you can't do too little. You've got to do just the right amount if you want to do this effectively."
Spousal consent rules
The second revenue ruling facilitates the purchase of annuities within 401(k) plans that start at retirement "so we don't run into that 701/2 rule, because this one would be designed to pay out an earlier age," explains Hamburger.
Ordinarily, offering annuities in 401(k) plans subjects the entire plan to spousal consent rules, which is a deterrent to offering annuity products in DC plans. This ruling, though, gives employers three different ways these products can be structured so that only the portion of the account invested in the annuity is subject to the spousal consent rules.
"If you treat it as an investment, where people can move their money in and out of the annuity, then it wouldn't be subject to the spousal consent rules because it would be treated as another form of investment," says Hamburger. "The downside to that is the annuity may not be as good because the liquidity will dampen the ability of the annuity provider to give you favorable rates."
For annuities to gain widespread acceptance, employers will have to embrace the concept and invest the time and money to get the infrastructure in place. Whether they will do so remains to be seen.
"From the employer's perspective, they may not see the benefit of investing the time and money in this space," says Abraham. "However, there's been a huge hidden cost of moving away from guarantees, moving away from DB plans, and that is that participants tend to stay longer than their useful years."
Treasury factsheet: Expanding lifetime income choices
To accompany the recent guidance on annuities, the Treasury Department issued a factsheet, Helping American Families Achieve Retirement Security by Expanding Lifetime Income Choices. Here is an excerpt:"[O]ver time the use of annuities and other lifetime income in retirement plans has been diminishing. Unfortunately, defined benefit pension plans, a traditional source of low-cost lifetime income, have declined; and defined benefit plans have increasingly offered and made single-sum (or lump sum) cash payments, either by adding a lump-sum option to the plan's payout choices or by converting the plan to a hybrid, lump-sum-oriented format. ... In short, although the term 'pension' traditionally has referred to a regular stream of income guaranteed for life, the nation's private pension system has been steadily shifting away from lifetime retirement income payments to single-sum cash payments. To help address these issues, the Treasury and Labor Departments have undertaken an initiative to give employees and employers more options for putting the "pension" back in our private pension system. The initiative has included a joint request for information from the public regarding the desirability and availability of lifetime income alternatives in retirement plans. The joint RFI elicited nearly 800 written comments from a wide range of organizations and individuals. Many comments suggested that the Departments encourage broader availability of secure and attractive retirement income options. The Departments then held a two-day public hearing to learn more, including about whether current rules or regulations present any unnecessary impediments to plan sponsors and participants who might choose retirement income.After reviewing the comments, Treasury and the Internal Revenue Service are releasing an initial package of proposed regulations and rulings intended to remove impediments and otherwise ease the offering of lifetime income choices that can help retirees manage their savings.[This] administrative guidance is only a first step in clearing the way for better and more accessible retirement income options; it does not attempt to address all of the issues raised by public comments in response to the joint RFI. However, it is a meaningful first step - reducing regulatory barriers in order to increase interest in lifetime income, encourage innovation among stakeholders, and expand choices for individuals with a view to promoting greater retirement security for American families."
