Publications

Additional Lifetime Income Guidance

Author, Emily Meyer, New York, +1 212 556 2312, emeyer@kslaw.com.

Earlier this year, the Treasury Department issued proposed rules and two revenue rulings intended to encourage employers to incorporate more “lifetime income” distribution options into their retirement plans.  The proposed rules would simplify the calculation of benefit distributions from defined benefit plans that have both lump sum and annuity components and would exempt certain deferred annuities from required minimum distribution (“RMD”) requirements.  The revenue rulings establish rules for obtaining spousal consents with respect to deferred annuity contracts and converting distributions from defined contribution plans (“DC plans”) to defined benefit plan (“DB plan”) annuities.

Background

The guidance, which is a follow-up to the Request for Information (“RFI”) that the Internal Revenue Service (“IRS”) and the Department of Labor (“DOL”) released in 2010, is a clear indication that expanding the availability and popularity of lifetime income options remains a priority of the IRS and Treasury.  (A Compensation and Benefits Insights article discussing the RFI is available here.) The guidance is only a small step in that direction, however, as the exemptions in the proposed regulations are limited and the holdings in the revenue rulings are narrow.

Simplifying Calculation of Bifurcated Benefit Distributions

The guidance included proposed regulations amending the DB plan distribution rules to simplify the calculation of distributions that are part lump sum and part annuity, known as “bifurcated benefit” or “partial annuity” distributions.  According to the preamble, current regulations require that both the lump sum and annuity portions of such a distribution must meet the minimum present value requirements applicable to lump sum distributions.  (Under the DB plan rules, the present value of the amount of any DB plan distribution, other than distributions in the form of certain annuities, must not be less than the present value of the accrued benefit calculated using the applicable mortality table and interest rate specified under Code Section 417(e).)  The proposed regulations would allow a plan to treat the two portions of a bifurcated benefit distribution as two separate optional forms of benefit, such that the annuity portion could be calculated using the plan’s regular conversion factors (assuming the form of the annuity is not subject to the minimum present value assumptions).  Only the lump sum portion would have to be calculated using the more complicated minimum present value assumptions.

The problem with the proposed regulations is that many plans that offer bifurcated benefit distribution options already calculate them according to the simplified method outlined in the proposed regulations.  Given that the proposed regulations are not effective until finalized, the task of calculating bifurcated benefit distributions has been complicated rather than simplified in the short term.  Furthermore, if the regulations are finalized as proposed, they will apply Code Section 411(d)(6) protection to bifurcated distributions, which means that the more generous minimum present value requirements will still apply to the annuity portion of the benefit accrued before the date the plan adopted the simpler calculation method.  As a result, plan sponsors will not be able to take full advantage of the simpler calculation method immediately.

Longevity Insurance Exempt from RMD Requirements

Under the RMD requirements, distribution of each participant’s entire interest must begin by the required beginning date, which is generally April 1 of the calendar year following the year in which the individual reaches age 70½ or retires, whichever occurs later.  The guidance includes proposed regulations creating an exemption from the RMD requirements for certain annuity contracts purchased through DC plan accounts or traditional IRAs.

Under current regulations, an annuity contract must be annuitized (i.e., in pay status) before its value is excluded from the account balance used to determine a participant’s RMD.  As a result, RMD distributions may be required based on the value of a deferred annuity contract even before annuity payments commence under the contract.  According to the preamble to the proposed regulations, the IRS and Treasury were concerned that the existing RMD rules would discourage participants from purchasing deferred annuities that begin at an advanced age (known as “longevity annuities” or “longevity insurance").

If finalized, the proposed regulations would establish a category of annuity, the “qualifying longevity annuity contract” (“QLAC”), which would be excluded from the account balance used to determine RMDs prior to the commencement of payments under the QLAC.  A QLAC must have a fixed starting date no later than the first day or the month coincident with or next following the participant’s attainment of age 85 and premiums that do not exceed the lesser of a specific dollar or percentage limitation.  The dollar limitation is $100,000, less any premiums previously paid by the employee for the QLAC.  The percentage limitation is 25% of the employee’s account balance under the DC plan or IRA at the time the QLAC is purchased, less previously paid premiums.

The only survivor benefits that may be paid from a QLAC are 1) a life annuity to the surviving spouse that does not exceed the payments made before the participant’s death (unless the qualified pre-retirement survivor annuity (“QPSA”) rules result in a higher payment), or 2) a life annuity payable to a designated beneficiary that does not exceed the applicable percentage, determined under one of two alternative tables, of the payments made before the participant’s death.

The purpose of a QLAC is to provide a predictable stream of retirement income.  Accordingly, a variable annuity contract, equity-indexed contract or similar contract that could result in variable annuity payments cannot be a QLAC.  Similarly, a QLAC may not have a commutation benefit, cash surrender value or other similar feature.

QLAC issuers would be required to provide the annuitant an initial report containing basic information about the QLAC and to submit an annual form to the IRS (with a copy to the annuitant).

The potential impact of the proposed regulations is hard to predict.  Longevity annuities have been increasing in popularity, but the QLACs’ relatively low premium limitation may limit participants’ interest.  Further, the reporting and disclosure requirements may discourage issuers from entering the QLAC market.  Even if the final regulations loosen some of the restrictions on QLACs, plan sponsors may be reluctant to offer them, given that longevity annuities present them with a number of unresolved administrative and fiduciary issues.  For example, it is not clear how longevity annuity products should be benchmarked or how switching from one group annuity provider to another should be handled.  Also, the Department of Labor (“DOL”) did not design its safe harbor method for the selection of annuity providers with longevity annuity products in mind.

QJSA and QPSA Requirements for Deferred Annuities

Revenue Ruling 2012-3 provides guidance on how a defined contribution plan such as a 401(k) plan may satisfy the spousal consent requirements with respect to deferred annuity contracts purchased prior to retirement.  If a defined contribution plan is required to obtain spousal consent, the ruling clarifies that the time at which plan sponsors must obtain spousal consent depends on when the annuity form of benefit payable under the deferral annuity contract becomes irrevocable.  The date on which the annuity form becomes irrevocable is the date on which an annuity form of benefit is considered to have been elected (and the date on which the contract is subject to the QPSA and qualified joint and survivor annuity (“QJSA”) rules).  Therefore, if the participant may not transfer amounts out of the contract or elect a lump sum instead of an annuity, the contract is subject to the QPSA/QJSA requirements beginning with the participant’s first investment in the contract.  (As long as the plan separately accounts for the deferred annuity contract, the remainder of the participant’s account balance may remain free of the QPSA/QJSA requirements.)  If the annuity is revocable until the annuity starting date, spousal consent may be obtained just before the annuity is scheduled to begin.

The deferred annuity contract in the ruling provides that if the participant dies before the annuity starting date, the surviving spouse is entitled to a death benefit equal to the nonforfeitable accrued benefit under the contract.  The ruling does not address what rules apply when the surviving spouse is entitled to a lesser death benefit.  The ruling also does not clarify whether and when deferred annuity contracts are exempt from the minimum present value requirements of Code Section 417(e).

Conversion of DC Plan Distributions to DB Plan Annuities

In an attempt to encourage employers that sponsor both DC and DB plans to give DC participants access to DB plans’ lower annuity purchase rates, Revenue Ruling 2012-4 establishes conditions under which a DB plan may accept a direct rollover of an eligible rollover distribution from a DC plan for the purposes of providing an additional annuity under the DB plan.  The basic ruling is simple:  The DC plan rollover amount must be converted to an annuity under the DB plan using the Code Section 417(e) interest rate and mortality table and must be credited with interest at 120% of the federal mid-term rate during the period (if any) between the date of the direct rollover and the annuity starting date.  (If the annuity is calculated using more favorable actuarial assumptions, the resulting excess benefit is treated as an employer provided benefit in the DB plan and must be taken into account in satisfying the annual benefit limits under the DB plan.)

The DB plan must have an adjusted funding target attainment percentage (“AFTAP”) of at least 60 percent for the entire year that includes the date of the rollover.

Although the ruling’s effective date is January 1, 2012, plan sponsors may rely on its holdings with respect to rollovers made prior to that date.

Future Guidance

The guidance is a modest step toward increasing access to and election of annuity options—the exemptions in the proposed regulations are limited and the holdings in the revenue rulings are narrow.  The guidance also left many annuity-related issues unaddressed.  Plan sponsors that wish to expand the annuity options must contend with a number of administrative and fiduciary issues.  For example, they must determine how to apply the plan asset and nondiscrimination rules and how to properly select annuity providers and benchmark deferred annuity options.  They must also deal with the logistical issues associated with changing contract providers and locating missing participants. 

Future guidance may solve some of these issues.  According to the “Treasury Fact Sheet” released with the guidance, it is “only a first step” that “does not attempt to address all of the issues raised by public comments in response to the joint RFI,” and further guidance from the IRS and the DOL may be expected “later this year.” This planned guidance may take the form of a new mandate rather than a clarification of existing rules, however.  DOL Assistant Secretary Phyllis Borzi has hinted that the DOL is poised to issue some sort of lifetime income disclosure requirement (under which DC plans would issue statements converting participants’ accrued benefits to a lifetime income stream of payments).  Also, the outcome of the upcoming presidential election may affect the degree to which lifetime income remains a regulatory priority.

King & Spalding would be pleased to assist you in analyzing whether this new guidance is helpful for your plans.

Additional Lifetime Income Guidance

Author, Laura Westfall, New York, +1 212 556 2263, lwestfall@kslaw.com.

On May 30, 2012, the Internal Revenue Service (the “IRS”) issued proposed regulations clarifying what constitutes a “substantial risk of forfeiture” for purposes of the timing of income related to property transferred in connection with the performance of services under Section 83 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”) (the “Proposed Regulations”) and certain other requirements.

Substantial risk of forfeiture  

Code Section 83 sets forth the rules for the taxation of property that is transferred to an employee or other service provider in connection with the performance of services (such as grants of restricted stock and transfers of stock upon the exercise of an option or under a restricted stock unit award). If property is transferred to an employee (or other service provider) in connection with his or her performance of services, the employee recognizes income when the property is no longer subject to a “substantial risk of forfeiture,” or when the employee can freely transfer the property, if earlier.  Section 1.83–3(c)(1) of the existing regulations provides that a “substantial risk of forfeiture” exists where rights in property are conditioned, directly or indirectly, upon either (i) the future performance (or refraining from performance) of substantial services by any person (a “service-based condition”), or (ii) the occurrence of a “condition related to a purpose of the transfer” (where the possibility of forfeiture is substantial if such condition is not satisfied). 

The Proposed Regulations provide that a substantial risk of forfeiture may be established only through a “service-based restriction” or a “condition related to the purpose of the transfer.” The IRS indicated in the preamble to the Proposed Regulations (the “Preamble”) that this change is intended to clarify that no other conditions (such as transfer restrictions) may be treated as a substantial risk of forfeiture that would delay taxation under Code Section 83.

INSIGHT: This amendment would make Code Section 83’s definition of “substantial risk of forfeiture” more similar to the definition of that phrase for purposes of Code Section 409A. Under Code Section 409A, a “substantial risk of forfeiture” exists where “entitlement to an amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial.”  However, unlike the Section 83 regulations, the Section 409A regulations expressly provide that refraining from performing services (for example, a non-competition agreement) is not a substantial risk of forfeiture.  26 C.F.R. §1.409A-1(d)(1).

The Proposed Regulations also clarify that in determining whether a “substantial risk of forfeiture” exists based on a “condition related to the purpose of the transfer,” both (i) the likelihood that the forfeiture event will occur and (ii) the likelihood that the forfeiture condition will be enforced must be considered, at the time the arrangement is established. The Preamble provides the example of a plan under which stock transferred to an employee would be forfeited if gross receipts of the employer fell by 90% over the next three years, but where there was no indication based on the employer’s past profitability that such a drop in profits would occur.  The IRS stated that no “substantial risk of forfeiture” would exist for purposes of Code Section 83 because it was extremely unlikely that the forfeiture condition (decline of gross receipts by 90%) would occur.

INSIGHT: Given the emphasis placed by the IRS in the Proposed Regulations on the requirement that an employer consider both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced at the time an arrangement is established, an employer may want to document its decision-making process when establishing the arrangement, to show that both likelihoods were taken into consideration.

Restrictions on Stock Transfers  

As stated above, the general rule under Code Section 83 is that a person recognizes income related to property transferred in connection with the performance of services when the property is no longer subject to a “substantial risk of forfeiture,” or when the person can freely transfer the property, if earlier. However, where a sale of property at a profit could subject a person to suit under Section 16(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), Code Section 83(c)(3) provides that such person’s rights in such property are treated as subject to a substantial risk of forfeiture and as not transferable (and, therefore, such person does not recognize income during that period). Further, Section 1.83–3(j) of the existing Treasury Regulations provides that if the sale of property at a profit within 6 months after its purchase could subject a person to suit under Section 16(b) of the Exchange Act, such person’s rights in the property are treated as subject to a substantial risk of forfeiture and as not transferable until the earlier of (i) the expiration of such 6-month period, or (ii) the first day on which the sale of such property at a profit will not subject the person to suit under Section 16(b) of the Exchange Act.

In IRS Revenue Ruling 2005-48, the IRS provided guidance on Code Section 83(c)(3), holding that Section 16(b) of the Exchange Act is the only provision of the U.S. securities law that would delay taxation under Code Section 83. The Proposed Regulations incorporate the holding of that Revenue Ruling, by adding an example to the existing Treasury Regulations illustrating this limitation.

INSIGHT: The Proposed Regulations reiterate the IRS’s long-held view, stated in Revenue Ruling 2005-48, that other transfer restrictions under U.S. securities law, such as insider trading restrictions under Rule 10b-5 of the Exchange Act or lock-up provisions after an initial public offering, will not delay taxation under Code Section 83.

Effective Date

The Proposed Regulations, if finalized as proposed, will apply to transfers of property made on or after January 1, 2013. Comments on the Proposed Regulations must be submitted to the IRS by August 28, 2012.

As always, King & Spalding is happy to assist employers and employees in understanding the impact of the Proposed Regulations (and Code Section 83 in general) on their equity compensation programs. Feel free to contact any member of our Executive Compensation and Employee Benefits Practice with your questions.

Upcoming Filing and Notice Deadlines for Qualified Retirement and Health and Welfare Plans

The table below sets forth key filing and notice deadlines common to calendar year retirement and health and welfare plans for July and August. Please note that the deadlines will be different if your plan year is not the calendar year. For a look at the key filing and notice deadlines for the entire year, please see the March edition of the K&S Compensation and Benefits Insights.

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