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Section 415: Take it to the Limit One More Time 2006 Conference of Consulting Actuaries Annual Meeting Session #53

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### Section 415: Take it to the Limit One More Time2006 Conference of Consulting Actuaries Annual MeetingSession #53

Rick A. Block, ASA, MAAA, COPA

Scott A. Hittner, FSA

Agenda

- PPA provisions
- Prior pay
- Lump sums
- Other payments subject to 417(e)
- Miscellaneous
- Proposed 415 regulations
- 401(a)(17)
- Other pay issues
- Alternative forms and annuity starting dates
- De minimis benefits
- Multiple annuity starting dates
- 411 vs. 415-Who’s the winner?
- Miscellaneous

Pre-Participation Pay-PPA

- PPA amends 415 to recognize pay earned prior to an employee entering a plan or prior to the establishment of a plan
- Effective for years after December 31, 2005
- Reverses the position taken by Treasury in its 2005 proposed regulations which reversed Treasury’s position taken in the 1980 final regulations which ignored the plain language of the statute

Maximum Lump Sum Settlements under PPA

- For distributions after December 31, 2005 plans must use an interest rate that is the greater of:
- 5.5%
- The rate that provides a benefit of not more than 105 percent of the benefit that would be provided if the applicable interest rate (as defined in §417(e)(3)) were the interest rate assumption
- Rate defined under the plan

Maximum Lump Sum Settlements under PPA

- What is “the rate that provides a benefit of not more than 105 percent of the benefit that would be provided if the applicable interest rate (as defined in § 417(e)(3)) were the interest rate assumption?”
- Solve for the interest rate of the APR at the distribution date that is equal to 1.05 times the APR using the 417(e) interest rate.
- Don’t even think about determining the 415 limitation and maximum lump sum as a deferred annuity

Maximum Lump Sum Settlements under PPA – Example 1

- Jim has accrued the 415 limit in 2007 of $195,000. Jim is 62 as of the payment date. Payments are made annually.
- 417(e) rate is 6.25%
- Annual APR at 5% 94 GAR is 13.1383
- Annual APR at 6.25% is 11.8217
- Annual APR at 5.50% is 12.5808
- APR at 105% interest rate is 11.8217 x 1.05 = 12.4128
- Effective interest rate is the APR that is equal to 12.4128 which is 5.68111%-Why do we care?
- LSS is the annual benefit times the largest interest rate, which in this case is 105% interest rate
- Maximum LSS is $195,000 x 12.4128 = $2,420,496
- If we valued this benefit as a deferred annuity at age 65, the 105% interest rate is 5.79691%

Benefits Subject to 417(e)(3)

- Why do we care about the 105% rate? Because Jim has now read the SPD and wants his benefit in the form of a 5 year certain
- Under 5%, the annual payment is $563,572
- Under 5.5%, the annual payment is $544,545
- Under 5.68111%, the annual payment is $539,019
- We take the benefit at the largest interest rate whether or not that benefit is larger or smaller than others
- Is it possible to increase an annuity benefit subject to 417(e) with the use of the higher interest rate?

Interest Rates for Maximum Lump Sums (Age 65 APRs)

Rates determined at age 65 immediate monthly payment assumed

Maximum Lump Sums for 2006

- New interest rates take effect after December 31, 2005, queries:
- The law prior to PPA requires a plan to use the 417(e) rates or the rates under the plan
- What about distributions that used the 417(e) rate before PPA was signed?
- Does the answer change whether the distribution is on account of a plan termination?

Miscellaneous PPA Provisions

- Higher limits under EGTRRA made permanent
- Compensation limit not applicable for church plan NHCEs (effective after 12/31/2006)
- Special benefit limitations applicable to employees of police and fire departments of a State or political subdivision apply to tribal plans (effective immediately)

Proposed 415 Regulations

- Consolidation of all prior guidance on maximum benefits
- If finalized, would generally be effective for limitation years beginning on or after January 1, 2007
- Temporary grandfather — May 31, 2005
- Proposed Regulations did not afford post-5/31/2005 amendments grandfather treatment
- 5/31/2005 date will be replaced in final Regulations with a date no earlier than publication date (Notice 2005-87)

Proposed 415 Regulations

- Reliance permitted for rules on —
- Post-severance compensation
- Changes in form of payment for 401(a)(9)
- Corrective and clarifying changes in 457

401(a)(17) Application

- Pre-proposed Regulation interpretation
- The compensation limit under 401(a)(17) of the Code applies for purposes of nondiscrimination and benefit determinations only
- It does not apply for purposes of determining the 100% of pay 415 limit
- The 100% of pay limit applies at any age to any form, it is not increased for delayed commencement

401(a)(17) Application

- Proposed Regulation limits benefits to the lesser of:
- Age 65 dollar limit (actuarially decreased before age 62 and increased after age 65) and,
- High 3 year pay where each year is limited to the 401(a)(17) limit in that year
- Regulation adversely impacts older workers (age 58 when first eligible) in small businesses
- Interesting public policy basis — value of the 415 limitations decline after approximately age 68
- Exemptions
- Are pre-2007 accruals unrestricted?

401(a)(17) Application-LY 2006(*211,667 is the average of 205,000 210,000 and 220,000)Chart Assumes rules in effect for 2006 and Participant has 10 Years of Service/Participation

401(a)(17) Application Example 2

- Pat is age 70, Years of Participation-7, Years of Service-8, Pay is $300,000 for all years. 2006 determination date.
- Dollar limit: $255,344 x 7/10 = $178,741
- % limit: $211,667 x 8/10 = $169,333
- Benefit payable: $169,333

Compensation Issues

- Compensation paid while on active duty is generally included
- Severance and other post-employment pay
- Generally only amounts paid within 2½ months of termination are includible and only if the amounts would have been paid had employment continued
- Includes sick pay, accrued vacation, differential pay etc
- Excludes severance pay etc
- Commentators have asked for this pay to be optional and also for an allowance as to what limitation year they are included in

Compensation Issues

- Conclusion for 401(k) Plans
- Salary deferral elections are nullified as of the participant’s termination date

Adjustment for Alternative Forms

- Aggregate effect of interest and mortality (retains Rev. Rul. 98-1 approach as contrasted with literal translation of statute)
- Social Security Supplements — adjust
- Partial QJSA — no adjustment for QJSA part
- Fixed COLA — adjust

Adjustments for Alternative Annuity Starting Dates

- No mortality adjustment if no forfeiture
- No charge for QPSA — Must use treatment for both pre-62 and post-65
- Post-65 increases — restricted by plan factors for actuarial increase (if any)

De Minimis Benefit

- $10,000 may be paid in any form
- Phased over 10 years service
- Never participated in any DC plan maintained by employer
- Normal form must be least valuable form under the plan
- Or plan must limit the normal form such that the least valuable form does not violate the $10,000 limit

De Minimis Benefit

- Assume a $10,000 10 C&L benefit and an $11,000 life only benefit are actuarially equivalent
- Plan can provide a $10,000 benefit with 10C&L as the normal form
- Plan cannot permit an optional form of life only
- Paying $11,000 would violate 415
- Paying $10,000 as a life annuity would be an impermissible forfeiture under 411

De Minimis Benefit

- Plan could limit normal form benefit
- If max 10 C&L under the plan was $9090.90, the equivalent life only benefit would be $10,000 satisfying 415
- Clarifies long held IRS position that the $10,000 de minimus benefit cannot be paid as a lump sum
- Lump sum would be limited to the greater of $10,000 or the lump sum value of the 100% of pay limit
- If that result is less than the PVAB of the de minimus annuity, it is an impermissible forfeiture

Multiple Annuity Starting Dates

- Applies when there are more than one distribution which count against the 415 limit
- Examples
- Prior plans
- 401(a)(9) payments
- 415 COLA adjustments to benefits in pay status
- Rehires
- Payments to alternate payees
- Top 25 restrictions under 1.401(a)(4)-5
- Participants in multi-employer and single employer plans
- Lump sums to retirees at plan termination

Multiple Annuity Starting Dates

- The remaining 415 limit is equal to the total 415 limit reduced by the actuarial equivalent of the prior payments and the remains of the existing stream of payments
- The actuarial equivalent of the prior distributions is the greater of the amount determined using plan assumptions or the amount determined using statutory assumptions (Applicable mortality and 5% interest)

Multiple Annuity Starting Dates

- Change in form of benefit
- In situations where the form of benefit is changed 415 must be met as if the change in form constituted a second annuity starting date
- Entire benefit stream must also satisfy 415 as of the original Annuity Starting Date (with COLA adjustments)

Multiple Annuity Starting Dates

- 417(e) benefits-
- In determining the offset for a prior 417(e) distribution (i.e. a lump sun or installments)
- Revalue the annuity paid via the lump sum using the greater result of the plan rate for current distributions or the statutory rates
- Plan rate for current distributions includes current GATT rates
- As rates go up, a prior distribution will offset a smaller annuity…. As rates decline it will offset a larger distribution

Multiple Annuity Starting Dates

- Benefit determinations
- Because the offset from prior 417(e) distributions is dependent on current GATT rates, a participant’s benefit may change from year to year (or stability period to stability period)
- Remember…
- The offset is to the 415 limit ...not to the benefit

Multiple Annuity Starting Dates

- Benefit determinations
- In situations where a plan has a fixed actuarial equivalence interest rate, there is a double whammy, a whipsaw, when 417(e) rates were less than the plan’s interest rates
- Consider the following
- Kurt is age 55
- Kurt’s Accrued Benefit payable at age 65 is $100,000
- Plan interest 6%
- Gatt Interest 5%
- Both use 94 GAR Unisex

Multiple Annuity Starting DatesExample 3

- Consider the following
- Plan interest 6%
- 417(e) Interest 5%
- Both use 94 GAR Unisex
- 6% APR = 10.8658
- 5% APR = 11.7941
- Probability of surviving from age 55 to 65 = 0.940699
- Kurt’s Lump Sum at age 55 =
- $100,000 x 11.7941 / (1.0510) = $724,055

Multiple Annuity Starting DatesExample 3

- Minimum 415 reduction
- Plan rate equivalent of distribution
- $724,055 x (1.0610) / 10.8657 / 0.940699 =$126,859
- So the $100,000 accrued benefit will result in an offset of Kurt’s 415 limit by $126,859

Multiple Annuity Starting Dates

- Instances where 415 Limit does not actuarially increase
- 100% of pay limit
- Age 62 to 65 dollar limit
- In these cases a single Annuity Starting date provides larger benefits
- Suspension of benefit rules may be apply for periods in which the value of the income stream is the same or less than for a prior annuity starting date

Multiple Annuity Starting DatesExample 4

- 100% of pay limit
- Paul is a 5% owner has 415 average pay of $50,000
- Under 401(a)(9) he must commence taking payments
- Takes an annuity of $50,000 starting at age 70.
- Wants a lump sum at age 73
- Can Paul take a lump sum equal to the actuarial equivalent of $50,000 per year ???

Multiple Annuity Starting DatesExample 4

- 100% of pay limit
- Isn’t Paul’s lump sum equal to the commuted value of the $50,000 benefit?
- Under the Prop. Reg., Paul’s prior benefits are normalized to the second annuity starting date with interest and survivorship and offset the maximum benefit Paul may receive at his second annuity starting date
- Since the adjusted lump sum is less than the value of Paul’s annuity benefit, the Prop. Reg. contends the reduction is an impermissible forfeiture under 411
- Paul would have been better off not taking the 401(a)(9) payments and submitting the problem under VCP when he elects a lump sum

Multiple Annuity Starting DatesExample 5

- Age 62 to 65 dollar limit
- Assume Mike’s dollar limit is $180,000
- Assume no dollar limit COLAs
- Mike is age 62 and commences a $180,000 life annuity
- Plan terminates at age 65 and offers lump sum
- Can Mike get the lump sum?

Multiple Annuity Starting DatesExample 5

- Age 62 to 65 dollar limit
- NOOO!
- By the same reasoning the $180,000 limit must be reduced by the actuarial equivalent of the three distributions he already received
- The maximum lump sum will be less than the actuarial equivalent of a life annuity at 65 of $180,000
- This is less than Mike’s accrued benefit and would violate 411(a) to have an optional form of less than his accrued benefit

Multiple Annuity Starting DatesExample 6

- Larry retires in 2000 and takes an annual benefit of $20,000 starting at age 65. 415 pay is $25,000
- 5 years later, the employer would like to increase Larry’s benefit
- Post retirement COLAs brings his % limit to $31,481
- The accumulated value of the payments is $121,667 (5% 94GAR). The equivalent annual benefit is $11,353
- Larry’s benefit may be increased to $20,128 ($31,481 - $11,353)

Multiple Annuity Starting DatesExample 7

- Ed turns NRA (65) in 2000 and begins annual benefits of $20,000 because the plan does not provide for actuarial increases between ages 65 and 70. 415 pay is $25,000
- 5 years later, the employer would like to increase Ed’s benefit
- Because Ed did not retire there are no post retirement COLAs
- The accumulated value of the payments is $121,667 (5% 94GAR). The equivalent annual benefit is $11,353
- Ed’s benefit may not be increased because the second annuity starting date’s 415 limit is $13,647 ($25,000 - $11,353)

411(a) Issues

- 411(a) generally requires that the benefit payable in an optional form be equivalent to the accrued benefit
- Several places where the proposed regs point out a conflict between 411(a) and 415
- MASDs and $10,000 deminimis sections both point out areas where an optional form could cause a failure of 415 but eliminating or reducing the size of the optional form could cause a failure of 411(a)

411(a) Issues

- If 411 “trumps” 415 then if a plan’s actuarial equivalency is 5% 94 GAR that plan may NEVER offer a lump sum settlement that is limited by the PFEA/PPA interest rate of 5.5%

COLA Adjustments

- COLAs apply to both the dollar limit and the 100% of pay limit
- 100% of pay limit is adjusted by the ratio of the age 62 dollar limit for the prior year
- Adjustments to the 100% of pay limit only apply to years after separation from service

Timing of COLAs

- Surprising change of interpretation
- 415 COLAs are announced for limitation years ending within calendar years
- Proposed regulations provide that the COLA cannot be applied until January 1st regardless of the limitation year, i.e., benefits payments may not anticipate the increase until the January 1st payment

Timing of COLAs

- Surprising change of interpretation
- Assume the 2008 415(b) limit rises from $185,000 to $190,000
- Participant takes a lump sum benefit on December 15, 2007
- Plan’s limitation year ends on May 31st.
- Even though distribution is in the 2008 LY, it is not allowed to take into account the 2008 COLA
- Cannot give COLA to someone completely paid out in a prior limitation year who could not accrue more without the COLA

Plan Provisions

- Preclusion of violation in accrual, annual addition, or distribution
- Must satisfy rules for definite determinability
- Must specify coordination between plans
- Incorporation by reference
- Default governs unless plan states otherwise
- If no default on alternatives — must specify
- Former requirement — must specify

Miscellaneous

- Rollovers — 411(c) factors used
- Rules for transferred benefits
- Same controlled group — in transferee plan
- Predecessor — lump sum from transferor plan
- Corrections will be via EPCRS

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