(From the December 17, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
Congressional Research Service Anticipates PPA Changes to Result in Reduced Lump-Sum Distribution Amounts After 2007
The Congressional Research Service reports that changes made by the Pension Protection Act are expected to result in reduced lump-sum distribution amounts from defined benefit pension plans after 2007, with younger participants experiencing greater reductions than older participants. The reduction is expected to be relatively small for 2008, but will increase as the new corporate bond yield curve rates used to calculate lump-sum values are phased in from 2008 to 2012. CRS Report for Congress, "Lump-Sum Distributions Under the Pension Protection Act" (December 3, 2007).
PPA Changes Affecting Lump Sum Distribution Amounts
Congressional Research Service ("CRS"), which provides policy and legal analysis to the House and Senate, summarized key changes under the Pension Protection Act ("PPA") which are scheduled to become effective in 2008 and which will impact the value of lump sum distributions from defined benefit pension plans. Broadly, the minimum lump-sum value will be calculated using a new mortality table that reflects increased life expectancy, and using a new interest rate based on corporate bonds that is anticipated to produce a higher interest rate than the existing 30-year Treasury bond rate. CRS concluded that the overall effect of these changes will depend on the participant's age, eligibility for an immediate annuity or a deferred annuity, and the difference between the Treasury bond and the corporate bond interest rate. Generally, however, the lump sum value will be smaller under the PPA changes, and younger participants will experience a greater reduction in value than older participants.
Although a plan can provide lump-sum values that are greater than the minimum (e.g., by electing to use a lower interest rate), PPA considers such higher lump sums to be a subsidy whose cost must be taken into account in calculating the plan's liabilities and funding requirements. CRS cites outside sources who have estimated "a one-time increase in plan liabilities of about 5 percent" if a plan continues to use the existing Treasury bond interest rate to determine lump sum values.
New Corporate Bond Interest Rate
PPA requires plans to use rates that will be derived from a three-segment "yield curve" of investment-grade corporate bonds. The corporate bond interest rate will be based on the date the annuity would otherwise be payable -- with the portion of the annuity payable within 5 years valued using a short-term corporate interest rate (the 1st segment), the portion payable in 6 to 20 years valued using a medium-term interest rate (the 2nd segment), and the portion payable in more than 20 years valued using a long-term interest rate (the 3rd segment). Use of this new corporate bond rate will be phased in over 5 years. To accomplish this phase-in, for 2008 the corporate bond rate will be weighted at 20 percent and the Treasury bond rate at 80 percent. Following that, the corporate bond rate will be weighted at 40 percent for 2009, 60 percent for 2010, 80 percent for 2011, and fully phased-in at 100 percent for 2012 and later years.
PPA Impact on Lump-Sum Values
CRS estimates that changes in the mortality table will increase the lump-sum value by 1-2 percent, depending on the age of the recipient. However, replacing the Treasury bond interest rate with a corporate bond interest rate is expected to reduce the lump-sum value, although the effect of this change will be mitigated during the phase-in period from 2008 through 2011.
CRS generated the following comparison of pre- and post-PPA lump-sum values, where each of three participants, aged 65, 60 and 55, is entitled to an immediate annuity of $12,000 pe r year:
Present Value of an Immediate Annuity of $12,000 per Year
The Table shows that the effect of the PPA changes on lump sums paid in 2008 is likely to be relatively small. An individual eligible for an immediate annuity of $12,000 at age 65 is likely to see the lump sum reduced by less than 1 percent, and individuals eligible at age 60 or 55 will see their lump sum value reduced by less than 2 percent. However, if the PPA interest rates were fully in effect for 2008, the difference would be greater. Individuals at age 65 would be likely to see their lump sums reduced by about 9 percent, and those at age 55 would see their lump sums reduced by about 12 percent.
1Calculation is based upon the pre-PPA mortality table and the October 2007 Treasury bond interest rate of 4.77%.
2Calculation is based upon the PPA mortality table and the weighted average of the Treasury bond interest rate and the three segments of the corporate bond yield curve.
3Calculation is based on the PPA mortality table and the three segments of the corporate bond yield curve as if the corporate bond interest rates were fully in effect for 2008.
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