Frozen DB wants to add lump sum feature - 63% AFTAP

[Dennis Povloski]

A defined benefit plan that was frozen in 2001 currently doesn't have a lump sum feature. The AFTAP is 63%. I seem to recall that there is an exception to the restriction on paying out lump sums under 436 if the plan was frozen before 2005.

If that's true, can this plan be amended to add a lump sum optional form, and then start paying out lump sums?

Or would that somehow be considered an amendment increasing benefits and therefore not permitted?

Any other ways something like this could blow up?

Thanks!

[Andy the Actuary]

The final 436 reg. provides:

C. Limitations on Plan Amendments Increasing Plan Liabilities

In accordance with section 436©, the regulations provide that a plan satisfies the limitation on plan amendments increasing liability for benefits only if the plan provides that no amendment to
the plan that has the effect of increasing liabilities of the plan by reason of increases in benefits, establishment of new benefits, changing the rate of benefit accrual, or changing the rate at which benefits become nonforfeitable is permitted to take effect if the AFTAP for the plan year is less than 80 percent (or
is 80 percent or more but would be less than 80 percent if the AFTAP were redetermined taking into account the benefits attributable to the amendment).

It would seem that the spirit of "establishment of new benefits" would override the exemption that was granted to plans frozen September 1, 2005, but a "Gray Book" may address this more definitively.

[My 2 cents]

Question 17 from the 2014 Gray Book (informal guidance from IRS personnel speaking for themselves and not for the IRS) says, first, that adding a lump sum option to a plan frozen before September 1, 2005 would not cost the plan the exemption from most of the requirements of IRC Section 436 because adding a benefit payment option would not be considered an accrual.

The second point in the answer to Question 17 says that the amendment adding the lump sum option would be treated as a benefit increase due to a plan amendment under Section 436 if it increases the Funding Target. Two things to note here:

1. While most of Section 436's restrictions are not applicable with respect to a plan frozen before the magic date of September 1, 2005 (and it is noted above that the plan would not lose its exemption due to the adoption of an amendment only adding a lump sum option), a frozen plan would not be exempt from the provision in Section 436 concerning plan amendments increasing the Funding Target. So if the amendment adding the lump sum option to the plan (already only 63% funded) increased the Funding Target, you would need a special Section 436 contribution for it to become effective.

2. In assessing whether an amendment adding a lump sum option raises the Funding Target (and if so, by how much), remember that the anticipated amount of each expected lump sum (if based only on 417(e) rates) for purposes of calculating the Funding Target must be measured using unisex mortality under 417(e) and the same segment rates/yield curve as are used for purposes of Section 430 minimum funding (the IRS "substitution rule"). That is, notwithstanding the fact that a plan being funded based on HATFA rates will have to pay lump sums much larger than the participant's share of the Funding Target, the impact on the Funding Target prior to the making of actual lump sum payments will be minimal since all expected future lump sums (including those expected to be paid in the current plan year, where the actual Section 417(e) segment rates are already known) will be calculated assuming that the Section 417(e) rates are the current HATFA rates. Of course, if the plan is to provide lump sums based on a comparison between the 417(e) rates and some other basis, this would not necessarily be true.

Please do keep in mind the fact that the IRS is not bound by the Gray Book, but it appears from the answer there that the plan could be amended to permit lump sums and not be required to restrict the payment of lump sums. Of course, lots of lump sums would tend to raise the minimum funding from year to year (but probably would not have a major impact on the PBGC premium, since the PBGC segment rates are actually not that different from the 417(e) segment rates). Watch out also to make sure that if adding the option, the likely reduction in the AFTAP in future years would not violate any loan covenants that may be in force. Falling below 60%, if prohibited under an existing covenant, could adversely affect the sponsor more than having to make larger contributions to the plan.

[Dennis Povloski]

That's the piece I was missing. Thanks all!

[david rigby]

"...the impact on the Funding Target prior to the making of actual lump sum payments will be minimal..."

With respect to the orginal question, this is the essential information.

However, that may overlook the larger question: is this a good thing to do?

As discussed, it will lead to a funding loss, and corresponding amortization.

It could also affect the audit requirement.

Discuss these issues with your EA.

[My 2 cents]

"...the impact on the Funding Target prior to the making of actual lump sum payments will be minimal..."

With respect to the orginal question, this is the essential information.

However, that may overlook the larger question: is this a good thing to do?

As discussed, it will lead to a funding loss, and corresponding amortization.

It could also affect the audit requirement.

Discuss these issues with your EA.

If an ongoing plan permits lump sums at retirement, then if/when it terminates, all participants not in pay status with benefits worth more than $5,000 have the absolute right, without regard to the cost to the sponsor, to elect deferred annuities that must also permit lump sums when those people reach retirement age. It is even worse when the plan permits lump sums at any time after termination of employment. The annuities have to permit that, and boy, do insurance companies charge extra for a right like that (assuming that they are even willing to offer such annuities)! Is it not the current view that any such annuities must determine lump sum amounts based on whatever the 417(e) rates may be on the date of payment, even if years after the plan termination?

That could be where "something like this could blow up".

[david rigby]

BTW, what is the goal? If the ER wants to offer a temporary window with a lump sum option, that can be done without making it a permanent feature of the plan.

As before, discuss with your EA.

[Dennis Povloski]

The plan sponsor read an article about whether or not an employee should take the lump sum if offered one. So we were discussing some pros and cons (the biggest being that if he paid out lump sums, his funded status would go down the toilet). The article was written in a way that made it sound like employers were offering lump sums to save a buck and provide employees with a less valuable retirement benefit, so the author made it sound like the annuity was generally the way to go from the employees perspective.

In the end, even if they could offer lump sums, it wouldn't make sense for this particular plan to drain it's investments to pay them out.