Purchase of Service Credit

[Guest slt]

I am very confused about something. Does 415(n) allow me to use any funds at all to purchase service credit? For example, can I have a rollover to a DB plan and then use these funds to purchase service credit? When I read the conference report to EGTRRA, it intimates that only after-tax contributions could have been used in the past. Now it permits plan-to-plan transfers from 403(B) or 457 amounts. I am inclined to take a very conservative position and state that rollovers from an IRA or another qualified plan may NOT be used to purchase service credit. Of course, these amounts can be rolled over into the plan (but, of course, why would anyone in their right mind do that if it is a DB plan?), but just not used to purchase credit.

Does anyone agree with me? Disagree?

Thanks!

[MGB]

I agree with your interpretation. Only after-tax cash from the participant or a direct trustee-to-trustee transfer from 403(B)/457 (no rollovers) are allowed.

[joel]

An IRA is allowed to be rolled over to a 401(a) plan. If it is a DC plan then the amount rolled over is simply credited to the participants individual account. If it is a DB plan then to what use is the IRA put if not to purchase allowable prior service credits?

Additionally, 403b and 457 may be rolled over to 401(a) plans. But if the 403b/457 holder is desirous of using these accounts for the express purpose of purchasing allowable prior service credits from a governmental DB plan the transaction must be effectuated as a trustee-to-trustee transfer, not a rollover.

Peace,

Joel L. Frank

[Carol V. Calhoun]

If amounts can be rolled over to the DB plan, why could they not be used to purchase service credit? The only relevant statutory language dealing with purchases of service credit states that a transfer from a 403(B) or 457(B) to a DB plan can be used only for the purchase of service credit. But that language merely prohibits transfers from a 403(B)/457 plan to a qualified plan at a time when a distribution is not otherwise allowed, unless such transfer is for purposes of purchase of service credit. In my view, once you are entitled to a distribution (and thus a rollover) from a 401(a), 403(B), or goveernmental 457(B) plan to a defined benefit plan, the rollover can be used for the purchase of service credit if the DB plan so provides.

Section 415(n) deals with how after-tax contributions to purchase service credit will be treated for purposes of the limitations on contributions and benefits of sections 415(B) and ©. Before it existed, all after-tax contributions were subject to the section 415© limits on annual additions. In many instances, this prevented the purchase of service credit, because purchasing many years of service credit in one year would cause the amount of the purchase to be above the then-existing limits of 25% of compensation or $30,000. The effect of section 415(n) was to permit such purchases instead to be subject to the 415(B) limit on total benefits. Since that limit is not applied to each year's contributions, but to the total benefits payable, a purchase was less likely to cause a violation.

The section 415(n) definition of a purchase of service credit is cross-referenced in the new rules allowing for plan-to-plan transfers to purchase service credit at a time when a distribution is unavailable. However, since the 415(B) and © limits do not apply to rollovers (as opposed to transfers), section 415(n) does not apply to them.

[Guest slt]

Thank you everyone for your replies!

So Carol, you are saying that a TRANSFER from a 457 or 403(B) to a DB plan is only permitted where it is used to purchase service credit? In other words, you are saying that the change in EGTRRA really only goes to the ability of participants to make plan to plan transfers without experiencing a distributable event? Outside of that, Section 641 of EGTRRA would give me authority for allowing funds to be rolled over (assuming there is a distributable event) to a qualified DB plan and then using those funds to purchase service credit.

I think this intuitively makes sense. Since purchases of service credit are made when the individual is close to retiring, I guess 403(B) and 457 sections would have precluded aparticipant from transferring those sums prior to her termination - thus preventing her from purchasing the extra service. Therefore, that is the reason for the change by EGTRRA. But why then was there no change for individuals who also participate in grandfathered 401(k ) plans? I suppose the thinking is that they can take a distribution at 59 1/2 which is prior to their normal retirement age.

(the light bulb is turning on).

Now I think my original post is too literal of a reading of the rules and that a distribution would be permitted.

[Carol V. Calhoun]

The reason the legislation did not deal with 401(k) plans is that an in-service transfer from one qualified plan to another (for any purpose) was permitted even before the legislation. (In the context of a private plan, such transfers require the preservation of 411(d) rights, but of course section 411 does not apply to governmental plans.) The legislation simply expanded the permissible transferor plans to include 403(B) and governmental 457(B) plans, but only under limited circumstances. (My understanding is that the major reason for the limitations was the opposition of 403(B) and 457(B) vendors to the potential loss of those accounts.)

[joel]

Anyone using funds from a DC plan (IRAs, 457, 401k, 403b, etc) to purchase service credits from a DB plan must understand that if the DB plan compels lifetime annuitization he/she is transferring his/her title to the assets of the individual account plan to the DB plan in return for a lifetime income guarantee without any further growth of the invested assets and without any right to invade the capital beyond the monthly annuity payment.

[Carol V. Calhoun]

Typically, the amount necessary to purchase service credit is calculated in such a way that the employee in effect receives some further growth of the invested assets. However, the rate of earnings assumed for this purpose varies greatly from one plan to another. And of course, there is a trade-off involved: in a defined benefit plan, you cannot typically invade capital once annuitization has occurred, but you also will not outlive your assets if you live longer than the mortality tables would indicate. As with so much in this area, the employee needs to consider carefully the financial aspects of his or her choices, not just the tax consequences.

[joel]

Typically, the amount necessary to purchase service credit is calculated in such a way that the employee in effect receives some further growth of the invested assets. However, the rate of earnings assumed for this purpose varies greatly from one plan to another. And of course, there is a trade-off involved: in a defined benefit plan, you cannot typically invade capital once annuitization has occurred, but you also will not outlive your assets if you live longer than the mortality tables would indicate. As with so much in this area, the employee needs to consider carefully the financial aspects of his or her choices, not just the tax consequences.

----------------------------------------------------------------------------------

Carol--

The amount necessary (purchase price) is calculated solely to guarantee additional lifetime income to the pensioner. It is the plan sponsor, not the pensioner, that receives some further growth of the invested assets (purchase price) to the extent that the actual investment earnings exceed the Assumed Investment Return adopted by the plan's actuary.

[Carol V. Calhoun]

Joel--

You're right that the plan sponsor receives growth in excess of the Assumed Investment Return adopted by the plan's actuary. (And conversely, the plan sponsor takes the risk of growth less than that of the Assumed Investment Return.) All I was pointing out is that the Assumed Investment Return is itself a form of earnings to the participant, in the sense that what the participant puts in will, if mortality assumptions are correct, be less than what the participant takes out. This Assumed Investment Return (along with the advantage of not outliving the account balance) must be compared to the earnings on and advantages of other forms of investment available to the participant.

[Guest KCW]

I think I recall reading in a survey that public db plans' assumed rates of return for funding purposes are typically around 8% to 9%.

This compares favorably with the typical discount rate used for annuities purchased from a 457 vendor, which was under 4.25% the last time I checked.

However, I think the 7% discount rate our db plan document specifies (in conjunction with the GAM '83 mortality table) for early and delayed retirement benefit computation is more relevant to this discussion than the 8% assumed rate of asset return used in the actuarial cost method adopted by our plan's governing board.

Since our plan does not permit purchase of service credit, I don't know what assumed rate and mortality table would be used to compute the future value of a dollar of purchased service credit.

Is there any requirement that the method used to compute the amount of service credit a dollar purchases is consistent with existing methods of computing benefits? (I would assume that fairness would demand this.)

Our db plan specifies 3% and GAM '83 when calculating the commuted value of a monthly benefit paid to an estate as a lump sum death benefit.

(I know GATT requires the use of a certain maximum rate and GAM '94 for commuted benefit computation in non-414(d) ERISA plans.)

[Carol V. Calhoun]

Federal law does not impose a requirement that the cost of service credit be determined by reference to the rates assumed in funding the plan. In the past, though, the most common deviation was that employees were permitted to purchase service credit for less than the actuarial cost of such credit. For example, it was once common to see situations in which an employee could purchase service credit merely by paying the contributions (without interest) which such individual would have paid had s/he been an employee for the relevant period. In recent years, I've seen a lot less of that, as plans have become more sophisticated in determining actual costs. However, ultimately the cost is a function of applicable state and local law and the plan document. All this means is that, as with any other financial decision, you need to look at what is being offered, and how it compares with other uses of the money.

[Guest KCW]

Thanks, Carol.

There has been growing interest of late in adding a service credit purchase provision to my employer's db plan. Especially with the new ability to fund such purchases with 457(B) assets.

We'll have to do what you suggest: check state laws, do a survey of what other plans of comparable sponsors are doing out there, and develop cost models (if the proposal gets that far).

Developing cost models is complicated (or perhaps simplified) by the fact that our plan has not had required EE contributions since 1976. We do have a small number of participants who have voluntary contribution balances which will subsidize their regular annuity. It would appear we have a good starting point with voluntary contribution subsidy formula.

But, I digress . . .