415 application when lump summing deferred annuity

[Andy the Actuary]

Of course in my 2,000 years of practicing, I've never had to determine the maximum distributable lump sum on a deferred pension. Alas, my day has come, in particular, because of the NRA=62 requirement.

So, facts are participant age 52 with NRA=62 has over 10 years of whatever and has accrued the full benefit of the high three (H3) average compensation under 415(b)(1)(B). Since lump sum is available, then presumably "annuity starting date" is at age 52 and not age 62.

So, we do as follows:

(1) Determine the lump sum for a deferred annuity to age 62 valued at age 52 using the plan factors.

(2) Convert this lump sum to an immediate life annuity at age 52 using the lesser of the Plan actuarial equivalence or the applicable mortality table and 5.5% interest. I.e., produce the greater annuity.

(3) Reduce H3 to an immediate annuity using whichever produces a lower factor -- the Plan actuarial equivalence or the applicable mortality table and 5.5% interest. I.e., use the lower amount.

(4) Assuming (3) < (2), the distributable lump sum is (1) / (2) x (3)

Any disagreement?

[Mike Preston]

What is H3?

[Andy the Actuary]

What is H3?

H3=average of high 3. Sorry

[Mike Preston]

Oh, High 3. Got it. Back in a few minutes.

[Mike Preston]

Still confused about H3. How do you reduce an average compensation by an annuity factor? Or, are you saying that you reduce the 100% of pay 415% limit? If the latter, I don't think I usually go through that step.

I find it hard to believe that a benefit limited by High 3, deferred for 10 years, will ever bump up against the 415 dollar limit, so I must be missing something fundamental in your description.

How about numbers, they always seem to help me understand.

[Mike Preston]

Let’s take a simple example:

H3 at age 52 is $100,000

415$ limit at age 62 is 16250/month

Actuarial equiv. Is 94GAR/5%

417/415 is 417e-09/5.5%

Benefit payable at age 52, per plan provisions is:

100000 / 12 * 152.15731 * (1.05) ^ - 10 = 778,428

Benefit equates to an immediate annuity using plan rates of: 778,428 / 183.35921 = 4,245.37

Benefit equates to an immediate annuity using 415 rates of: 778,428 / 176.08029 = 4,420.87

Since 4420.87 (the greater of the two) is still miles less than the 415% limit (100000 / 12), there is no cutback due to the % limit.

So, let’s check the 415$ limit.

At age 52, that amount is $8,298.57, which is miles bigger than $4,420.87, so you are ok there, too.

This analysis makes sense as long as you aren’t trying to define a benefit payable at age 62 which exceeds the 415 limits at that age. Some people have tried to do that in the past and most IRS reviewers won’t allow it. If the plan says the NRA is 62 then they will limit the benefit payable from the plan at that age to no more than 100% of the lesser of the 415% or 415$ limit.

Obviously, once you limit the benefit payable from the plan at NRA to the 415 limit applicable at that age, in the case of a person who is at the 415% limit at age 62, they are significantly beneath that same 415% limit at a much lower ASD such as age 52.

Maybe once you provide numbers we can see where your concern is.

[Mike Preston]

Two things:

1) Of course, this assumes the 417(e) rates are such that they do not force an uptick in the lump sum relative to the plan's actuarial factors. This WOULD be the case, for example, if the plan was making its determination in 2009 using the November, 2008 rates. It WOULD NOT be the case if the plan was making its determination in 2009 using the December, 2008 rates.

Even if using the December rates, however, and the minimum lump sum is bumped up a bit, it would still be significantly lower than the 415$ limit at the H3 shown in my example.

2) It is only once the H3 approaches the high end of the allowable scale (around 187713.542 [approx. ] would an individual age 52 with a retirement age of 62 potentially run into 415$ limit issues. The bottom line maximum for somebody age 52 is 1461215.31 (176.08029*8298.57).

In conclusion, you don't ever have a 415% limit issue when the ASD is at age 52 when the NRA is at 62, but you have a 415$ limit issue when the lump sum exceeds 1461215.31, whether the cause of that is the increase in lump sum due to 417(e) or otherwise.

Note that we don't have final 415 regs on much of this, so others may have different techniques that they have used and successfully navigated an IRS audit or review with.

[Andy the Actuary]

Still confused about H3. How do you reduce an average compensation by an annuity factor? Or, are you saying that you reduce the 100% of pay 415% limit? If the latter, I don't think I usually go through that step.

I find it hard to believe that a benefit limited by High 3, deferred for 10 years, will ever bump up against the 415 dollar limit, so I must be missing something fundamental in your description.

How about numbers, they always seem to help me understand.

Very simply, hubby and spousette. Hubby at 245,000; spousette at 50,000. Hubby is age 69, spousette is age 52. 100% plan so H3=50,000 (roughly) for spousette.

[Mike Preston]

Are you terminating the plan?

[Andy the Actuary]

Are you terminating the plan?

Sometime in 2010 with distributions whenever the IRS gets around to approving.

[Mike Preston]

Amend plan to provide that xs assets are allocated to participants up to the 415 limit.

Terminate plan.

Pay out husband (termination of plan is a distributable event... if it isn't within the document, make it so).

File with IRS.

Get DL.

Pay out spouse.

[Andy the Actuary]

Mike, thank you for your help and especially your time. Greatly appreciated.

Best Regards,

andy

[tymesup]

We had a couple of these surface recently. Here's what we did:

1 - Determine lump sum under plan actuarial equivalence

2 - Determine lump sum under 417(e)

3 - Take greater of 1 and 2

4 - Determine dollar limit at age 52, using worse of plan factors or 5% *

5 - Determine comp limit

6 - Take lesser of 4 and 5

7 - Determine lump sum of 6, using worse of plan factors or 5.5% **, ***

8 - Take lesser of 3 and 7

* - Plan can be amended to increase benefit

** - Plan can be amended to increase benefit

*** - 105% prong does not apply to "small" plan

[Andy the Actuary]

We had a couple of these surface recently. Here's what we did:

1 - Determine lump sum under plan actuarial equivalence

2 - Determine lump sum under 417(e)

3 - Take greater of 1 and 2

4 - Determine dollar limit at age 52, using worse of plan factors or 5% *

5 - Determine comp limit

6 - Take lesser of 4 and 5

7 - Determine lump sum of 6, using worse of plan factors or 5.5% **, ***

8 - Take lesser of 3 and 7

* - Plan can be amended to increase benefit

** - Plan can be amended to increase benefit

*** - 105% prong does not apply to "small" plan

Thank you. Good recipe. I like the way it tastes!

andy t.a.

[tymesup]

One of my old firms screwed this up royally once. Another actuary caught us. Luckily, he didn't know how to do it, either.

We screwed this up a year ago, too, although it was moot.

If I were writing the Code, there would be two tables that applied to all plans. One is the dollar limit at all ages, updated annually for indexation. The other is a table of lump sum factors at all ages. The only calculations needed are pro-rating for participation and compensation and compensation averaging for three years. Simple to apply, equitable for all plans.

Excuse me, they're paging me for Room 101.

[Andy the Actuary]

You certainly have my vote to replace Jim Holland.

[Mike Preston]

Reviewing this in light of Q&A8 from RevRul 98-1, there is one step that has been left out. If the actuarial equivalent of a benefit under the terms of the plan is more favorable than the 417(e) factors in effect, there is a pro-rata reduction in the 415$ lump sum available.

So, the question is whether people still use the 98-1 methodology, or, in light of the fact that this issue has not made it into the 415 regulations, can it be ignored?

Example from the regs:

Monthly benefit under terms of plan: $7,471.33/month

Lump Sum under terms of pla: $950,000

Lump Sum under 417(e) of $7,471.33/month benefit: $905,346.2 (I disagree with the factor cited in the rev rul, but that is irrelevant to this discussion)

Since 905346.2 is less than 950000, the benefit being "purchased" by the $950,000 is increased by the ratio: 7471.33 * 950,000 / 905,346.2 = 7839.83/month

I've always been bothered by this step as it seems to be double penalizing the participant for an actuarial equivalence provision that isn't actually in the plan.

Of course, if the 417(e) applicable rates are more generous than the plan's actuarial equivalence, this doesn't come into play.

[Andy the Actuary]

So, the question is whether people still use the 98-1 methodology, or, in light of the fact that this issue has not made it into the 415 regulations, can it be ignored?

The 415 regs are entitled "final rule" and not "final with unnoted exceptions." I'd vote for the ignore, which means via the first law* of Andy T. A., I am wrong!

*If the probably that I make the correct decision is 50%, there is a 100% chance I will make the wrong decision. E.g., taking Yogi Berra's fork in the road.

[Mike Preston]

OK, on further looking at the final 415 regulations, the methodology of 98-1 is included in Example 1 on page 108 of the version which is 210 pages long. That is section 1.415(b)-1©(6) ("Adjustment to form of benefit for forms other than a straight life annuity").

But I think it is sort of a red herring, because the original "steps" (from tymesup) included at item 7:

"7 - Determine lump sum of 6, using worse of plan factors or 5.5%"

which can arguably refer to the offending section of the regulations. However, I think that 7 needs to be modified to say:

"7 - Determine lump sum of 6, using worse of plan factors, 417(e) factors or applicable mortality/5.5%"

Let's try, using age 65, a maximum benefit, the 2009 mortality assumption (417e-09), and sticking with the 5.25% 417(e) interest assumption of the regulation example, but pushing the benefit up to the point where it just touches the 2009 limitation (195000):

1 - Determine lump sum under plan actuarial equivalence

A. I determined that a monthly benefit of $15,859.98 payable at 65 has a lump sum of $2,244,647.96 under plan's actuarial equivalence. (If you prefer the number in annual form it is $190,319.76)

2 - Determine lump sum under 417(e)

A. $2,236,873.25

3 - Take greater of 1 and 2

A. $2,244,647.96

4 - Determine dollar limit at age 65, using worse of plan factors or 5% *

A. $195,000 (since we are at age 65, no factors come into play)

5 - Determine comp limit

A. A number higher than $195,000, so that we are just focusing on the $ limit.

6 - Take lesser of 4 and 5

A. $195,000

7 - Determine lump sum of 6, using worse of plan factors or 5.5% **, *** modified to read:

7 - Determine lump sum of 6, using worse of plan factors, 417(e) factors or applicable mortality/5.5%

A. Lesser of:

1) $195,000 / 12 * 141.52905 = $2,299,847.06; or

2) $195,000 / 12 * 141.0388 = $2,291,880.50; or

3) $195,000 / 12 * 138.1321 = $2,244,646.69

The answer is therefore $2,244,646.69

8 - Take lesser of 3 and 7

A. Lesser of $2,244,647.96 and $2,244,646.69, which is $2,244,646.69

But the key to this whole discussion is that this results in a 415(b) dollar limit benefit of $16,250, even though the plan benefit payable was only $15,859.98.

So, we can see that the only thing the regulation does is modify the monthly benefit from $15,859.98 to $16,250 that the participant is deemed to be receiving from the plan under 415(b), it is not double reducing the lump sum, as I previously theorized it might be. This basically serves to reduce the ultimate benefit from a second plan being set up down the road being done to theoretically use more of the 415 limit than originally thought of as being used.

Things get a bit more fun when 417(e) changes, post-PPA, to the segment rates, but the above methodology is easy to apply. Again, using 2009 rates (a lookback of one month, to Dec 2008) of 4,41%; 4.57%; 4.27%, the middle calculation of item 7 changes from:

2) $195,000 / 12 * 141.0388 = $2,291,880.50; or

to

2) $195,000 / 12 * 150.677347 = $2,448,506.89; or

And since that is greater than the 3rd calculation it has no effect on the ultimate lump sum payable.

It is instructive to look at what happens if the same underlying rates stay in effect for two more years (which I know they won't, but humour me, will ya'?). The factor changes to 132.042442 (based on 417e-11 mortality), which changes the lump sum to $2,145,689.68.

Which means that the lump sum *IS* reduced by $98,957.01 and yet the 415(b) benefit being distributed is still deemed to be $16,250.

Whew!

[Andy the Actuary]

Mike, I'm confused (for a change). Example #1 to which you referred appears to incorporate the 105% crud, which for small plans, was removed by WRERA. Is there some other provision (or example) that specifies in TYPESUP's #7 that you would use the 417(e)(e) rates?

The confusion, perhaps, is that the 415 regs were not revised (at least I don't think they were revised) to recognize WRERA.

[Mike Preston]

I have ignored the 105% portion of the example in my writings. As you know, it is no longer applicable.

[Andy the Actuary]

Yes, I noted you ignored the 105% but including in item 7 the 417(e) confused me as I didn't see it in the example (I only saw 105%). Did I misread the final reg?

[Mike Preston]

I think so.

[Andy the Actuary]

Oh, well, I have slept on this for months.

WRERA provides:

SEC. 122. MODIFICATION OF INTEREST RATE ASSUMPTION REQUIRED WITH RESPECT TO CERTAIN SMALL EMPLOYER PLANS.

(a) IN GENERAL.—Subparagraph (E) of section 415(b)(2) of the 1986 Code (relating to limitation on certain assumptions) is

amended by adding at the end the following new clause:

‘‘(vi) In the case of a plan maintained by an eligible employer (as defined in section 408(p)(2)©(i)), clause (ii) shall be applied without regard to subclause (II) thereof.’’.

Section 415(b)(E)(ii)(II) -- i.e., Subclause II -- of the IRC provides:

"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 section 417(e)) were the interest rate assumption."

In short, WRERA appears to eliminate (for small plans) altogether the calculation in Subclause II. Your interpretation in accordance based upon 98-1 is that it doesn't and that it only eliminates the 105%. This is not what the words say.

Any new thoughts on this subject???

[Mike Preston]

How would my example change in your interpretation?

[Andy the Actuary]

How would my example change in your interpretation?

In your (7) above, you would take the lesser of Plan factors and AMT, 5.5% BUT not 417(e).

Your position seems reasonable. It simply is not apparent where it is supported by the Code as modified by WRERA.

[Mike Preston]

I didn't want to leave you hanging. It may take a while for me to dig into this. If I don't respond by 11/15 (not a typo), remind me.

[Andy the Actuary]

I didn't want to leave you hanging. It may take a while for me to dig into this. If I don't respond by 11/15 (not a typo), remind me.

Mike, thanks. This particular area is difficult for the IRS/Treasury because new IRC appears to have somewhat trumped some well-thought out concepts.