Can a traditional defined benefit plan be converted to a 412(i)?

[Guest picwrc]

Can a traditional defined benefit plan be converted to a 412(i)? This assumes the money from the traditional DB would be placed in qualifying insurance annuities.

[Guest KAR]

It can be converted. However there are a number of restrictions and guidelines that need to be followed, such as timing. Along with some costs of making the plan "fully funded" that may not be deductable.

I would if at all possible work closely with an actuary that is familiar with 412i plans and conversions.

[Guest picwrc]

Thanks. Where might I find the guidelines and restrictions? I have looked everywhere that I can think of.

[Blinky the 3-eyed Fish]

Just curious, but what is the situation that makes this client want to switch to the 412(i) plan?

[Guest DOM]

picwrc: I suggest you start with Rev. Rul. 94-75 this should answer most of your question especially as to "timing". Is it safe to assume that the reason(s) for this coversion might be: "guarantees", "current deductions" "satisfying a life insurance need (tax deductible)", especially if rated, "fear of current market conditions" among others? Also I think KAR has offered some real good advice in getting "an actuary that is familiar with 412i plans" I would further add that if you do he or she should be UNBIASED. GOOD LUCK!.

[AndyH]

Blinky, he's a doctor of course. Geez I thought you would have figured that out!

[Effen]

How about.... because he cares deeply for the well-being of his insurance agent?

[Guest Carol the Writer]

I want to go in the other direction, converting a 412(i) to a "traditional" split-funded defined benefit plan. I have a plan sponsor who wants to do this.

I had been planning to use the "without wear away" approach, and the fractional rule for future accruals. However, one of the caveats that Datair provided with its volume submitter DB plan, is that you cannot do this at all, whether or not it is for a 412(i) plan conversion.

Now I am really puzzled. This approach makes all the sense in the world to me. What approach would you use for future accruals, particularly in light of the fact that you would not want to front load the future accruals? Any thoughs would be appreciated.

[Guest DOM]

I find this posting very interesting since it shines the light on the hypocracy of some ASPA members when it comes to these 412i plans. You know "like" the old adage "it depends on who's Ox is getting gored" Let me guess, the commentators with the inappropreate snide remarks would prefer converting to a Cash Balance Plan? Eh!!!

I also notice with interest that some found the time to be cute, but no effort to help picwrc with the original question.

[Blinky the 3-eyed Fish]

In my brief experience with 412(i) plans, I have found that interest in these plans in many cases is for the wrong reasons. Depending on who is providing the recommendation, the biggest hook is the very large deduction available. What is not expressed is the fact that there are many other issues to consider.

I have seen promotional material from insurance agents, mostly, that are absolutely filled with hyper-aggressive tactics that the IRS has expressed over and over again they will disallow. They are still touting the springing cash value and disregarding the 415 lump sum limits. Am I saying insurance agents are the only ones to blame? No, but they are the head of the monster, and most of the body I might add.

So, to understand why this client would want to convert, I posed the question. The original poster's question was answered as far as I know. And where is the hypocrisy? Hypocrisy is saying one thing and doing another. What I see is people, whether ASPA members or not, pointing out the flaws in 412(i) arrangements and calling out insurance agents (mostly) for their sham tactics.

P.S. Are you from Canada?

[WDIK]

Also I think KAR has offered some real good advice in getting "an actuary that is familiar with 412i plans" I would further add that if you do he or she should be UNBIASED.

If by unbiased you mean willing to explain all of the pro's and con's about 412(i) plans, I agree wholeheartedly. If instead you mean without opinion based upon personal experience, I would guess it would be impossible to find such a person.

[AndyH]

Mr. Firmani, if we thought we could help picwrc with his question we would have.

To help someone it is best to envision a sucessful result. Blinky's question went unanswered and it did not seem like an answer was likely, so we had a little fun with it.

But now we know that you have the answer, so why not share it with us hypocrites?

[Guest pension222]

I have been more involved in 412(i) plan than I EVER thought I would be and I ask a lot of questions that the insurance folk, well, just don't ask and because of this, I'm not always the most popular person in the room. For many, this can quickly become an emotional issue.

The 412(i) plan is the hot topic now (my wife works for a bank and even they are being encouraged to sell them). I think after the regulated demise of the 419 MET, and with the low interest rate environment, it was inevitable.

A 412(i) plan is the plan to have if, the plan covers one person and that one person, for sure wants to take the benefit payment as an annuity. The monthly payment is guaranteed and provides a secure income for the retiree. If this person needs insurance, the plan is a great place to provide some. Making it fit for a group of say 30 employees, well, this may be a stretch. This is when “carve outs” allowed by meeting the requirements of 401(a)(26) for the 412(i) plan pop up and I know that there are those of you out there using this technique to combine a conventional defined benefit plan with a profit sharing plan. This is nothing new.

Now we all know that the driving sales reason is the huge deduction for the client and of course the equally large commission paid to the salesperson. Getting paid is a great sales incentive and getting paid a few hundred thousand dollars at a time is an even greater one.

A whole lot of pension professionals get very upset over these two issues as witnessed by any response to any 412(i) question. No matter what the 412(i) topic, it seems like someone always asks "why does the client want to do this?" with the implied (sometimes explicit) follow-on of "is he stupid?"

Some might ask the same question of a person who is considering buying a large SUV. In the end it all comes down to personal need and choice. I like to say that nothing is bought but everything is sold and a lot of folks are selling the 412(i) concept. Will they be as popular if the market goes back to giving us 15-20% returns? I suspect not.

The important thing to keep in mind is that a whole lot of pension professionals who have ignored section 412(i) (as I always have) now have to deal with the 412(i) issue. If they aren’t involved in selling or administering these plans, their clients are being approached about 412(i) plans.

So having said all of this, if one is to properly administer a 412(i) plan, it is important to do your research and trust me, don’t always just assume that because the insurance company has been doing something one way (for instance the conversion of an existing defined benefit plan to comply with 412(i)) that they are correct.

Also, of one is to “defend” your clients from the 412(i) marketing machine, one needs to understand what they are and are not, and keep in mind that a 412(i) plan is just a defined benefit plan exempt from section 412 with a strange accrual rule under 411(b)(1)(F) and yes, section 417 applies also.

[Blinky the 3-eyed Fish]

No matter what the 412(i) topic, it seems like someone always asks "why does the client want to do this?" with the implied (sometimes explicit) follow-on of "is he stupid?"

Just to clarify, the follow-up was not my line of thought. There are some legitimate reasons to implement a 412(i) plan and there are some very foolish reasons to do so. Because the latter is very prevalent, this question is important.

[AndyH]

Very thoughful comments, pension222.

Can anybody envision a scenario in which it would be a good idea to convert a traditional db into a 412(i)?

I would imagine that some estate planning reason may exist; I'm open to learning.

[Guest pension222]

And that's just my thinking Blinky, these questions are all very important and they need to be asked.

I just love the exchange of ideas on these message boards.

[Guest DOM]

Speaking from the viewpoint of a 40 year veteran probably servicing more 412i plans than 99% of folks reading these 412i messages, let me say for the first time in my memory I am seeing some thoughtful dialogue without the sarcasm toward 412i plans. Excuse me for venting but I must. I think the most recent onslaught of 412i and insurance agent bashing has emerged from the November 2002 annual ASPA breakout 412i session. The meeting committee for some reason made a decision to use one of the "Usual Suspects" who turned out in the opinion of many to have an obvious negative bias toward these plans and apparently insurance and insurance agents in general. That session should have been an embarassment to everyone in the room pro or con 412i. If you think my comment is over the top, listen to the tape and draw your own conclusions. I have been an ASPA member since 1971 and I have attended most of the annual meetings. This session was the first time in my memory that I can recall any speaker/presenter obviously without hands-on experience of the issues along with negative and condecension toward the subject and practitioners involved. This isn't going to be a surprise to the powers since I have made these thoughts very clear to Washington. What makes the whole thing most irritating is the fact that I and others suggested candidates with credentials along with field and backroom design/technical experience. The whole package so to speak.

To Blinky: Re your 8/27, 8:19AM posting. I'm very glad to see that you agree "there are some legitimate reasons to implement a 412i plan" and I agree with you that there are "very foolish reasons to do so." The sad thing is that there will continue to be a divide within the ASPA membership that in the long run is going to be destructive so long as some continue to demean others because their philosophies don't agree. In my opinion anyone who would purport that this condescending attitude doesn't exist is either a liar or just plain stupid. The last thing I would try to do is to defend the "Johnny come lately" types selling 412i as the plan Du Jour, with springing values and 415 and incidental rule violations. I resent the negative attention they bring to the IRS who might customarilly over react and, well, you know the rest. My firm and most of the practitioners I know well use traditional Whole life and Annuities (sometimes indexed) without the "Spring" and other no no's. But to hear some commentators anyone earning a commission is wrong. I wonder how they think new business comes into their firm if somebody isn't selling something?

To WDIK: Excellent comment, but do you think most non product practitioners are giving the "pro" side? All one would need do is listen to the ASPA November tape and read the comments on this message board over the past 6 months to get a feel for that answer.

To Mr. AndyH: For clarification, are you saying you couldn't help because you can't envision any sucessful result having to do with 412i? And in answer to your obvious smart remark I do have the answers and I did share it with "you hypocrites" review my 8/22, 1:22PM post to picwrc. I also responded to Blinky the same day but apparently the post didn't take because now I can't find it wherein I suggest that some reason 412i might work is for as you state "Estate planning" or maybe for an older person who wants guarantees, or someone who has a definite need for additional insurance or wants to make the premiums tax deductible, or maybe someone who is highly rated and can enjoy the deductions for the excess premiums, or maybe just someone like me who fears and hates the stock market after what has happened to their nest egg in the past 2 to 3 years. I could go on but I don't want to bore you with facts. I don't see the market doing near as well as a good annuity in the next 5 years or more do you?.

To Pension222: Very thoughtful and well presented arguments. However I do disagree with you regarding your opinion that these plans only work well for one person operations. They can work very well for 5 or 6 with the right demographics and even more with a carve-out as you suggested in your posting. I strongly disagree with your comment about only taking the annuity payout unless you are thinking that a lump sum would be taken and the market shopped for the best purchase rates. I hope it is OK but I intend to steal your comments about the large SUV analogy to 412i in regard to personal needs and desires. Thanks.

DF

[WDIK]

To WDIK: Excellent comment, but do you think most non product practitioners are giving the "pro" side?

Probably not, but do you think that most product practitioners are giving the "con" side?

[AndyH]

Mr. Firmani, I did not attend the 412(i) session at ASPA last year that you are bashing, but I did read the outline presented by Larry Starr and think it was terrific. I found it to be the most informative and balanced material on the subject that I have found.

And, if I am not mistaken, Mr. Starr is a CLU just like you.

I did attend the conference, however, and clearly heard Jim Holland et al sternly warning, in the general session, the sharks in the water to be weary. Jim Holland is not a member of ASPA.

Perhaps you could explain your objections to the session or the outline or the speaker(s).

And rather than defending a session that I did not attend, I am pointing out that perhaps the bias may be on your side.

[Effen]

I have read many of the arguments and tend to come down on the con side of the argument. Not because I have some built in bias created by ASPA (which I am a member, but disagree with many of their positions). My anti 412(i) bias comes from real life experience.

I keep hearing people like dom firmani say that there are places where they work, but as of yet I haven't seen one. The only 412(i)'s I have seen presented lately are jamming round pegs into square holes.

Andy asked directly "Can anybody envision a scenario in which it would be a good idea to convert a traditional db into a 412(i)?" and he got no response.

Blinky asked "Just curious, but what is the situation that makes this client want to switch to the 412(i) plan? " and he got no response.

Well, if dom feels so strongly that "we" aren't giving 412(i)s a fair shake, how about giving us some real life examples to debate. You present your ideal 412(i) client and we will either agree it works, or demonstrate a better, cheaper way to accomplish the same thing.

Please provide all the specifics including premiums, accumulation amounts and distribution strategy.

[AndyH]

Hands down, Effen has the two best posts on this thread.

Or is it threads on this post, BTW?

And perhaps the best username as well

[Guest DOM]

Since posting todays reply I have heard from two associates from different parts of the country with almost identical advice, being that I should back off with my natural combative demeanor because first off I'm talking to a "brick wall" and secondly I'm just P_ _ _ _ _ _ everybody off.I'm going to take their advice but before I do I'm going to answer AndyH and Effen, (the best user name?) really?

Incidently to WDIK's question to me about product practitioners giving all the "Cons" of course not, but I know some are.

Andy, in response to your question as to my bashing the ASPA's annual, presentation.

There is nothing wrong with the outline, I agree it is pretty good, in fact I and at least two other practitioners that I'm personally aware of submitted materials to LS for his review and use if he so chose. As I suggested, listen to the tape and get a feel for the demeanor, that's more important in any presentation and its everything with this one because of the obvious bias. Of course I have a bias at this point but it was caused by the presentation not the subject or materials.

Effin, Your challange to submit a specific case is silly, we could debate 20 different area's of the planning (no plan is in a vacuum) there are too many personal and emotional aspects to consider) and any one could be used by either party to try to discredit the other, using the past couple years investment climate would make it easy to prove numerically that in some cases 412i is better. Why not read my previous response to Andy and before that to Blinky? I gave several scenario where 412i might work.

the only thing dumber than the challange would be for me to answer it.

This will be my last posting on this issue, I think the back and forth is getting too personal and childish it isn't fair to the people reading this stuff who are interested in learing not attacking. Todays dialog kind of reminds me of a bunch of teenage boys sitting around debating who has the biggest, (insert your own). I'm also now fully convinced that trying to convince some people that 412i has a place and that insurance agents aren't the anti-Christ is like trying to convince the environmentalist that the lumber industry is their friend.

I know that there are other insurance people and other open minded people out there reading these postings and using 412i in their planning, I can't help but wonder why they haven't jumped in?... Ciao and GOODBYE..

[Blinky the 3-eyed Fish]

the only thing dumber than the challange would be for me to answer it.

Not constructive and has no place on this message board.

[WDIK]

[Point A] Speaking from the viewpoint of a 40 year veteran probably servicing more 412i plans than 99% of folks reading these 412i messages, let me say for the first time in my memory I am seeing some thoughtful dialogue without the sarcasm toward 412i plans. * * *

[Point B] This will be my last posting on this issue, I think the back and forth is getting too personal and childish

I'm not sure I follow how we got from Point A to Point B based on the posts inbetween.

[mwyatt]

I'll just add the following that occurred with a new client at a meeting last week. He had been pitched heavily about 412(i) plans, both pure annuity and with insurance levels three times as high as the traditional 100x limit. We did a study of what a traditional DB plan would do, and it came out to be a difference of 320k for the traditional plan and 400k for the 412(i) plan w/o insurance. Of course, the CSV of the annuity contract at NRA was about 30% over the current 415 limit valued at best case assumptions (94GAR @ 5%). This guy was pretty sharp (Wharton MBA) and finally figured out that it didn't make a tremendous amount of sense to get an additional "deduction" now that he would never see again. His comment: you know, I can take out a million dollars cash out of the bank, burn it up, and get a deduction for a million, but I'm still out 600,000 dollars...

[Guest DOM]

To WDIK: OK so I lied about 8/28 being my last posting. I have just one more thing to say and this really is my last post.

MISSION ACCOMPLISHED!!!!!!!!!!!!

[Blinky the 3-eyed Fish]

I thought you were going to say, "Another wow."

http://www.benefitslink.com/boards/index.p...t=0entry70492

[Effen]

I agree with WDIK, I don't see how dom gets from point "a" to point "b". Talk about a childish response. Just because you get challanged you take your ball and go home? And what the heck does "Mission Accomplished" mean?

dom, I was very serious in my request for a "real life example" to debate. Isn't that the point of these boards? To debate ideas and concepts?

Your lack of response does nothing but to solidify my position. Apparently you can't come up with anything to offer so you respond like Iraq's previous Information Minister. You can't change opinions by simply spouting your own opinion. You need to present facts so that we can choose to agree or disagree. What is the motto of the Society of Actuaries.... "substitute facts for impressions"

[mwyatt]

Hey Blink:

Interesting link. Looks like someone got caught (thanks to Mike Preston). I think the analogy of a house of cards is appropriate with this carve out scenario...

Actually Dom:

After reviewing Blink's link, my only advice is watch your back. You need to...

[Guest Pete Swisher]

AndyH

There are good reasons to convert to 412i, and (as mentioned previously) bad ones.

I would offer this on the seemingly sensitive issue of the merits of 412i: we humans often tend to strong opinions before we know all the facts. Before becoming a pension geek I was (still am, technically) a CFP/RIA/stockbroker but my start in the business was with MassMutual selling, among other things, life insurance. To ensure I understood what I was selling I ran the numbers: net present value calculations on streams of unequal cash flows, net of tax, to see when life policies were efficient and when not. Few life agents know how to run those numbers or what to compare them to, so I feel like I understand the math better than most.

So:

1. Yes, there are estate planning reasons for 412i. The setup is tricky and aggressive but a trust can own the death benefit of the life policy outside of the plan and outside of the participant's estate. Since pension dollars are very "tax hostile" (subject to Income in Respect of a Decedent as well as estate tax--can be over 80%) this is a tool to move those tax hostile dollars out of the plan (away from IRD) and out of the estate. Similar strategies can be employed in DC plans.

2. The principal advantage of life insurance is its tax treatment, which is moot in a qualified plan, but the "rollout" strategy is therefore crucial--how will the participant get the money out? Just as important, where will the money go? If the annual benefit in retirement will not be spent 100%, then the "rollout" can simply be to distribute portions of cash value which then remain in the policy, and on which all future growth will be tax-free. Not needing the money is thus a good reason to convert.

3. Life policies have a much narrower application from an investment efficiency standpoint than the insurance companies would prefer. When you're a hammer... But they DO have powerful application in financial planning for ordinary folks, not just the wealthy. So "need" is a good reason to convert (life insurance need) but that concept is tricky--includes wishes for family, liquidity, risk tolerance, feelings about likelihood of long life/early death, and (very important) present and future insurability on favorable terms. For those of you who think "buy term and invest the difference" is the only way that "intelligent" people do it, I respectfully submit that you have never done the math and don't understand the human lifecycle (or soul).

4. In the absence of a life insurance need, life insurance is a piss poor investment. Using life insurance to fund 412(i) is probably not the best choice if you have no life need and are just after a big deduction. If any of you have clients that want big deductions just have them call me--I'll be happy to bill them a rapacious fee so they can deduct it.

5. Life insurance is not the only form of insurance--412(i) calls for "insurance contracts" not life insurance. So annuities are an option. I've sold a ton of fixed annuities in the past and believe strongly in them for the right client. If a client is highly conservative, older, wants guarantees, then a fixed annuity can be fantastic in or out of a qualified plan. They can be combined with life insurance where appropriate, and doing so helps water down the death benefit to keep it below the incidental limit.

6. And yet...I've seen a lot of trash illustrations, too. Ridiculous deductions and face amounts, miniscule employee contributions, big red flags crying "please audit me." IRS has already announced its intention to go after abusive 412i's, and the illustrations I'm seeing sure look abusive, but I'm not an administrator or actuary and can't properly speak to that side.

7. And last but not least, the fiduciary issues...don't get me started. Suffice to say I think they are being ignored.

So 412i can be a good thing, but probably a lot less often than its most ardent proponents would prefer--one man's opinion.

[AndyH]

Thank you for your interesting and informative comments. Reasonable people can disagree.

You lost me, however, as a non-skeptic when you stated that you have sold tons of annuities in the past and that they can be a "fantastic" investment in or out of a retirement plan. I could not disagree more.

And, I have nothing against brokers or people who sell insurance. I have close relatives that do. But I think that annuities are usually sold to take advantage of uninformed people.

Just another opinion.

[joel]

"But I think that annuities are usually sold to take advantage of uninformed people."

=====================================================

Andy: I COULD NOT AGREE WITH YOU MORE! Does your belief extend to a DB pension plan that compels lifetime annuitizing? Afterall, such a payout scheme is nothing more than purchasing an immediate fixed annuity with the retirement reserve fund.

Peace and Hope,

Joel L. Frank

[mbozek]

Pete: I am very intersted in how a trust can own a LI policy outside of the plan and the participant's estate since retirement benefits must be held for the excluisve benefit of the participants in a qualified trust and be non alienable under IRC 401(a)(13), eg., the participant cannot waive rights to benefits. I have heard many promoters make similar statements but I am unaware that any ruling has ever been issued by the IRS. The problem is that the client's estate, not the client, will pay the estate tax (unless the LI is paid to the spouse). However avoiding estate tax is a poor reason to over pay for a death benefit in a retirement plan with tax deductible dollars since the estate tax will be eliminated for most taxpayers in the next few years. After paying income taxes (with max rates of 35% though 2010) the dollars could be invested in more productive investments such as dividend paying stocks with a max tax of 15% for both dividends and cap gains which is considerably less than the 80% tax on IRD that you used.

[Guest Pete Swisher]

Yikes. Lively topic.

1. With all due respect, if you think all annuities are a ripoff (as two of you imply) you need to study the products and the customers who use them more carefully (with financial calculator in hand).

2. MBozek: every time I jump in on these message boards I seem to tweak the nose of providence by tangling with attorneys or legal issues on which I am not an expert, but...I have worked with a number of estate planning attorneys in the past (for wealthy financial planning clients) and know just enough to be dangerous, and the trick as I understand it is not to own the whole policy outside the plan but for an irrevocable trust to own some of the death benefit. Since the DB is tax free (in excess of policy cash value as reflected by Interpolated Terminal Reserve) due to ongoing PS58 payments, it is permissible for a trust to own it. The problem as with split dollar arrangements is the "rollout"--how do you get the cash out? That involves distributions, and becomes a math game of efficient capital transfer from plan, gifting issues, springing cash value hurdles, etc. Anti-alienation doesn't enter into it (try IRM Defined Benefit Pension vs. US Life Ins Co, No. 95-2029, 4th circuit 1996 for ownership/treatment of death benefits). I'm pretty sure there are some pertinent PLR's but my enthusiasm for research is waning.

3. MBozek again: I can see how it might appear, based on recent tax laws, that client plans should be based on these temporary tax advantages (that are already scheduled to "sunset" or were never permanent to begin with), but I feel very safe saying that this is not the consensus view in the estate/financial planning community.

One thing I very much respect: insurance products are often (perhaps usually) sold in situations where they are not the best choice, to the detriment of the industry. But just because car salesmen are shysters doesn't mean cars are bad. So my (plagiarized) advice to pension practitioners on insurance topics is:

"A little knowledge is a dangerous thing,

Drink deep, or taste not that Pierian Spring."

[mbozek]

I have heard that claim made before but all assets of a qualfied plan must be held for the exclusive benefit of the participants. It is a violation of the exclusive benefit rule for plan assets to be held outside of the plan in an irrevocable trust for the benefit of the heirs of a participant. If the participant dies the proceeds will be paid to the trustee of the plan or the beneficaries as an asset of the participant's estate. I have heard of mysterious PLRS that allow the LI benefits to be held outside of the plan and the participant's estate but no one has ever been able to find a citation. Also a retirement plan is not permitted to make inservice withdrawals of benefits to an active participant prior to normal retirement age. IRS announcement 75-110. My reference to non alienation was to the transfer of assets (li policy) outside of the control of the plan trustee, not to the ability of the participant to designate the beneficary of the death benefits.

[Guest Pete Swisher]

Mbozek,

You an implacable and worthy foe. I wish I could figure out how to enable the email response thing so I'd know when someone responds.

Just because a portion of a LI policy's death benefit is held by a "person" (such as a trust, which is a legal person) outside of the plan does not mean that the trust is holding plan assets. Simple example: I buy a life policy in the plan and have an annual PS58 cost of $1,000, paid by ME out of pocket. Who "owns" the death benefit? I do. The plan owns the policy, but my LI beneficiary gets the death benefit, tax free, other than that attributable to ITR. I don't think this is a matter of dispute. Nor is it a matter of dispute that I can purchase a policy from the plan, avoiding the transfer for value rule since I qualify for one of the four or five TFV exceptions. Same thing with a grantor trust--it's just a different "person" paying the PS58 cost or purchasing the policy. There are still plenty of issues to worry about (like rollout), but I'm pretty sure being able to own the DB outside the plan is not one of them.

The irony is I've never sold or recommended a 412i and might never do so--not part of my business. I just think you're wrong and that the age-old enmity against insurance is misplaced if not entirely ill-founded. Next time I see my buddy that does this stuff a lot I'll try to get some citations for you and email them.

[Lame Duck]

It's too bad I can't carry a tune.