DROP Plans - Are lump sums eligible rollover distributions?

[Guest Ben]

I have read material on this message board about DROP plans, including the excellent article on DROP plans by Carol Calhoun and Arthur Tepfer. We do not really have any direct experience with DROP plans, but have someone who may be interested in this design. Is the lump sum payment that is paid under a typical governmental DROP plan where the DROP is part of the DB plan an eligible rollover distribution? I did not see this addressed in Calhoun and Tepfer article on DROP plans. Looking at the regulations, it seems to me that the lump sum would be an eligible rollover distribution as a payment independent of a series of subtantially equal payments under Reg. sec. 1.402©-2, Q&A 6(a). However, because I have not had experience with this type of plan design, I was not sure and wanted to ask someone who has worked with or seen this type of plan if this is the right answer. Thanks for any information you mught have on this.

[This message has been edited by CVCalhoun (edited 04-19-2000).]

[Guest jimri]

By the way, there is another another possible interpretation of sec 415(B)'s DB limitation on DROP plans ---- the limit is not applied when the transfer (DROP credit) happens, but when the benefit is actually distributed to the member.

This way the benefit payment is understood as being made partly as a monthly lifetime benefit and partly as a partial lump sum payment - both at the time of the member's actual retirement. The lump sum part would be converted (on paper) to a life annuity and, added together with the regular monthly benfit, and tested against sec 415(B).

Some plans might even allow the DROP account balance to purchase a higher monthly benefit from the DB component plan at the time of the member's actual retirement - a transfer of assets and liabilies back again. In that event, the ultimate test of compliance with sec 415 would be solely on the final (increased) monthly pension benefit.

Surely, we would not want to find ourselves testing for 415© at the time of the credits to the DROP, then again at the time of the re-purchase test for sec 415(B).

[This message has been edited by jimri (edited 04-20-2000).]

[This message has been edited by jimri (edited 04-20-2000).]

[Carol V. Calhoun]

Well, I'm still here, so maybe I can comment on that

I do not believe that the DROP benefits can be treated as a "transfer from one component plan to another." The defined benefit component of the plan does not have any liability to pay that year's benefit distribution if the employee is still working. Indeed, the previous actuarial funding for the defined benefit portion of the plan will have been based in part on an assumption that not every employee will retire at the earliest possible time. The employer contributions in the past will have been reduced to reflect the actuarial advantage to the plan when some employees stay later than normal retirement date. Thus, the DROP component involves the creation of a new liability (one measured by an annual contribution plus earnings based on the performance of a defined contribution account) with new funding, not the transfer of a liability from the defined benefit component of the plan to the defined contribution portion.

The DROP feature also involves employer contributions to fund that new liability, assuming that there are any contributions to the defined benefit plan as a whole. In calculating the actuarially required contributions to fund the plan, the actuaries must count both the defined contribution and defined benefit liabilities. The liability on the defined benefit side is measured by the present value of the future benefit to be paid, taking into account turnover, mortality, earnings, and other assumptions. But the liability on the defined contribution side is exactly equal to the contribution. Thus, if the employer continues the same level of contributions it has made in the past, what it is really doing is lowering the contributions to the defined benefit component, and making new contributions to the defined contribution component.

Even if there are no contributions to the plan, you may still have an annual addition if the funding is coming from forfeitures by other employees. As you know, forfeitures as well as contributions are annual additions.

The one area in which arguably there are no annual additions arises when the plan is overfunded, and surplus is used to fund the benefit. However, in the private employer context, the IRS has treated a transfer of assets from a defined benefit plan to a defined contribution plan as representing the termination of a portion of the defined beneefit plan, a reversion of assets to the employer, and then a recontribution of the same assets to the defined contribution plan. Obviously, there remain questions as to <nobr>(a) whether</nobr> this reasoning would apply to a public plan, and <nobr>(B) whether</nobr> it would apply to a transfer

between components in a single plan, as opposed to a transfer between plans. However, I don't believe it is 100% safe to assume even where there are no employer contributions to the plan that there is no annual addition.

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[Guest jimri]

Something in the article bothers me. It was written in 1998 and, maybe, Ms Calhoun's opinion has changed since then. In any event, it is the comment about the application of section 415© that bothers me.

I agree that a DROP plan which credits earnings at the same rate as the actual earnings of the underlying assets is a defined contribution component plan and, therefore, subject to the limit on "annual additions" of IRC sec 415©. However, in the example given, is the $12,000 credit to the account an employer contribution? or an employee contribution? or a forfeiture?

I do not believe it is any of those. The $12,000 credit seems to be more like a transfer from one component plan to another, ie, a transfer of assets and liabilities. The $12,000 amount transferred to the DC component plan (the DROP account) is a discharge of the DB component plan's liability for that year's benefit distribution. As such the section 415's DB limitations would apply to the $12,000 transfer.

Accordingly, and because it is not an erc, an eec, or a forf, the $12,000 credit in the DC component plan is not an "annual addition".

If, however, the plan permitted or required the member to continue their own contributions to the plan but have them credited into the DROP account, those eec's would be subject to the "annual additions" limit, but not the $12,000 credit.

Tell me what you think.

Thanx.

[This message has been edited by jimri (edited 04-20-2000).]

[Guest Ben]

Thanks for the discussion on the 415 issue. Does anyone have any thoughts on the original question about whether the DROP lump sum payment is an eligible rollover distribution?

[Carol V. Calhoun]

Sorry, got off on a tangent here. Yes, we have looked at the issue, and agree with you.

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Employee benefits legal resource site

[Guest Ben]

Thanks very much for the confirmation on this point.