COLAs

[DTH]

If a DB plan has a COLA tied to CPI and terminates does the calculation of a lump sum distribution have to reflect the COLA?

[Guest dsyrett]

I would think so but what does the plan say?

[david rigby]

I agree with the suggestion to review plan provisions. However, isn't the COLA part of the accrued benefit, not to be ignored in determining a present value?

For example, Gray Book Q&A 94-39:

Automatic COL Provisions - Lump Sums and other issues -- 411, 415, 417(e)

A plan provides for lump sum distributions based on actuarial equivalent interest rates equal to the PBGC interest rates on lump sums in plan terminations (i.e., the 417(e) rates). The plan also provides for annual post-retirement cost-of-living increases based on a National Cost-of-Living index, but not to exceed 3% in any year. The plan states that for the lump sum determination, it is assumed that there would be no increase in the COL index.

Does the lump sum cashout feature satisfy the qualification rules? If not, how can the plan be changed to comply? How are the 415 limits applied to this plan -- (a) can the initial amount of annual annuity be as high as the full current 415(b)(1)(A) amount and (b) how is the maximum lump sum determined?

RESPONSE:

Subject to section 415 (discussed below), an automatic cost-of-living provision is an integral part of the participant's accrued benefit and, therefore, must be taken into account when determining amounts payable under optional forms of benefit. The assumption that there will be no increase in the COL index in determining lump sums would not be reasonable and, therefore, would result in the impermissible forfeiture of accrued benefits under section 411.

The plan should specify a reasonable basis for determining the value of the COL provision. Various approaches could be considered, such as a fixed annual increase rate (e.g., 2.5%), a moving basis equal to the COL index (subject to the 3% cap) as of a recent date or the average over a recent period, etc.

In accordance with Reg. §1.415-3(b)(2)(iii), no reduction in the 415 limits are required to reflect an automatic COL increase provision to the extent that such increases do not exceed those provided under 415(d). Thus, for example, assume that the plan grants annual COL increases that are determined using the same percentages that apply under 415(d), subject to a maximum increase in any one year of 3%. An employee retiring at age 65 in 1994 could receive up to the full $118,800 dollar limit during 1994; such amount would increase by the plan's COL adjustment in subsequent years.

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[MGB]

There have been a handful of court decisions going all the way back to the mid-80s saying that the COLA is included in the accrued benefit. Therefore, COLAs may not be eliminated under 411(d)(6) and must be included in the value of the lump sum. The most recent was Laurenzano vs. Blue Cross Blue Shield of Mass. I think the final decisions were made in 2001 or 2002.

One of the old court cases made a significant effort to separate the COLA from the retirement benefit and state it as a separate, supplemental ancillary benefit. The court rejected that.

A more recent court case (Devlin) found that an ad hoc COLA that was not automatic in the plan document could be eliminated by amendment (reducing future payments). The reasoning was that the COLA was granted after the participants' termination of employment. 411(d)(6) is very specific that it only protects benefits accrued while an EMPLOYEE. Automatic COLAs are considered to be accrued while an employee even though not effective until later.

[AndyH]

I agree with the responses but wonder why a COLA must be factored into a lump sum when an early retirement subsidy does not. Where is the logic there?

[david rigby]

Logic? Tax code? Regulations?

Any more questions?

[AndyH]

Easy or they'll give us the flat tax and we'll all be out of business.

[KJohnson]

There was a 4th Circuit Sheet Metal Plan case in early '03 that found a COLA not to be an accrued benefit in certain circumstances.

http://pacer.ca4.uscourts.gov/opinion.pdf/021273.P.pdf

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2/5/2003: 4th Cir.: Pension Plan May Eliminate Benefit for Those Retired Before Benefit Was Added (The Segal Company)

Excerpt: "In Board of Trustees of the Sheet Metal Workers' National Pension Fund v. Commissioner of Internal Revenue, the U.S. Court of Appeals for the Fourth Circuit ruled that trustees of a pension fund acted legally when they amended the plan to eliminate a cost-of-living adjustment (COLA) for participants who were retired at the time the COLA provision was adopted."

[MGB]

This last reference was the Devlin case that I referred to above. Note that it was an ad hoc COLA granted after retirement.