Desire to Move to Lifetime Income Options -- Is It Real?

I read an article this morning that tells me, among other things, that two in ten defined contribution (DC) plan participants plan to use some portion of their plan assets to purchase lifetime income products. I don't dispute the research that was done, but I absolutely dispute that behaviors will be as the data imply.

Before you read on, I want to be clear. Any criticism that I have here is not of the author. The piece does an excellent job of explaining what the data say. My criticism is also not of the data collection. The Employee Benefit Research Institute (EBRI) asked legitimate questions and reported the answers that they received.

But, this is a case where I posit that a perfectly good interpretation of perfectly good data is likely to not be a good predictor of future behaviors, at least not as the law exists today. What we need to help these data to be a reliable predictor is a statute that is focused on retirement policy not on the assumption that small groups of people will abuse the Tax Code. And, once that statute works, we need plan designs that give well-meaning plan participants the ability to customize their individual retirement income streams to meet their own needs without worry that somehow they will fall prey to regulations that were written to stop abuse by a few. (For the retirement and tax geeks reading this, yes, sections like 401(a)(9), I mean you.)

Is this newfangled design DC? Maybe or maybe not. Is this newfangled design defined benefit (DB)? Maybe or maybe not. Why do we really need such a broad distinction?

I'll return to the design issues later, but first I am going to make a u-turn back to my comment about these data as predictors.

Yes, two in ten DC plan participants would like to get some lifetime income or longevity protection from their DC plans. But, what options are available? Generally speaking, whether they are in plan or out of plan, they are retail priced annuities (meaning they are priced favorably for the annuity provider and therefore unfavorably for the annuity buyer). There are traditional annuities and there are qualified longevity annuity contracts (QLACs). The experience in the marketplace thus far (anecdotally) is that participants will pay anywhere from 15% to 40% more for these annuities from DC plans than would be considered actuarially equivalent to a lump sum in a DB plan. Insurers need to be both risk-averse and profitable and therein lies a difference. DB plans, on the other hand, are intended, generally speaking, to provide optional forms on an agnostic basis.

So, how do we get there? As I said earlier, changing the statute to allow common-sense streams of income for participants is a great first step. Then we need a new type of design. To me, it probably doesn't fall into the current, common notion of DB or DC.

Let's call it the Plan of the Future.

And, once those common-sense options are available, my prediction is that far more than two in ten participants will want some amount of lifetime income whether it's from DC plans, DB plans, or just qualified retirement plans.

Good News -- IRS Floods Us With Guidance on Lifetime Income Options

When it rains, it pours. And, unlike in days of future past (for you, Moody Blues fans, with a slight spelling change), when the IRS decides to provide guidance on a topic, we get a package. In this case, the package is related to distribution options, primarily from qualified defined contribution (DC) plans, but also with implications for defined benefit (DB) plans and individual retirement accounts (IRAs).

So, here's what we got:

• Proposed regulations essentially on partial annuity distributions from DB plans
• Proposed regulations on longevity annuity contracts
• Revenue Ruling 2012-3 on survivor annuity requirements for deferred annuity contracts in DC plans and IRAs
• Revenue Ruling 2012-4 on treatment of rollovers from qualified DC to qualified DB plans in order to receive an additional annuity

So, what's in them? Since it's American Idol season, dim the lights, here we go. 

Partial Annuity Options

For participants, this is good news. For plan sponsors and especially for plan administrators, this could be a nightmare, because participants may actually elect split options. Under these regulations, participants could take a split distribution option from a defined benefit plan. For example, a participant could elect a partial lump sum and a partial annuity. 

The proposed regulations specify that [Code Section] 417(e)(3) assumptions would be used to calculate the lump sum amount, but that plan assumptions (plan's definition of actuarial equivalence) would be used to calculate the amount of the annuity. This makes things way simpler than the existing rules which would require use of 417(e)(3) assumptions for the entire calculation.

Let's consider an example. Suppose a participant was entitled to an immediate single life annuity of $1000 per month or a lump sum of $140,000, among other options. Further, suppose that the plan conversion factor for this participant and this participant's spouse for a 50% Joint and Survivor Annuity payable immediately is 0.95 (if you don't like my factors, you may write your own blog, but they seemed simple and convenient for my purposes). Now, suppose that the participant elects a split option: 60% as a lump sum and 40% as a 50% Joint and Survivor. The math gets simple. The lump sum would be 0.60*140,000 = $84,000. The monthly annuity would be 0.40*0.95*1000 = $380 per month.

Hmm, maybe this is more of a pleasant daydream than it is a nightmare for plan administrators, but computer-based administration will require a lot of re-programming.

Longevity Annuities

This is great news for plan participants. I repeat, this is great news for plan participants. When a participant uses their DC or IRA account to purchase a longevity annuity (sometimes referred to as longevity insurance), the longevity annuity piece will be disregarded for purposes of the minimum distribution rules under Code Section 401(a)(9).

Here is how it works. Sometime before a participant turns 70, he elects to allocate some portion of his account to a Qualified Longevity Annuity Contract (QLAC). In order to be a QLAC, the single premium for the annuity must not exceed the smaller of 25% of the account balance or $100,000 (indexed for inflation). A participant may make multiple QLAC allocations, but in that case, the total QLAC premium is similarly limited. The QLAC must specify the deferral date for the deferred annuity and that date cannot be later than age 85. 

In the event that participant makes such an allocation, the QLAC allocation will not be subject to the required minimum distribution rules. 

And, in a piece of bad news, money in a Roth account will not be considered a QLAC.

DC Spousal Consent Rules

This one is very simple. It clarifies that when a participant invests part of his DC account balance in a deferred annuity, that part of the account is not subject to the Qualified Preretirement Survivor Annnuity (QPSA) requirement until the participant makes an affirmative election to begin annuity distribution immediately.

DC --> DB Rollovers

This is another piece of good news. Suppose you are a participant in both a DC plan and a DB plan. Revenue Ruling 2012-4 allows a DB plan to be amended to accept rollovers from a DB plan. And, when you do so in order to get an  annuity, you get the DB plan's definition of actuarial equivalence rather than having to subsidize the profits of an insurance company.