Notice 2019-18, issued March 6, supersedes Notice 2015-49 (see Tax Alert 2015-1353), in which the IRS originally announced that it planned to issue guidance that would prevent qualified defined benefit pension plans from offering lump-sum payments to current retirees in lieu of a monthly annuity. Plan sponsors should consider this guidance as part of the development of any overall de-risking strategies for their pension plans.

Background

Section 401(a)(9) generally requires annuity payments made from a qualified retirement plan to be distributed over the participant's lifetime (and the lifetime of the participant's beneficiary if so elected). The regulations prohibit any change in the period or form of the distribution after it has commenced, except under certain conditions (outlined in Reg. Section 1.401(a)(9)-6, A-13 and A-14).

Reg. Section 1.401(a)(9)-6, A-1(a) provides that annuity payments are permitted to increase only on the bases described in Reg. Section 1.401(a)(9)-6, A-14. While A-14(a)(5) allows a beneficiary's survivor portion of an annuity to be converted to a lump sum upon the participant's death, no such provision explicitly permits conversion to a lump sum prior to the participant's death. However, A-14(a)(4) permits annuity payments to increase as result of a plan amendment, which some plan sponsors had used to justify offering lump sums to retirees.

In 2012 some employers sought private letter rulings to obtain approval for offering their retirees a window in which to elect a lump-sum payment of their benefits already in payment status. In the years that followed, many other plan sponsors viewed these private letter rulings as sufficient precedent for offering similar windows to their retiree populations.

In Notice 2015-49, the IRS described amendments that it intended to make to the Section 401(a)(9) regulations that would restrict the use of lump-sum payments. Under the yet-to-be-issued regulations, any pension plan participant receiving an annuity form of payment would not be permitted to change the form of payment to a lump sum or any other accelerated form of distribution. Specifically, "a retiree lump-sum window would not have been eligible for the [Reg. Section] 1.401(a)(9)-6, A-13(a) exception under which an annuity payment period may be changed in association with an annuity payment increase described in [Reg. Section] 1.401(a)(9)-6, A-14," the IRS explains in Notice 2019-18.

Notice 2019-18

In Notice 2019-18, the IRS rescinds its decision to issue regulations that would explicitly disallow a lump-sum distribution option to current retirees. Similarly, IRS determination letters will no longer state its caveat that the agency expresses no opinion regarding the tax consequences of a retiree lump-sum window.

However, the notice emphasizes that Treasury and the IRS "will continue to study the issue of retiree lump-sum windows." In addition, the IRS issued a reminder that any such plan amendments and related distributions must satisfy other IRC requirements, including Section 401(a)(4) nondiscrimination requirements; Section 411 participant consent; 415 maximum benefits; 417 minimum lump sum payments and spousal consent; and 436 benefit restrictions.

Implications

Cashing out participants with lump sums has certain advantages over ongoing annuity payments for employer pension plans. Ongoing payments are subject to interest rate and mortality risks, as well as ongoing administration costs that can be mitigated with a lump-sum distribution. In particular, some costs of administering a plan are assessed per capita (such as flat rate premiums to the Pension Benefit Guarantee Corporation, or PBGC), posing a relatively high administrative burden for smaller annuity payments.

Plan sponsors may want to consider offering lump sums to current retirees — especially those with relatively small monthly payments — to reduce costs. A lump sum option may result in adverse selection, in which participants who knowingly have poor health (and higher mortality expectations) are more likely to accept the lump-sum offer. This effect could result in greater potential for actuarial losses, albeit off of a smaller base to the extent smaller monthly payments are targeted.

Annuity purchases through insurance companies are another way to mitigate risks and reduce costs of administering defined benefit pensions. These transactions have not typically been challenged from a regulatory perspective, so long as the plan sponsor can demonstrate that it has met its fiduciary responsibilities in selecting the insurance carrier. However, lump-sum payments are often less expensive than annuity purchases.

Recent guidance related to the determination of lump-sum amounts

In addition, the IRS issued Notice 2019-26 on March 22, 2019, which outlined the prescribed mortality assumption that would apply for plan years beginning in 2020 under Section 417(e) for the purposes of determining minimum lump sum amounts, as well as under Sections 430 and 436 for the purposes of determining minimum funding requirements and benefit restrictions. The assumption is based on the Society of Actuaries' (SOA's) latest mortality improvement scale, "MP-2018," which, in conjunction with a base mortality table, is used to estimate future mortality rates assuming continued longevity improvement. This release is the IRS's second consecutive update to use the SOA's latest mortality projection scale. In addition, the IRS requested feedback on the regularity of updates to the projection scale as well as the appropriateness of an alternative projection scale the SOA issued this year.

The mortality improvement experience represented in the release of the MP-2018 improvement scale reflects the fourth consecutive year in which the SOA reduced its expectations for longevity improvements. As a result, all else equal, lump sums paid in 2020 using the MP-2018 improvement scale will be slightly smaller (i.e., less expensive for the plan) than lump sums paid during 2019 using the currently applicable MP-2017 improvement scale. This change may not be significant enough to affect the year in which plan sponsors choose to offer a one-time window to retirees, although plan sponsors may want to monitor changes in Section 417(e) interest rate levels because they could have a greater impact on costs.

For plans that pay lump sums through the normal course of operation, sponsors should also consider the financial accounting implications of the newly released information regarding the applicable improvement scale (for measurement dates on or after March 22, 2019) in estimating lump-sum payments expected to be paid in 2020 and beyond.

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