By Carol Buckmann
All strategies have benefits and risks. De-risking reduces PGBC premiums and balance sheet pension liabilities, making de-risking strategies attractive to many defined benefit plan sponsors. The two primary ways to do this are to cash out the pensions by making lump sum distributions or to purchase paid up annuity contracts to pass the liabilities on to an annuity provider. But there are risks and technical requirements to be weighed by plan sponsors considering these steps, and IRS has just changed the rules for those considering cashouts.
Changing IRS Positions. Windows (that is, limited time periods) in which deferred vested and retired employees could elect lump sum options, even though the plan didn’t ordinarily permit lump sums, became an attractive strategy for plan sponsors after IRS issued private letter rulings to individual sponsors approving cashouts of pensions in pay status. This was due to unattractive annuity purchase rates and the favorable actuarial assumptions used to calculate lump sums. Then IRS put a halt to retiree cashouts when it announced in 2015 that it would be issuing regulations prohibiting the cashout of pensions in pay status. IRS has just issued Notice 2019-18 stating that it will not be issuing these regulations after all, though it is still studying the issue. Although IRS will no longer caveat the determination letters of plan engaging in these cashouts, it will not recommence issuing private rulings on this issue.
What It Means. This is a clear signal that plan sponsors may go ahead with windows that include retirees. Many will want to consider this strategy now, because the IRS could change its position again in the future, particularly if there is a Democratic president elected in 2020. This group can include plan sponsors who have offered limited lump sum windows before, but limited them to deferred vested participants. Plan sponsors should consult their actuaries about the current cost implications of lump sums vs. annuitization through insurers. However, there are also policy and technical issues to be considered.
Retirement Policy. Retiree cashouts have been criticized from a policy perspective because of fear that retirees would dissipate the funds intended to last through their retirement or were ill-prepared to invest the lump sums wisely, even if they rolled them over into IRAs.
Plan Distribution Regulations. The big technical issue here is that current regulations on benefit payments prohibit changing a form of payment once payments have commenced, which the lump sum cashouts to pensioners clearly do. There is an exception for certain options with increasing payments, and the IRS previously accepted the argument that acceleration of payments in a lump sum cashout was a permissible form of increase. Notwithstanding the IRS about-faces, If you read it carefully, Notice 2019-18 does not clearly state that cashing out retirees is permissible. It is possible that retirees who squander their payments could come back to sue sponsors, particularly if the communications they received were poor. Although retirees may not be likely to win such suits, defending ERISA litigation takes time and money. Plan sponsors who want to offer these cashouts should be aware of litigation risk.
Implementation. There are a number of other technical issues to be considered when plan sponsors consider retiree cashouts as a de-risking option:
• Only well-funded plans may offer lump sums. The Code restricts lump sum payouts once the plan is less than 80% funded.
• The window must be offered to a group that does not discriminate in favor of highly-compensated participants.
• The regulations under Section 411(d) of the Code state that a plan sponsor making multiple amendments to provide benefits for limited periods that are close in time could be treated as having amended the plan to provide a permanent lump sum option. It is a facts and circumstances determination. Plan sponsors who have done multiple windows should consult with ERISA counsel about their risk under this provision.
• Plan amendments are required to implement retiree cashouts and they should specify a limited time period for elections with fixed beginning and end dates. Under current IRS rules, a sponsor of a plan that already has a determination letter won’t be able to get a window amendment approved.
• Married participants should get spousal consent.
• Communications to retirees should disclose all relevant information and should not encourage retirees to take the lump sums. Retirees should be told to consult a financial adviser before making their decision.
While retiree cashouts can be a useful tool to manage risks and liabilities, plan sponsors should consider these technical requirements and risks as well as de-risking alternatives before making a decision to offer retiree cashouts.