Pension Buyout Exception Ends

We don't often blog about the IRS, but a recent announcement they made will dramatically impact pension fund operations within the United States. An IRS rule change in 2012 opened up a new option for pension funds struggling to meet their liabilities. Now, three years later, the agency is moving to close that option.

Treasury regulations have long held that no changes can be made to the period or form of pension distributions once they have begun (see Q&A-13). However, an exception was made for increases in payment (see Q&A-14). Employees have always had the right (see Q&A-13(b)(1)) to elect a lump sum payment at the point of retirement, but the rules have been very clear that once an income stream has been selected no further changes can be made. In 2012, Ford and GM submitted for Private Letter Rulings from the IRS asking if a lump sum buyout of pension benefits could, in fact, be seen as an increase in benefits. The IRS granted that request, and since then companies have been using that exception as a means to reduce and/or manage their pension liabilities.

Many companies jumped on the rule change as an opportunity to reduce some of the risk of meeting the payment obligations they had under defined benefit pension plans. Using a lump sum payout, they could transfer to the retiree the risk of meeting required distributions in the future (most commonly, lump sums are rolled into IRA accounts that the employee is then responsible for). The relative value of the lump sum that employees have been offered has been called into question by market commentators, who have indicated that the lump sum may not be appropriately valued compared to the income stream the employee is giving up. The Government Accountability Office studied whether or not plan participants could properly evaluate the potential reduction in assets they were accepting by choosing a lump sum, and concluded that individuals were not being provided adequate data to make their own assessments. Congress has also been investigating whether or not these pension advances represent a benefit, or detriment, to retirees.

The concern over how retirees have been impacted by these lump sum offers has led the IRS to issue Notice 2015-49, stating their intention (along with Treasury) to amend their rules to definitively remove lump sum buyouts as an option once a defined benefit pensioner has begun receiving payments (they can still elect lump sum at retirement if they choose). The rule, once effective, will be enforced retroactively back to July 9th, 2015, essentially making it live today.

For defined benefit pension plans, this will remove an opportunity to reduce future liabilities from their already strained resources. Many plan sponsors had been using buyouts in order to avoid the new mortality tables coming into effect in 2016, which will have negative consequences for them, as life expectancy rates are set to increase. For plan participants, the government agencies involved hope that it will have a positive effect, although those who become ill after the point of retirement (at which point they could still choose a lump sum) will lose the option to take a lump sum based on their reduced life expectancy. Similarly, retirees who become concerned about the ability of the plan sponsor to continue making payments will lose the chance (again, post retirement) to “sell” their income stream in the form of taking a lump sum.

Interestingly, from an actuarial perspective, closing the lump sum payment option may have positive effects. As plan participants exit the plan, the assumptions that underlie the actuarial model of the plan are undermined, specifically in the form of reducing available credits to the plan through differences in the expected lifespan of plan participants (which are mortality credits back to the plan as a whole). This problem is exacerbated via adverse selection when those in poor health (or suddenly diminished life expectancy) choose to take out a lump sum, leaving only those who expect to live a long time remaining. The plan itself is constructed based on the assumption that some of the funds that are no longer needed for those who have passed away will be used to fund the income stream owed to those who live longer than expected. An option to take a lump sum at any point in time undermines this balance.

In any case, the IRS was instrumental in creating the wave of lump sum payment offers, and after a period of reevaluation, has decided to take that option back off the table.