compliance alert

August 7, 2014

Guidance on Offering Longevity Annuities in DC Plans

On July 2, 2014, the Internal Revenue Service (IRS) published final rules intended to make it easier for defined contribution (DC) plans to offer lifetime income payment options to participants by removing the technical barrier to one of those options: longevity annuities.1 This guidance will help plans offer solutions to participants concerned about “outliving their money” as they contemplate how to draw down their assets in retirement. The rules, which are effective July 2, 2014, apply to contracts purchased on or after that date.

After summarizing the guidance, this Compliance Alert lists some preliminary observations as well as issues that interested employers might wish to consider.

Qualifying Longevity Annuity Contracts

Generally speaking, a longevity annuity is a deferred annuity purchased at or before retirement (e.g., at age 65) that does not begin to pay benefits until the individual attains an advanced age, typically age 80 or 85. This type of annuity is intended to help people protect against outliving their incomes.

The final rules allow a DC plan participant to purchase a certain type of longevity annuity, called a qualifying longevity annuity contract (QLAC), with a portion of his or her account balance without that amount being included in the calculation of the required minimum distribution (RMD) under Section 401(a)(9) of the Internal Revenue Code (IRC).2 Generally, when a participant reaches April 1 of the year following the year he or she attains age 70½ (or the date of actual retirement, if it is later and allowed by the plan), the plan must start distributing a fractional share of the the participant’s account balance determined by dividing the account balance by the distribution period (e.g., number of installment payments or life expectancy). Prior to this change, the premium value of any annuity contract held in the account that was not in pay status was included in that determination. With that value in the numerator of the fraction, a participant who exhausted the non-annuity portion of the account would have been in the difficult position of needing money from the annuity to satisfy the RMD rules, but not being able to get it because the terms of the annuity did not yet allow payment. The final rules make this problem go away when the annuity in question is a QLAC.

The final rules describe the requirements that a longevity annuity must satisfy in order to be a QLAC. The annuity contract must be purchased from an insurance company and must:

  • Have a premium value of no more than 25 percent of the participant’s account balance, or if less, $125,000 (indexed);3
  • Provide a distribution commencement date of no later than the participant’s attainment of age 85;
  • Pay a fixed monthly amount (i.e., it cannot be a variable annuity), but may provide for dividend payments (if the underlying annuity is structured to participate in the distribution of some portion of the provider’s profits) or include cost-of-living increases in accordance with the IRC rules applicable to annuities generally;
  • Pay any death benefits in the form of a single life annuity, but may provide for a return-of-premium feature in lieu of an annuity in certain circumstances (e.g., to a beneficiary after the death of both the participant and surviving spouse);
  • Not include features such as accelerated payment of future benefits or cash surrender rights; and
  • Specify at time of issuance (either in the contract itself, or in a rider or endorsement) that the contract is intended to be a QLAC.

In addition, the insurance company issuing the QLAC must satisfy annual requirements for reporting to the IRS and the covered individual.

Observations and Issues

Many DC plan participants currently do not have the option of purchasing any type of annuity coverage through their DC plans and do not have adequate (or any) guaranteed lifetime income available from a defined benefit plan. If employers are willing to include QLACs as plan investment options because of their targeted purpose, participants might be interested in them as a way to supplement any other sources of guaranteed income they might have (e.g., Social Security).

There are, however, other significant issues, generally not in the jurisdiction of the IRS, that still must still be resolved before it can be determined if these contracts will be successful as DC plan investment/distribution options. These issues include the fiduciary issues related to the selection of QLAC providers, the adequacy of state guarantees to back up the financial solvency of the providers, and the cost of the coverage under the plan as opposed to the cost outside of the plan, e.g., under an IRA.4 Nonetheless, while the new rules do not solve all the problems or answer all the questions related to QLACs, they are a positive step along the path of helping participants manage the risks of outliving their retirement income.

 

1 The guidance was jointly released by the Department of the Treasury and the the IRS, but for ease of reading, both are referred to jointly as the IRS. The rules are on the IRS website. Minor corrections to the guidance were published in the August 6, 2014 Federal Register. (Return to the Compliance Alert.)

2 Although not discussed in this Compliance Alert, the final rules also apply to the purchase of QLACs in individual retirement accounts (IRAs), §403(b) plans and governmental §457(b) plans. In general the rules applicable to qualified plans also apply to §403(b) plans and governmental §457(b) plans; the rules are modified in some respects for IRAs. (Return to the Compliance Alert.)

3 The 25 percent limit is plan-by-plan, but the dollar limit applies on an aggregated basis to all of a participant’s annuity- or account-based plans or accounts, including IRAs other than Roth IRAs. The rules also provide a mechanism for correcting premium payments in excess of the specified percentage or dollar limit. (Return to the Compliance Alert.)

4 This cost differential is because annuities purchased by qualified plans must use unisex mortality tables whereas annuities purchased outside of plans, e.g., by IRAs, may use gender-based tables. (Return to the Compliance Alert.)