The Pension Benefit Guaranty Corporation (“PBGC”) recently finalized its rule on insurance for amounts rolled over from a defined contribution plan to a defined benefit plan. Although amounts rolled over will be subject to greater protections than apply for most other benefits (i.e., benefits derived from employer contributions), the full rollover benefit will not necessarily be protected if the plan terminates with insufficient assets. Employers should assess the impact of the limitations on PBGC protection for their plans and consider updating participant communications to better explain the potential risks from a rollover to a defined benefit plan.
Background. When former employees receive distributions from a section 401(k) or other defined contribution plan, they often choose to roll over the distribution to another employer’s tax-qualified retirement plan or an IRA. It is often desirable to roll over the distribution to a defined benefit plan (if the employer has one), so that the employee can annuitize the benefit without having to buy an annuity from an insurance company. This is particularly popular for floor-offset arrangements; and regulators have issued guidance in the last few years that is intended to encourage more lifetime annuity options for distributions from defined contribution plans.
The Risk. Any time one purchases an annuity, there is some risk of the annuity not being paid if the provider becomes insolvent. A rollover from a defined contribution plan to a defined benefit plan is no different: if the defined benefit plan terminates with insufficient assets to pay benefits, participants might not receive 100 cents on the dollar.
When an ERISA defined benefit plan terminates with insufficient assets, two things happen:
- Benefits are divided into six priority categories. The benefits in the higher priority categories get paid before benefits in the lower categories; and
- The PBGC pays certain benefits (usually in the lower priority categories) for which the plan does not have sufficient assets.
Limits on PBGC Guaranty. Although the PBGC steps in to pay certain benefits that cannot be paid by a terminating plan, the PBGC’s guaranty is subject to certain limits, including the following (among others):
- The PBGC does not pay benefits in excess of a maximum amount. For 2015, the maximum benefit is a single-life annuity of $5,011.36 per month ($60,136 per year). This limit is indexed for inflation; and
- The PBGC does not cover certain benefit increases and new benefits that are put in place less than five years before the plan terminates. This is sometimes called the “five-year phase-in” because the PBGC guaranty on benefit increases and other new benefits phases in gradually over five years (20% per year).
What This Means for Rollovers. The PBGC’s final regulation divides rollovers from defined contribution plans into two parts: (1) a baseline amount (which the regulation calls “the accrued benefit derived from mandatory employee contributions”) and (2) an excess amount.
- The baseline amount equals the amount rolled over, increased with interest from the time of the rollover to the termination date at 120% of a federal mid-term interest rate, and converted to a single-life annuity using Internal Revenue Code section 417(e) factors (the same factors as are used to calculate lump sums).
- The excess amount equals any excess over the baseline amount. For example, suppose a defined benefit plan specifies that an amount rolled over from a defined contribution plan will be converted to an annuity assuming 7 percent interest and the plan’s mortality table. In the current interest rate environment, the resulting annuity would be larger than the baseline annuity. We call the difference between the annuity promised by the plan and the baseline the excess amount.
The baseline amount will be afforded special protections. The baseline amount:
- Will have the same priority as benefits derived from mandatory employee contributions (second on the priority list to voluntary employee contributions);
- Will not be subject to the PBGC’s maximum protected amount; and
- Will not be subject to the five-year phase-in. The full amount will be protected.
The baseline amount generally must be paid in an annuity, and may not be paid in a lump sum.
In contrast, any excess amount will generally be subject to the same restrictions as apply for other employer-provided benefits. This means that any excess amount:
- Will have a lower priority than the baseline amount. If the benefit is already in pay status, it will have the next-highest priority after the baseline amount and other amounts derived from employee contributions;
- Will count toward the PBGC’s maximum protected amount. Benefits in excess of the maximum will not be covered by the PBGC; and
- Will be subject to a five-year phase-in, starting from the time of the rollover. This means that if the plan is terminated less than five years after the rollover, part of the excess amount will not be covered by the PBGC.
Next steps for employers. Employers who allow rollovers from a defined contribution plan to a defined benefit plan (and employers who are considering offering this kind of rollover) should review the impact of the PBGC’s final rule on their plan design. In particular, employers should understand the extent to which amounts rolled over will be treated as excess amounts. Employers should consider updating rollover forms and other participant communications to explain the limits on PBGC protection for amounts that are rolled over.
Source: The National Law Review