The General Agreement on Tariffs and Trade (GATT) treaty imposes a limitation on qualified defined benefit (DB) plans, specifying how much can be taken as a lump sum from a DB plan–whether it’s an Internal Revenue Code (IRC) Section 412(i) or a traditional DB plan. This limitation commonly is referred to as the “GATT limit.”

Although some participants in a DB plan might be content with a lifetime annuity at retirement (the GATT limit does not affect a lifetime annuity payout from a DB plan), many plan participants would prefer the flexibility of a lump sum distribution. However, if the lump sum is in excess of the GATT limit at the time the participant takes a lump sum distribution, the participant may lose the amount in excess of the GATT limit. Since this limit changes from year to year, financial professionals need to exercise great caution when educating a client on the establishment of a qualified DB plan.

Background on GATT and DB plans

How is the GATT limit determined? The lump sum calculation uses the applicable interest rate. This rate, according to the Retirement Protection Act (included as part of GATT), is the monthly yield on the 30-year Treasury bond. Since the U.S. Treasury Department has not issued a new bond between 2002 and 2006, the current applicable interest rate is based on the 30-year Treasury bond issued in 2001.

On April 10, 2004, President Bush signed into law the Pension Funding Equity Act of 2004, which provided transitional relief for certain calculations, including lump sum distributions from DB plans. The act substituted a uniform rate of 5.5% for GATT calculations for 2004 and 2005.

Expected to be issued on Jan. 1, 2007, is a new 30-year Treasury bond that will establish the interest rates to be used for future GATT lump sum calculations. It is important to note that there is an inverse relationship between the interest rate used in the calculation and the amount of a lump sum that can be distributed; the lower the interest rate, the higher the lump sum and vice versa.

Nest eggs in jeopardy

The chart is an example that illustrates a participant’s anticipated loss if he or she chooses a lump sum distribution from a 412(i) DB plan that exceeds the GATT limit. In this example, the client could lose nearly one-third of his or her retirement benefit. It is important to remember that the GATT limit does not apply if the plan participant chooses a life annuity payout.

Steps to take to help protect clients

As evidenced above, failure to monitor the GATT limit on an annual basis can adversely affect a participant’s retirement nest egg. As a result, it is crucial the financial services professional take the appropriate steps to keep his or her client informed of the effects the GATT limit can have on that participant’s qualified DB plan.

The following steps may help to minimize these negative effects:

Step 1: Educate the client on the advantages/disadvantages of establishing a qualified DB plan.

Step 2: Explain how the GATT limit can affect future retirement plans.

Step 3: Work with a third-party administrator (TPA) that is experienced with GATT and provides GATT limit monitoring on an annual basis.

Step 4: If a client is funding a plan to its maximum, the plan may hit the GATT limit before normal retirement age. The client should be made aware of this time frame to ensure his or her ability to plan accordingly.

Don’t forget the importance of GATT the next time you discuss a qualified DB plan with a client or prospect!