On August 17, the President signed into law the Pension Protection Act of 2006. Most of the changes in the PPA address the funding and disclosure requirements for traditional defined-benefit (DB) plans.
Factors that prompted the passage of the PPA include the artificially low interest rates used for discounting traditional pension valuations and the numerous corporate failures in the past decade that resulted in the dissolution of employees’ pension plans.
The PPA will bring about significant changes in the valuation of lump sum distributions. These changes include new interest rates and new mortality tables that will ultimately cause a reduction in the General Agreement on Tariffs and Trade treaty limitation.
The GATT treaty imposed a limitation on qualified DB plans, including 412(i) plans, specifying how much can be distributed as a lump sum. This limitation does not affect annuitized distributions. If the lump sum distribution exceeds the GATT limit at the time the participant takes it, the participant will not receive the amount in excess of the GATT limit. An article detailing the GATT limit on lump sum distributions from qualified defined benefit plans appeared in the June 12, 2006, issue of National Underwriter.
Clients Have a Lot to Lose
Monitoring GATT limits on DB and 412(i) plans can protect clients from losing a significant portion of an anticipated lump sum distribution. In the example below based on current law, a 55-year-old male with a 412(i) plan who plans to retire at 65 with $3.3 million in cash available at retirement but with nearly $2.1 million available as a lump sum could lose roughly $1.3 million of the cash value/benefit where the GATT limit is exceeded (see chart).
PPA Changes the Valuation of Lump Sum Distributions
The PPA introduces a new pension funding model. Lump sum distributions from DB plans will be valued using a 3-segment yield curve, which is based on the rates for the month before the distribution, rather than on the 24-month average used for the plan’s funding.
GATT Limitations Reduced on Lump Sum Distributions
Under the new PPA calculation, lump sum amounts will most likely be lower than under the current calculation, which is based on 30-year Treasury bond rates. 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 higher the interest rate, the lower the lump sum, and vice versa. The new rates will be phased in at 20% increments over 5 years beginning in 2008. This change will most significantly affect younger plan participants.
New Mortality Tables to Be Developed
Currently, the mortality table is a 50/50 male and female mortality rate combination from the 1994 Group Annuity Reserving Table. Under the PPA, the Treasury Department will develop a mortality table (most likely one recently proposed by the IRS) specifically for funding purposes. Although no date has been set for the implementation of this table, no substitute tables will be allowed.
Working with a TPA to Monitor Plans
For the next 5 to 10 years, careful and consistent monitoring of GATT limits on traditional DB and 412(i) plans is even more important as a result of the PPA. Financial services professionals should inform clients how the GATT limitation may affect the distribution of their retirement plans.
Additional planning may be needed to address clients who want to fund a plan to its maximum, as is the case with many 412(i) plans. These clients may hit the new GATT limit before normal retirement age and will need to plan accordingly.
With the PPA changes, the role of an experienced and knowledgeable third-party administrator becomes paramount in the management of 412(i) plans. Financial services professionals should use the checklist in the accompanying chart to verify that their TPAs are aware of the PPA’s impact on the GATT limitation, mortality tables and lump sum distribution valuation.
Understanding the impact of GATT on lump sum distributions and working closely with a qualified TPA to monitor your clients’ retirement plans will help to ensure that their plans for retirement are met.