Fully insured defined benefit plans have been in existence since 1974. Prior to the enactment of the Pension Protection Act of 2006, the rules and requirements for these plans were contained in Internal Revenue Code section 412(i), but on Jan. 1, 2008, these rules were relocated to Internal Revenue Code section 412(e)(3). The basic rules and principles, however, have not changed.
How it works
A 412(e)(3) plan is a special type of qualified defined benefit pension plan. Like all defined benefit plans, it promises to pay a retirement benefit, normally monthly, to a plan participant at the plan’s normal retirement age. The current maximum annual benefit is 100 percent of the participant’s three highest years’ compensation or $185,000, whichever is less. This maximum amount is reduced if the pension benefits begin before age 62.
What differentiates a 412(e)(3) plan from other defined benefit plans is the requirement that all benefits must be funded exclusively with fixed annuities or a combination of whole life insurance and fixed annuities. The policies must provide for fixed, level premiums, and the amount of policy premiums must be reduced by dividends, interest, or other earnings in excess of the amounts guaranteed under the policy. The plan benefits are equal to the policy benefits, and the insurance company must guarantee all benefits. Contributions to the plan are calculated based on the guaranteed rates and values under the policy, thus increasing the permissible deductible contributions in the early years of the plan. No policy loans are permitted under a 412(e)(3) plan.
What went wrong?
Beginning in the late 1990s, the IRS began to take notice of 412(i) plans that had certain characteristics, which the IRS labeled “abusive.” First, the plans were funded almost entirely with a life insurance policy in apparent violation of the “incidental insurance” rule. Second, there were funding differences between owners/key employees and other non-highly compensated employees, which the IRS thought might violate the “non-discrimination” rule. Third, some life insurance policies were designed with “springing cash value.” Such policies had low cash surrender values in early years, and the policy would be purchased from the plan for this artificially low value and then converted to another policy with enhanced cash value.
The IRS responded to these perceived abuses in 2004 and 2005 with a series of rulings. To address the “incidental insurance” issue,” the IRS issued Revenue Ruling 2004-20. The ruling stated that if policies provided benefits at retirement in excess of plan benefits, the plan was not a 412(e)(3) plan. However, such a plan could be considered a “regular” defined benefit plan, but it would be subject to rules regarding actuarial certification, minimum funding, quarterly contributions, etc. The financial effect of being a regular defined benefit plan rather than a 412(e)(3) plan would be that the amount of deductible contributions would be substantially reduced. The ruling also stated that if a plan owned life insurance policies with a face amount exceeding the plan death benefits, the premiums for “excess” insurance were non-deductible and subject to an excise tax, and if the policy death benefit exceeded the plan death benefit by more than $100,000, the plan was a “listed transaction” subject to registration and taxpayer disclosure.
The IRS also issued Revenue Ruling 2004-21 regarding life insurance in all types of qualified plans, and the ruling addressed the “non-discrimination” issue. In essence, the ruling stated that the plan must provide similar policies with similar benefits to all participants on a non-discriminatory basis — if the policy rights and benefits for highly compensated employees (HCE) are greater than those for the non-HCE participants, then the plan is discriminatory and it is not a qualified plan under IRC section 401, resulting in numerous adverse tax consequences.
In 2005, the IRS issued a Notice and Regulations designed to prevent the use of unreasonably low policy values for purposes of tax avoidance. To eliminate the “springing cash value” issue, the fair market value must be used to determine the value of a life insurance policy for tax purposes, and the fair market value of a policy is the greater of the “interpolated terminal reserve” or the “PERC” amount (premiums plus earnings minus reasonable charges) times the “average surrender factor” for policies with stated surrender charges. The net effect of these rulings is that, for income tax purposes, the value of a whole life policy will be its total cash value (including outstanding loans) and the value of a universal life policy with stated surrender charges will range from 70 percent to 100 percent of gross cash value.
A 412(e)(3) plan has several advantages over other types of retirement plans. Compared with defined contribution plans, it offers certainty and guarantees regarding retirement benefits, an attractive feature in today’s financial environment.
Compared with other defined benefit plans, 412(e)(3) plans are easier to understand for participants. Rather than plan benefits being expressed as a monthly pension payable at some time in the future, a participant’s “accrued benefit” is simply equal to the cash values of the policy. In addition, 412(e)(3) plans are simpler and less expensive to administer than other defined benefit plans. There are no complicated actuarial calculations and no requirement for periodic actuarial valuation and certification, and they are subject to reduced premiums payable to the Pension Benefit Guarantee Corporation. Also, contributions to a 412(e)(3) plan may be paid annually, whereas other defined benefit plans must be funded quarterly.
Tremendous market opportunity
There are 4 million small businesses with fewer than 10 employees with no retirement plans. Many of these businesses are ideal prospects for a 412(e)(3) plan. The ideal candidate is a small business with relatively few employees in which the owners and key employees represent a relatively high percentage of the total employees — for example, smaller professional practices (doctors, lawyers, etc.). Because defined benefit plans tend to favor older, higher-compensated participants, if the owners and key employees generally are older than the rank-and-file employees, the substantial majority of plan contributions may be allocated on their behalf and a 412(e)(3) plan will be very attractive. However, perhaps the most important characteristic of an ideal prospect is a primary objective and long-term commitment to save for retirement. Therefore, the business should have relatively stable and predictable revenues and profits, and adequate cash flow to pay contributions.
There is a tremendous opportunity in this market. The result of the recent IRS rulings is a clearer blueprint of the proper design and administration of 412(e)(3) plans, and many life insurance companies have created new life and annuity products, and plan sponsors and administrators have been designing compliant and attractive plans. It is a new day for fully insured defined benefit plans.
Lynn Nolan is senior advanced sales consultant for Penn Mutual Life Insurance Company. She can be reached at 215-956-8023 or firstname.lastname@example.org.