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Suggestions for Regulatory Next Steps to Accommodate DC Annuities

by Robert Toth
Posted on September 21, 2012
Both Treasury and Labor continue to engage in efforts to accommodate the availability of defined contribution plans to provide participants the ability to choose to use a portion of their account balances to choose some level of guarantee lifetime income.  The Treasury’s efforts have been especially notable, as Rev Ruling 2012-3 (which defined the spousal consent rules for plan annuities) and the proposed Qualified Longevity Annuity Contract regulation (which grants RMD relief for certain annuities) have established some very basic groundwork to enable DC annuitization to be broadly made available. 
 
Both of these agencies continue to attempt to support this process, using their existing regulatory authority. Though there are a number of things which probably need legislative action in order to really make guaranteed lifetime income readily available, there are still a few things regulators may want to consider doing to help it all along:
 
1.  Clarify the QPDA.  Both the QLAC at 2012-3 rely on a fundamental premise, that the annuity contract, or “qualified plan distributed annuity” (the “QPDA”) can be distributed from the plan. Distributing annuities from plans has been around for generations, and the concept is well imbedded in various parts of the Code. However, it would be helpful to consolidate those rules into a single piece of guidance discussing the rules which will apply to these distributed annuities.
 
2. Title 1 Clarification. While the DOL is focusing on important issues such as education and disclosure of lifetime income amounts, there is actually an important structural issue it can also address. We all assume that a distribution of a QPDA is also considered a distribution for Title 1 purposes as well, mostly because of the "ordinary notions" of property law upon which ERISA's plan asset rules are based. It s a fiduciary decision to purchase the right kind of an annuity, and any sort of post distribution protections which are needed can be built into such an annuity (such as not being used as an end-around the spousal consent rules). But there appears to be little reason not to treat annuities, even if they have a cash surrender value, or otherwise have an account balance, as a distribution from the plan under ERISA Title 1. This is particularly so where the participant has the right, instead, to take that same amount in cash rather than purchasing an annuity.
 
3.  Rollover Guidance. 1.401(a)31 Q&A 17 makes it clear that you can roll money over from a distributed annuity. The language is quite striking:
 
“Q-17. Must a direct rollover option be provided for an eligible rollover distribution from a qualified plan distributed annuity contract?
 
A-17. Yes. If any amount to be distributed under a qualified plan distributed annuity contract is an eligible rollover distribution (in accordance with Section 1.402(c)-2), Q & A-10 the annuity contract must satisfy section 401(a)(31) in the same manner as a qualified plan under section 401(a). Section 1.402(c)-2, Q & A-10 defines a qualified plan distributed annuity contract as an annuity contract purchased for a participant, and distributed to the participant, by a qualified plan. In the case of a qualified plan distributed annuity contract, the payor under the contract is treated as the plan administrator. See Section 31.3405(c)-1, Q & A-13 of this chapter concerning the application of mandatory 20-percent withholding requirements to distributions from a qualified plan distributed annuity contract.”
 
However, it is has never been entirely clear that you can roll funds into a QPDA.  Making this clear would increase the ability to consolidate and “port” these benefits, and to switch out of a contract that becomes unfavorable or from an insurer that becomes financially weak.  The complications for this, however, lie in the securities laws, and whether or not this annuity would need to be a registered product.  
 
In any event, there are a number of interesting steps the agencies can take within existing authority-even though I probably shouldn't be thinking about this stuff while we're surrounded by peak color season up in mountains....  
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BNA's "First Steps to Modernizing DC Annuitization: QLACs and Revenue Ruling 2012-3"

by Robert Toth
Posted on April 10, 2012

For those of you who do not subscribe to BNA, BNA published as an "Insight" an article I wrote on QLAC and Rev Rul 2012-3 (yes, my author agreement permits me to post it here, with attribution).  Look for Paul Hamburger's upcoming related article, delving into a number of technical and policy issues they raise, as well as discussing the releases on transferring to a DB plan. Link here: First Steps to Modernizing DC Annuitization: QLACs and Revenue Ruling 2012-3.

I will be speaking on a panel addressing this topic with Mark Iwry, Jeff Turner and Wally Lloyd at the ABA Section of Taxation's Employee Benefits Committee general session on May 12 in DC. 

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QLAC and the Fiduciary Standard in the Commercial Pooling of Interest

by Robert Toth
Posted on April 2, 2012

The Treasury's issuance of proposed regulations introducing the "Qualified Longevity Annuity Contract" is a substantial step in the efforts to better provide plan participants the ability to use their defined contribution balances to plan for retirement security. One of the QLAC's most useful effects is that it gives us a "base," a laboratory of sorts, which permits us to look closely at the legal and practical issues in "real time" which are related to using DC plans to help fill in the gaps left by the demise of defined benefit plans.

One of the fundamental issues the proposed regulation raises is one which is beyond Treasury's control:  what is the fiduciary's exposure to the potential future insolvency of an insurer when choosing a QLAC provider? Absent a federal insurance system like the FDIC or the PBGC which ultimately guarantees this risk-which is likely to be a number of years off, if even possible-does this means that it will never be prudent for a fiduciary to purchase a QLAC, or any annuity, under which a single insurance company insures the risk?

Many of us have been seeking legislative and regulatory solutions to this for a number of years, to little avail. Having thought about this much, and having blogged on it on the issue on more than one occasion, I have come to the conclusion that it is unfair to expect the DOL  (and likely well beyond its mandate) to develop much more of a standard beyond what it has already published. If you read its "annuity safe harbor" standard closely,  you will see that it is comprehensive and describes the fiduciary standard well. But there still exists a queasiness about how to apply it.

I believe that the issue, however, is not as intractable as it seems, and the answer does not lie in further regulation. It lies in becoming more comfortable with the idea of risk and the commercial pooling of interests.  Fiduciaries should be able to comfortably assess an insurer without either becoming insurance experts or- at least on the narrow issue of insolvency- having to rely on an expert's prognostication as to whether an insurer will be around decades from now.

The real issue, as made starkly clear by the SCOTUS in the oral arguments on heath care reform, is that there appears to be a serious lack of understanding in the legal, judicial and investing communities of the nature of risk and of the commercial pooling of interest.  This lack of understanding seems to be underpinned by a reluctance to accept that we, collectively as a society, share certain risks that can only be managed at a more global level.  

There are a few key (but not so obvious)  concepts, that have existed for centuries that the law (and financial advisors) should recognize, and upon which fiduciaries should be able to rely:

  1.  Risk is a natural part of life.
  2. Our individual risks often are inter-related. Thus people can, and have, well managed these risks by pooling interests with those who have similar risks.  
  3. Managing this pooling is complicated and requires specialized knowledge which has been successfully accomplished commercially (which also provides a level of financial accountability which structurally may be missing in government based programs).  
  4. Financial "scale" is necessary to make risk pooling commercially work.
  5. Such "scale"  and complexity makes it impossible for any single policyholder to protect itself against fraud and mismanagement of the pool.
  6.  Collectively acting through government provides the regulatory scale necessary to protect citizenry from insurance (pooling) mismanagement and fraud, and the regulation of pooling is significant. Making sure commercial insurance is able to fulfill the pool's promise is an appropriate government function for protecting the well being of its citizenry.

In the end, the risk of insurer insolvency is a societal risk for which no fiduciary should be held accountable, as long as they are familiar the regulatory structure which is in place and uses it in making their decisions.

Regrettably, I believe much of the misunderstanding about pooled risk is reflected in deeply rooted political beliefs which was epitomized by the "Ownership Society" concept promoted by the Bush II administration. Though no one can deny the need for accountability, one should neither deny that longevity risk can really only be managed by acting in accordance with our common, and thus pooled, interests.

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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.   

 

 

 

 

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How DC Annuitization Works; Using the QLAC

by Robert Toth
Posted on February 25, 2012

I have spent much of my career studying and practicing in the law of annuities as it applies to retirement plans-starting even prior to my long stint with an insurance holding company, when the Master Trust of the Fortune 100 company for which I was in-house ERISA counsel formulated its own synthetic, pooled GIC for the fixed account in its newly formed 401(k) plan back in 1986-87.

So it should have been no surprise when some very smart colleagues (whom I hold in high regard) were wondering about my enthusiasm about Treasury's newly released guidance on annuities (though there are a few others who do share this enthusiasm). After all, the rulings and the proposed regulation really seem minor in the grand scheme of things.  They did not resolve a number of issues, and almost seemed to raise more questions than they answered.

Sometimes, it seems, one can get too close to an idea and think that-of course-everyone sees what I see!

So, I've attached a graphic of how DC annutization works to help explain why the Treasury guidance is so fundamental and crucial to the next steps.  I invite you to take a close look at the chart in the first 4 pages of the patent application that Dan Herr and I filed in 2007, after actually working on it for a few years (it was assigned to my former employer, who has never used it; the patent was initially denied, never has been granted, and don't think it ever will (or can be)). It shows how your basic mutual fund 401(k) plan can serve as an annuity processing platform; how the distribution of annuities from the plan works; and why things like spousal consent and annuity starting date are so important to making it work.

The chart shows one way its possible to set up a QLAC with an automatic withdrawal program, using the plan's mutual fund, separate account, or even pooled investments which are then backed up with a QLAC or other lifetime guarantee. The chart is complex, in that the lifetime income demonstrated can be a set lifetime amount (such as a QLAC), variable annuitization, or even a GMWB.  It also shows how to do it within the plan itself, or to be distributed out of the plan, and how to do it using either an "in-plan" or "distributed" GMWB as well as a QLAC.

I was invited to Treasury's de-brief in DC the day the guidance was released, and it became clear to me then how this 6+ year old chart really puts the QLAC to great use (even for rank and file), and takes great advantage of the clarity provided in 2012-3.  Now can you understand my enthusiasm?

It ain't easy (yet), and it ain't pretty (yet). I caution that the description is in bureaucratic-speak, written by a patent lawyer in the way engineers are trained to do. But take some time on the charts, as they may help understand a few things about what may be going on with these things. 

The chart shows that Treasury actually answered key questions with its guidance. But my point is not that DC annuities are the "be all and end all" of retirement security, though they have an important place in making the system work right.  Nor is it that the insurance industry is the knight in shining armor (clearly, I know  its underbelly well) for which I am some apologist.  Its just that we now have the basic structure in place under which an important set of other operational and legal questions can be identified, asked and answered in an identifiable framework;  the argument-so to speak-has been framed. The rulings importantly  recognized that DC annuities will be treated as investments, with some strings attached to protect spousal rights; that there is a basic annuity starting date rule; that there is a forfeitability approach; and that Treasury is thinking about reporting and disclosure. Given this, we now know what even to ask.

Join us, by the way,  for a teleconference by the ABA's Joint Committee on Employee Benefits on March 1, where we will go over some of this stuff, in English....

 

 

 

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Treasury and IRS Successfully Lay the Base For Lifetime Income: The "2012-3 Annuity" and The QLAC

by Robert Toth
Posted on February 6, 2012

Treasury nailed it (or, as our eldest son is fond of saying, they just "friggin’" nailed it).

With just a relatively short regulation and a Revenue Ruling, Treasury simply and in a very straightforward way laid out the definitive structure for defined contribution plans (like 401(k) plans) to start providing lifetime income in a market friendly manner. The two pieces of guidance dealing with DB plans which were issued at the same time are very useful, but the meat of the matter is the critical guidance given under the proposed RMD regulation and the spousal consent Revenue Ruling, 2012-3.
 
The seminal guidance doesn’t answer all the questions, but it does creates the structure, and a context, in which other questions-both from the tax and the ERISA side-can be meaningfully addressed.  Amazingly, it is also structured in such a manner to accommodate both straight life annuities and the living benefit products as well (like the GLWB).
 
I had criticized IRS and Treasury in the past for what I had viewed as the less than thoughtful way in which they were addressing (and not addressing) critical lifetime income issues. The new releases change all of that, and–the more I look at it-in a pretty startling way. I’m not sure I have ever seen so much stuffed into so little a regulatory space.
 
I particularly like the proposed QLAC (“qualified lifetime annuity contract”): its an everyman’s rule. It is nonforfeitable (many argued that it be otherwise), and it is simply designed for meaningful use by the rank and file. Other, more exotic, annuities with living benefits and the like (which are generally geared for the high net worth participant) still can be used for lifetime income as 2012-3 Contracts, but they just won’t get the beneficial QLAC treatment under the RMD rule. There’s really no sane policy reason to incent those products, as such would actually serve as a disincentive to guaranteed lifetime income. 
 
I'd like to share with you some of my initial thoughts on just what the proposed QLAC reg and Rev Rul 2012-3 did. Discussion and further study may shift some of these, but for now:
 
 
 
1.  Lifetime income as an investment. The QLAC and 2012-3 both confirmed a critical point: that the annuity contract can be treated as a plan investment, rather than a plan benefit.  They both made it clear that the purchase of the product could be a plan investment, rather than as for funding a benefit feature under a plan design. It is a critical distinction.
 
They recognize that 401(k) plans are able to purchase these products (with their varying levels of features, terms and conditions) for accumulation of lifetime income; for purchase of a deferred annuity to be distributed at the time of separation from service; or to be held within the plan itself and paid out over time, under their plans’ investment rules without massive changes to the terms governing the plans’ benefit structures.  To do otherwise would make lifetime income virtually impossible,  given the way the plan document market currently operates.
 
There will still be some technical “in-plan” versus “out of plan” things a plan will have to deal with but, if you are a document drafter, just make sure that the distribution rules under the plan don’t require a cash distribution, and permits a lump sum distribution. Better yet would be specific language permitting an in-kind distribution from the plan or, even more specifically, the distribution of an annuity contract. These can be well addressed within this structure.
 
2.  Spousal rights. Though the annuity purchase may be an investment, and not a benefit structure, 2012-3 and QLAC clarified that spousal rights will still apply on distribution of funds from the annuity (even if the annuity is distributed from the plan) and described the manner in which those rights will be applied. Rev Rul 2012-3 actually took a different position (and a very meaningful and useful  one, at that) than both of the two methods outlined in the two previous and conflicting PLRS.  
 
It also has the effect of setting the stage (under standard DOL and state contract rules) for the “nervous administrator” of a plan to delegate that responsibility to annuity companies to take on the role of being the administrator.
 
3. Annuity starting date.  In outlining spousal rights, 2012-3 also provided us with a sensible definition of annuity starting date. Effectively, it is the payment date on which a contract payment can neither accelerated or commuted. The mere existence of a lifetime payment default at a future date will not trigger the annuity rules on those non-annuity withdrawals; the “profit sharing" rules will apply until the 180 day period before the actual default annuity staring date. There are likely a number of clarifications which will be needed to apply this rule under certain circumstances, but Treasury and IRS now has a structure within which to make consistent interpretations.  
 
This will serve the plan in many ways, including making possible sane application of the manner in which QDROs and the like will apply, as well as the manner in which a required minimum distribution is computed.
 
4. Forfeiture.  As I noted in the discussion of the QLAC, Treasury and the IRS made it clear that, once the benefits are purchased, they can only be forfeited by death (and, then, only if the spouse is protected or given the right to waive), and otherwise subject to the 401(k) rules.  This may create portability issues but there are better ways to address that issue than allowing forfeiture (see, for example, reporting and disclosure, below). 
 
5. Reporting and disclosure. A QLAC requires IRA type of reporting, and a new participant disclosure. This is probably the most striking of the new rules: the concept actually enables structural solutions to a number of other problems.
 
For example,  the reporting rules do not apply to annuities distributed under 2012-3, but Treasury should consider doing so when finalizing the QLAC regs.  The reporting could enable the DOL to manage portability (which, when it gets down to it, is really a Form 5500 problem) by doing such things as eliminating the 5500 reporting of these 2012-3 annuities which are distributed by a plan (as they probably are now); and would allow the DOL to provide simplified reporting for 2012-3 annuities still held by a plan.  From a pure public policy and tax administration view, reporting  these 2012-3 annuities prevents them from effectively “marching” put of the system-which they are, effectively, doing now.  
 
Oddly enough, reporting also enables 2012-3 contract consolidation after leaving the plan. The rollover regs treats amounts distributed from such contracts as being able to be rolled over to another qualified plan, a reg which could then simply be clarified to roll into another 2012-3 contract-without the IRS getting worried about these funds disappearing into a black hole.
 
These rulings even helps address the fiduciary issue: one option carriers will have is to design 2012-3 contracts” that fall within state guaranteed fund schemes, until such time as Congress creates alternate federal protection.
 
Helpful would be a ruling by the DOL that, as long as the insurer picks up the administration responsibility, that 2012-3 contracts should not be considered plan assets when distributed from the plan. Also, because a number of security law rules are implicated, it would be helpful to get the SEC to cmmit to play in this sandbox.
 
It’s finally begun.
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