Single employer defined benefit pension plans that have a lump sum distribution option must keep the plan at least 80% funded in order to continue to offer the full lump sum payment to their participants. This requirement was added by the Pension Protection Act of 2006 (PPA). Plans that were completely frozen prior to September 1, 2005 are not subject to this rule.
There are two levels of restrictions if the plan is less than 80% funded. If the plan is less than 80% funded, but is over 60% funded, only half of the otherwise payable lump sum may be elected by the participant. The remaining portion of the benefit must be either paid as an annuity (monthly benefit) or deferred until a later date, depending on elections of the plan sponsor.
If the plan falls below 60% funded, no lump sum may be paid.
There is an exception to the restriction on lump sum values less than $5,000 which are permitted to be paid in full regardless of the funded percentage.
Participants of the plan that would be affected by the limitation must be given a notice of the applicable status within 30 days. The notice must be issued both when a restriction applies and when the restriction is lifted.
In addition to this PPA limitation, there is a long-existing rule restricting lump sum payments from defined benefit plans to Highly Compensated Employees (HCEs) who are part of the top 25 paid group. A benefit payment to an HCE may not be paid in excess of the annual single-life annuity amount if the plan is less than 110% funded. This means that lump sums (as well as other forms of payment that would provide a benefit larger than the single-life annuity) may not be paid. There are limited options for the HCE to elect the restricted payment if certain, often undesirable, parameters are met, such as creating an escrow account, providing a bank letter of credit, or posting a bond, depending on the terms of the particular plan.
There are many twists and turns involved in the application of these restrictions on distributions. If your plan currently has a lump sum option, or if you are considering adding a lump sum option, you should consult with your plan advisors at Watkins Ross to help evaluate the circumstances specific to your plan. If you have someone in your personal network that has questions about this, please let us know.
Blog authored by Cheryl Gabriel, CPC.