The IRS has published a final regulation that allows defined contribution plans to offer longevity annuities commencing as late as age 85.  Although the final regulation is similar to the rule proposed in 2012, the IRS has made some welcome improvements in response to public comments.

The final regulation is effective for annuities purchased after July 1, 2014.  Employers might wish to consider whether to offer longevity annuities in their defined contribution plans, now that the IRS has explained the rules that govern these annuities.

IRS Modifies Minimum Distribution Rules to Allow Longevity Annuities

Tax-qualified plans are required to satisfy minimum distribution rules.  These rules generally require a defined contribution plan to begin distributing a participant’s account soon after age 70½ (or retirement, if later) and to distribute at least a minimum amount each year.  If the participant dies before his account is fully distributed, the account must be distributed at least as rapidly (and often more rapidly) to his beneficiaries.  Similar rules apply to IRAs.

The purpose of the minimum distribution rules is to ensure that tax-advantaged retirement plans serve primarily as a source of retirement income for employees, and not as an estate-planning vehicle that transfers retirement savings intact to their heirs.  As more and more employees lose access to the guaranteed lifetime income formerly provided by defined benefit plans, however, employers and the federal government have become concerned that employees will outlive their retirement savings.

One solution to this problem is to allow participants in section 401(k) plans, section 403(b) plans, and other defined contribution plans to use a portion of their account to purchase longevity insurance, which will provide a stream of payments commencing at an advanced age and continuing for the remainder of the participant’s life (and, if the participant elects, the life of a designated beneficiary).  The final regulation modifies the minimum distribution rule for defined contribution plans and IRAs to permit them to offer this deferred annuity option.

Qualifying Longevity Annuity Contracts (QLACs)

Like the proposed rule, the final regulation limits the portion of a participant’s account that the participant may use to purchase a longevity annuity.  Under the final rule, the limit is the lesser of 25% of the participant’s account or $125,000 (increased from $100,000 under the proposed rule).  The dollar limit is indexed for inflation.  The final regulation allows for more frequent indexing (in $10,000 increments rather than in $25,000 increments).  The annuity must commence no later than a specified age (currently age 85, although the IRS might increase the maximum age in the future to reflect changes in mortality).

Under the proposed rule, the longevity annuity could not provide any death benefit other than a life annuity payable after the employee’s death to a designated beneficiary or beneficiaries.  The final regulation allows the longevity annuity to include a “return of premium” feature, so that if the employee dies before receiving annuity payments at least equal to the premiums paid for the contract, the employee’s beneficiary will receive a lump sum equal to the unrecovered premiums.  If the contract provides a life annuity to the employee’s surviving spouse, the contract may provide the return of premium after the death of both the employee and the spouse.

The final regulation also includes the following helpful modifications or clarifications:

• A procedure for correcting premium payments that inadvertently exceed the permitted limits;

• Clarification that longevity annuities may pay dividends or provide for cost-of-living adjustments (but may not be variable annuities or provide a cash surrender value);

• A special exception that allows a plan to comply with the requirement to provide a qualified pre-retirement survivor annuity to a surviving spouse;

• A rule allowing insurers to designate existing contracts as qualified longevity annuity contracts in a rider, endorsement, or certificate, so that the insurer will not have to re-submit the contract for approval by state regulators;

• The elimination of a requirement to disclose specific information to participants when they purchase a longevity annuity (although the final regulation preserves an annual reporting requirement).

Longevity Annuities Under IRAs

The final rules permit IRA owners to purchase qualified longevity annuities with a portion of their IRA accounts.  The 25% limit applies to the owner’s IRA accounts in the aggregate (not including Roth IRAs, which are exempt from the minimum distribution rules).

While employer-sponsored retirement plans must use sex-neutral mortality tables to determine the price of longevity annuities, IRAs may use sex-distinct tables that reflect the longer life expectancy of females.  Accordingly, females might receive more favorable pricing if they purchase longevity annuities under an employer retirement plan, while males might receive more favorable pricing under an IRA.