By Jeff Bradley

Many sponsors of frozen, defined benefit (DB) pension plans are struggling to maintain key talent, especially older, long-service employees. In particular, these plan sponsors are finding that many older employees are terminating employment so they can draw on fully subsidized or nearly fully subsidized accrued pension benefits.

The Pension Protection Act of 2006 (PPA) added IRC Section 401(a)(36), permitting defined benefit pension plans to offer an in-service retirement option to active plan participants who have attained age 62. This allows plan sponsors to offer these participants full benefits under the plan while retaining them as employees. In this regard, defined benefit plan sponsors may wish to explore the possibility of amending their plans to offer an in-service retirement option.

Available alternatives
There are several alternatives available with regard to an in-service retirement option:

• The least expensive alternative for plan sponsors would be to allow active participants to elect to receive full normal retirement benefits after attaining the normal retirement age (NRA)
• The most expensive alternative for plan sponsors would be to allow active participants to elect to receive fully subsidized retirement benefits after attaining age 62

Certainly other alternatives are available, such as allowing active participants to elect to receive fully subsidized early retirement benefits upon attaining an age after age 62 (but before NRA) or to allow active participants to elect to receive actuarially reduced benefits upon attaining age 62.

Quantifying the cost
Plan sponsors need to be aware that providing in-service subsidized retirement benefits will generally increase the ongoing cost of the plan. Specifically, the plan amendment will most likely increase the minimum required contribution under IRC Section 430 and will most likely increase net periodic pension expense. Moreover, depending on the funded status of the plan, the increase in the IRC Section 430 funding target may need to be paid in full before the amendment can take effect.

However, depending on the actuarial assumptions used, allowing participants to elect to receive full normal retirement benefits after attaining NRA may not result in an increase in the plan’s funding target. This will instead cause the plan to forgo any actuarial gains expected for those participants who would otherwise continue to work past NRA. This may be an attractive alternative for those plan sponsors desiring to retain key talent at minimum cost for employees who are past NRA.

Other considerations
Please be advised that regulations have not been issued by the IRS on Section 401(a)(36). The following is a list of items that plan sponsors may wish to consider when deciding to offer an in-service retirement option.

• Including the subsidy: There is some question as to whether fully subsidized early retirement benefits can be paid to in-service retirees. Specifically, in Notice 2007-8, the IRS requested comments as to whether in-service distributions could include the value of early retirement subsidies. After discussing with counsel, plan sponsors may wish to request guidance from the IRS (either formal or informal) if early retirement subsidies will be included in the in-service distribution option.
• Death and disability benefits: In-service annuitants who die generally receive the death benefit paid by the benefit form elected. In-service annuitants who become disabled must receive the better of the disability benefit payable under the plan or the in-service distribution. In this regard, plan sponsors may wish to consider eliminating enhanced disability benefits for in-service annuitants.
• Who to cover: Plan sponsors do not have to offer the in-service retirement option to all plan participants. However, the group to whom this option is available must not discriminate in favor of highly compensated employees.
• Effect on workforce demographics: Early retirement subsidies are put into defined benefit retirement plans as incentives for workers to retire early. In-service distributions remove this incentive. Because many employees retire early, which is often due to health reasons, many plan sponsors could incur additional costs associated with active healthcare benefits because of those less healthy employees who choose to remain employed and receive in-service distributions.
• Formal phased retirement plan: Given the above consideration of a potential adverse impact to active healthcare costs, plan sponsors may wish to require that in-service retirements be conditioned on participation in a formal phased retirement program.

Milliman is here to assist you with this matter. Please contact your Milliman consultant for more information.

Defined benefit, Pensions defined benefit