This blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.
While last month’s blog explored the permissible times NDCP distributions may occur under section 409A of the tax code, this month’s entry examines the rules surrounding the forms of payment that may be offered under these plans. Accelerations and deferrals can just as easily be effected with a choice of form (e.g., lump sum versus installment payments) as they can with timing elections. These two sets of rules are connected because they share a common purpose: proving some degree of flexibility while preventing the type of excessive control that 409A was enacted to eliminate. The following will examine how sponsors can ensure that their NDCP’s forms follow 409A function.
First step: grounding form flights of fancy
NDCP participants are used to the free-flowing flexibility of the qualified plan world in which they can typically wait right up until their benefit commencement date (BCD) before having to commit to the form of payment under which they wish to have their plan benefits distributed. A further false sense of flexibility may arise from pre-409A provisions, which permitted the linking of the form of payment from the NDCP to the form of payment elected by the participant under the qualified plan that the NDCP was intended to supplement. These were most prevalent in defined benefit (DB) style NDCPs but occasionally also appeared in some defined contribution (DC) ones. The 409A rules do allow grandfathering of prior amounts (see the “Honor thy 409A Grandfather” entry of this series for details); however, such linking is prohibited for benefits attributable to post-December 31, 2004, accruals or contributions.
Because the rules governing NDCP form elections for such amounts are much more rigid, NDCP sponsors must make sure they clearly communicate these differences to participants, develop the appropriate 409A compliant plan design for their executive group, and vigilantly administer their NDCP(s) in accordance with such designs. 409A generally requires that the participant’s form of payment under a NDCP be designated much earlier than would be the case under a qualified plan. For most NDCPs, the rule requires participants to elect their form of payment when they first become eligible for the NDCP. Accordingly, sponsors need to provide participants with sufficient notice and means to make this election prior to the expiration of their initial eligibility period (i.e., generally 30 days from the date they are first designated as eligible).
Exceptions to the rule
There are two exceptions to this rule requiring participants to make form elections to be made when first eligible:
(1) The “How do you meet a deadline you didn’t know existed?” exception
This applies for “non-elective excess benefit” NDCPs (i.e., plans that solely provide benefits beyond those permitted in qualified plans). Under these plans, a participant often automatically becomes eligible when benefits under the qualified plan become limited under the rules governing qualified plans. Because determining whether a participant is eligible requires calculations, both the participant and the NDCP sponsor may be unaware that the participant has become eligible in the plan for some time after actually first becoming eligible. 409A addresses this concern with a special rule giving participants in these plans a one-time opportunity to elect the form of distributions within 30 days after the end of the first year in which they accrue a benefit under the plan. No new elections are permitted if the participant subsequently accrues benefits under a different excess benefit plan of the same NDCP sponsor.
(2) The real life annuities of 409A
409A permits NDCPs to treat all “actuarially equivalent life annuities” as one form of payment. This treatment is extremely beneficial because it means such annuities are not only free from the previously discussed 409A rule regarding initial form elections but also from the dreaded “12-month/five-year” rules described later in this blog. As a result, participants who limit their election to only these annuities are free to initially elect and then switch back and forth between as many of such annuity option their NDCP offers right up until their BCD. So the key question is — which forms of payment have 409A deemed worth of casting in this role? The general definition under 409A makes it clear that the traditional single life annuity and joint and survivor annuities (e.g., joint and 50% survivor) qualify as long as they are payable not less frequently than annually and are actuarially equivalent applying reasonable actuarial methods and assumptions. While “actuarially equivalent” and “reasonable actuarial methods and assumptions” are not specifically defined, the rules do offer the following guidance:
(a) When determining whether two life annuities are actuarially equivalent, the same actuarial assumptions and methods must be used in valuing each life annuity.
(b) The above requirement applies over the entire term of the participant’s participation in the plan, such that the annuities must be actuarially equivalent at all times for the annuity options to be treated as one time and form of payment.
(c) As long as the actuarial methods and assumptions are reasonable, there is no requirement that consistent actuarial assumptions and methods be used over the term of the participant’s participation in the plan.
(d) The plan may change the actuarial assumptions and methods used to determine the life annuity payments provided that all of the actuarial assumptions and methods are reasonable.
(e) There is no requirement that the actuarial assumptions and methods used under a NDCP plan be the same as those used in a qualified plan sponsored by the NDCP sponsor.
In addition, the rules generally provide that certain specified features are ignored for purposes of determining whether a particular annuity is treated as a life annuity under the form of payment rules (but not for purposes of determining whether a life annuity with such a feature is actuarially equivalent to a life annuity without such a feature). These include:
• Term certain features (under which annuity payments continue for the longer of the life of the annuitant or a fixed period of time)
• Pop-up provisions (under which payments increase upon the death of the beneficiary or another event that eliminates the right to a survivor annuity)
• Cash refund features (under which payment is provided upon the death of the last annuitant in an amount that is not greater than the excess of the present value of the annuity at the annuity starting date over the total of payments before the death of the last annuitant)
• Social security or railroad retirement leveling features (including leveling features related to early retirement, survivor, or disability benefits)
• Features applying a permissible cost-of-living index
Accordingly, a life annuity with any of these specified features may be treated as a life annuity if the two life annuities are actuarially equivalent (taking into account the feature) and have the same initial payment date. With respect to subsidized joint and survivor annuities, such forms are treated as actuarially equivalent to a single life annuity provided that neither the annual lifetime annuity benefit nor the annual survivor benefit available under the joint and survivor annuity is greater than the annual lifetime annuity benefit available under the single life annuity. For example, a single life annuity providing $200 a month for the lifetime of the participant may be treated as actuarially equivalent to a joint and survivor annuity providing up to $200 a month for the lifetime of the participant and up to $200 a month to the surviving joint annuitant.
A life only sentence is not the only option
While limiting the NDCP form option to only life annuities options described in the previous section certainly provides the maximum flexibility permitted under 409A when it comes to the timing of the election, such enhanced flexibility may not be sufficient motivation for participants to eagerly eschew two of the more popular payments form under NDCPs: lump sums and installments payments. This is especially true in DC-style NDCPs where, as with their qualified plan counterparts, we see these options much more than with life annuities.
If the NDCP provides these popular options either along with or in lieu of the aforementioned life annuity options, then it must include and enforce the early form election procedures discussed earlier (i.e., participants must make the form election when first eligible to participate). Once the participant makes the initial form election, the ability to change such election in the future will then depend on which form is chosen. Assuming life annuities are offered and such annuities meet the criteria previously discussed, participants electing one of these alternatives will be able to switch back and forth between such annuities all the way up to their BCD. However, once a lump sum or installment option election is made (whether as an initial election or as a change from an initial life annuity election), the 409A subsequent deferral rules apply. These rules provide that a plan may permit a subsequent election to change the form of payment, provided that the new election meets three conditions (i.e., the “12-month/five-year rule”):
(1) Made not less than 12 months before the first date a payment scheduled for a specified time or based on a fixed schedule would otherwise have been paid
(2) Takes effect at least 12 months after the date the new election is made
(3) Defers payment for no less than five years from the date the first payment otherwise would have been made
The payment date cannot be accelerated under these rules. For example, if the original payment terms provided for a lump sum payment at age 60, the subsequent deferral election must be made before the employee becomes 59 and the payment date cannot be earlier than age 65.
Because the 409A rules described above apply both to participants and NDCP sponsors, a participant, a NDCP sponsor, or both a participant and a NDCP sponsor may have and exercise discretion to defer payment after the form of payment has been specified provided that such discretion is limited to changes that comply with the 12-month/five-year rule. This is important to note because it means that a NDCP sponsor is not able to avoid this requirement by amending the plan. However, the rules do not apply to changes in the form of payment under the terms of a domestic relations order to the extent the change in the form of payment applies to a payment that will be made to the alternate payee and not the participant. For example, a domestic relations order generally may provide for a new form of payment to a spouse or former spouse of the participant or provide such spouse or former spouse discretion to determine the form of payment to such spouse or former spouse.
If installment payments are in the election mix, the sponsor and participants need to also consider whether such installments are considered as a single or separate payment for purposes of applying the 12-month/five-year rule. The first step is to check the plan document to see if it indicates the applicable treatment. Under the 409A rules, if the plan is silent, installment payments are treated as a single payment. Any subsequent elections for installment payments treated as a single payment must be made at least 12 months before the installments were scheduled to begin and the payment of the first of the installments must be deferred at least five years from the original commencement date. Alternatively, installment payments may be treated as a separate payments. In this case, the 12-month/five-year rule applies to each separately identified payment. This approach enables participants to make subsequent elections after commencement has already begun. (i.e., the employer or participant could then subsequently elect to further defer a portion of the installment payments rather than all of them). The following two examples illustrate the difference between the single and separate approaches:
Single: Assume the participant is in a NDCP that provides for payment in a series of five equal annual amounts that are not designated as a series of five separate payments. The first amount is scheduled to be paid on January 1, 2020. Provided the participant makes the election on or before January 1, 2019, he or she may elect for the first payment scheduled to be deferred until January 1, 2025. Because the single payment rule is in effect, the remainder of the payments will automatically commence on January 1, 2026, and each January 1 thereafter.
Separate: Assume the same facts as above except that under its terms, the NDCP designates each payment as a separate payment. The first payment is scheduled to be made on January 1, 2020. Provided the participant makes the election on or before January 1, 2019, he or she may elect for the first payment scheduled to be made on January 1, 2020, to be deferred until January 1, 2025. If the participant makes that election but does not elect to defer the remaining payments, the remaining payments continue to be due upon January 1 of the four consecutive calendar years commencing on January 1, 2021.
Special consideration must be given if the employer or employee wishes to change the form of payment from installments to a lump-sum payment if the plan provides that each installment is treated as a separate payment. The lump-sum payment date must be at least five years after the final installment payment date. For example, consider a plan that provides for the payment of five equal annual amounts, each of which is designated as a separate payment. The first installment is scheduled for January 1, 2016, and the last is scheduled for January 1, 2020. The employee wishes to receive the payment in a lump sum. Provided the election is made on or before December 31, 2014, the earliest the employee may receive the lump-sum payment is January 1, 2025, which is five years after the last scheduled installment payment under the original election. If the plan did not provide that each installment payment was treated as a separate payment, the lump-sum payment could be made as early as January 1, 2021 (i.e., five years after the initial installment payment).
Form flexibility is a fine feature for participants but can add administrative complexity and thus corresponding cost to plan sponsors. The sponsor’s decision regarding which, if any, choices, it provides to participant may also be influenced by whether or not it wants to hold on to the assets for participants who separate from service. Consequently, some sponsors may opt for a more simplistic approach by designing the plan to only include a single form of payment with no choice for participants or only provide choices between forms that are not subject to the 12-month/five-year rule. For example, some DC NDCPs only permit lump-sum distributions while some DB NDCP may limit the participants to choosing between the previously discussed “actuarially equivalent” life annuities.
Another device available to sponsors to help simplify this process are default provisions which can be used to either mandate a certain form of payment if no timely participant election is made and/or to specify separate forms of payment for various distribution triggering events. In the case of the latter, the 409A rules require the following requirements be met regarding such default provisions:
• Must be objectively determinable when payment is triggered
• May vary by triggering event (e.g., lump sum upon death, 10 annual installments upon separation from service)
• Alternative payment schedule may apply if triggering event (other than fixed date) occurs on or before one (and only one) specified date (e.g., lump sum upon separation before age 55, life annuity upon separation thereafter)
The 409A rules also contain two separate mandatory cash-out provisions that NDCP sponsors may use to ease their administrative burdens by giving them the ability to eliminate ongoing tracking of and processing installment payments of amounts under certain dollar limits.
Cash-out option 1:
Under the first cash-out option, an NDCP may require (or include a provision granting the sponsor the discretion to require) a mandatory lump-sum payment of amounts deferred that do not exceed a specified amount provided that the payment (1) results in the termination of the employee’s entire interest in the plan (and all plans of the same type under the plan aggregation rules — so a sponsor may not use this rule to cash out an amount under one arrangement but not another arrangement where the two arrangements would be treated as one plan) and (2) does not exceed the limit on elective deferrals under Internal Revenue Code Section 402(g) for the calendar year of reference (e.g., $18,000 for 2016). In addition, any employer discretion must be evidenced in writing no later than the date of such payment. The rules do not require that a participant have separated from service for the sponsor to cash out the amount deferred.
Cash-out option 2:
The rules also offer another cash-out option, which provides that a plan under which amounts are to be paid in installments may permit the immediate payment of all remaining installments (without causing an impermissible acceleration) if the present value of the unpaid deferred Post 409A amount falls below a predetermined amount. Such a provision must specify the predetermined amount no later than the time and form of payment is otherwise required to be established. The immediate portion can be any amount as distinguished from cash-out option 1, which is tied to the Section 402(g) limit.
However, any immediate distribution in an installment series will result in an impermissible acceleration if it is paid at the discretion of the employer or the participant unless the payment does not exceed the 402(g) limit. Furthermore, any change in an immediate distribution provision, including a change in the predetermined amount, is treated as a change in the time and form of payment (i.e., subject to one-year/five-year rule).
Rounding into 409A form
The many 409A rules governing the permissible forms of payment can lead to a lot of confusion for participants and sponsors alike. Even worse, if they fail to make sure that their NDCP’s document and administration comply with these rules, participants are exposed to substantial penalties: 409A failures require participants to include all previously deferred amounts under the NDCP in gross income and pay on this amount income taxes, employment taxes, and a 20% penalty tax as well as interest and penalties on this amount at the underpayment rate plus 1% and underpayment penalties. Due to the complexity of these rules and the severe consequences of noncompliance, sponsors and participants cannot afford to be left in the dark watching 409A Form Here to Uncertainty. Accordingly, they should seek the assistance of their benefit consultants and ERISA counsel in order to stay true to 409A form.