Lump-Sum Distributions Under the Pension Protection Act

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

The Pension Protection Act of 2006 (PPA, P.L. 109-280) established new funding requirements
for defined benefit pensions. The PPA also modified the provisions of federal law that prescribe
how the minimum permissible value of a lump-sum distribution from a defined benefit plan will
be determined in 2008 and thereafter. It also established conditions under which payment of lump
sums from defined benefit plans will be restricted. This report summarizes the provisions of the
PPA that affect lump sums paid from defined benefit pension plans. This report will not be
updated.

Determining the Minimum Value of a Lump Sum..........................................................................1
Guidance to Plans from the Internal Revenue Service..............................................................3
How Will the PPA Affect Lump-Sum Distributions?................................................................3
Other PPA Provisions Affecting Lump Sums..................................................................................5
Upper Limit on Lump-Sum Distributions.................................................................................5
Lump-Sum Distributions from Underfunded Plans..................................................................5
Lump-Sum Distributions from Cash Balance Plans..................................................................6
Table 1. Treasury Bond Interest Rate and Corporate Bond Rates...................................................3
Table 2. Present Value of an Immediate Annuity of $12,000 per Year............................................4
Table 3. Present Value of a Deferred Annuity of $12,000 per Year.................................................5
Author Contact Information............................................................................................................6

mployer-sponsored retirement plans are legally classified as either defined benefit plans or
defined contribution plans. Defined benefit (DB) plans pay pensions that are usually based
on each worker’s years of service and average pay. DB pensions must offer participants E

the option to receive an annuity: a series of monthly payments guaranteed for life. Some DB
plans also offer participants the option of taking their accrued benefits as lump sums when they
separate from the employer. Defined contribution (DC) plans are individual accounts established
by the employer for each participant. In a DC plan, the participant’s benefit is equal to his or her
account balance, which is the sum of employer and employee contributions, plus interest,
dividends, and investment gains (or losses). Employers usually pay these benefits as lump sums
to the participants when they quit or retire. They are not required to offer participants the option
of taking an annuity.
In a defined benefit plan, a participant’s accrued benefit usually is defined as an annuity
beginning at the plan’s normal retirement age, which typically is age 65. If the plan allows lump-
sum distributions, the lump sum must be equal to the present value of the future annuity to which
the participant is entitled. To calculate the present value of an annuity, the plan must apply an
interest rate and estimate the participant’s life expectancy. To protect the value of each
participant’s pension benefit, the Internal Revenue Code (IRC) prescribes the interest rate and
mortality table that the plan must use to determine the minimum lump-sum value of the annuity
that each participant has earned. A plan may pay a larger lump sum, but it may not pay less than
this minimum.
The PPA modified both the mortality assumptions and interest rate prescribed by the IRC.
Beginning in 2008, plans must use a new mortality table that reflects recent increases in life
expectancy. The new mortality estimates by themselves would increase the value of lump sums
by 1% to 2%, depending on the age of the participant. Under prior law, DB plans were required to
use the current interest rate on 30-year U.S. Treasury bonds to determine the minimum lump-sum ¹
value of an annuity. The PPA requires plans to use a corporate bond interest rate for this
calculation. The present value of an annuity is inversely related to the interest rate used to convert
the annuity to its present value: the higher the interest rate, the smaller the lump-sum and vice
versa. The interest rate on Treasury bonds has historically been lower than the interest rate on
corporate bonds of the same maturity because bond markets price Treasury securities as having
no risk of default. Replacing the lower Treasury bond interest rate with a higher corporate bond
interest rate will tend to reduce lump sums. The PPA requires the corporate bond interest rate to
be phased in from 2008 to 2012.

IRC §417(e) prescribes the interest rate and mortality table that plans must use to determine the
minimum present value of an annuity, and thus the minimum value of a lump-sum distribution
that a participant who elects to take a lump sum is entitled to receive from the plan. Section 302
of the PPA amended IRC §417(e) to replace the 30-year Treasury bond interest rate with a ²
corporate bond interest rate as the rate to be used in this calculation. The PPA requires plans to

¹^§7^67,^Re^tire^m^eⁿ^{t Pro}^t^e^c^tion^Ac^t^{of 1}⁹⁹⁴⁽^P^.L^{. 10}^3-⁴⁶⁵^,^D^e^c^e^m^b^e^r^8,¹⁹⁹⁴⁾^.
²^T^h^e^spe^cⁱ^fⁱ^c^inte^re^{st ra}^te^tha^t^a^pl^aⁿ^use^s^{to c}^a^l^c^u^la^te^a^l^u^m^p^sum^de^pe^{nds o}ⁿ^t^h^e^plaⁿ^{’s “}^s^ta^bility^pe^riod”^aⁿ^d
^“^l^ook^ba^c^k^m^onth.”^T^h^e^sta^b^ility^pe^{riod c}^aⁿ^be^a^m^onth,^q^u^a^r^te^{r, or}^y^e^a^r^{. T}^h^e^look^ba^c^k^m^{onth c}^aⁿ^be^aⁿ^y^o^f^the^fⁱ^v^e
^calen^d^a^{r m}^oⁿ^t^h^s^p^r^ecedⁱⁿ^g^t^h^{e stab}^ility^p^e^rio^d^{. If}^th^{e p}^l^aⁿ^y^{ear is a}^calen^d^a^{r y}^{ear, an}^d^th^e^p^l^an^u^s^{es a o}ⁿ^e^-y^{ear stab}^ilit^y
⁽^c^onti^nue^d.^..)

use interest rates that will be derived from a three-segment “yield curve” of investment-grade ³
corporate bonds to determine the minimum lump-sum value of an annuity.
The corporate bond interest rate that plans will use to determine the minimum lump sum value of
an annuity will be based on the date at which the annuity otherwise would be payable to the
participant. The present value of the portion of the annuity that is payable within five years will
be valued using a short-term corporate interest rate, (i.e., the first segment of the yield curve). The
portion of the annuity that is payable in six to 20 years will be valued using a medium-term
interest rate (the second segment), and the portion of the annuity that is payable in more than 20
years will be valued using a long-term interest rate (the third segment). As a result, when Section
302 of the PPA takes effect in 2008, the minimum value of a lump-sum will be calculated using
up to three different interest rates. In general, older plan participants will experience smaller
reductions in their lump sums than younger participants because part of their annuities will be
converted to a lump sum using short-term interest rates, which usually are lower than long-term
interest rates. For example, a worker who retires at age 65 and is eligible for an immediate
annuity would have the first five years of his or her annuity converted to a lump-sum using the
rate for the first segment of the interest rate yield curve. The sixth through twentieth years of the
annuity would be converted to a lump-sum using the rate for the second segment of the yield
curve, and the remainder of the annuity would be converted to a lump-sum using the rate for the
third segment of the yield curve. In contrast, a worker in a plan with a normal retirement age of
65 who separates from the employer at age 45 and elects to take his or her accrued benefit as a
lump sum would have the entire annuity converted to a lump sum using the third segment of the
yield curve.
The PPA does not require plan sponsors to use the corporate bond yield curve to calculate the
lump-sum value of an annuity. It merely prohibits plans from paying lump sums that are less than
the amounts that would result from using the corporate bond yield curve and the new mortality
table. A plan sponsor may elect to use a lower interest rate, which would result in larger lump
sums; however, in such a case, the PPA requires the plan sponsor to take this higher cost into
account when calculating its liabilities and funding requirements. Under the PPA, these higher
lump sums are considered to be a subsidy to the plan’s participants, and they must be treated as a
cost to the plan. Plan sponsors that elect to pay lump sums that are greater than those that would
result from using the corporate bond yield curve will have to make additional contributions to
their plans. A private-sector actuarial firm has estimated that if a plan sponsor chooses to continue
using the Treasury bond interest rate to determine minimum lump-sum values, it would ⁴
experience a one-time increase in plan liabilities of about 5%.

^(...c^on^tin^ue^d)
^pe^rⁱ^od^w^{ith O}^c^tobe^r^a^s^t^h^e^lo^ok^ba^c^k^m^{onth, l}^u^m^p^-^s^um^dis^t^rⁱ^buti^onsⁱⁿ²⁰^{07 w}^oul^d^be^c^a^l^c^u^la^te^{d us}ⁱⁿ^g^the^30-^y^e^a^r
^T^r^e^a^s^u^r^y^bon^{d i}ⁿ^te^r^e^s^t^r^a^te^f^o^r^O^c^tobe^r²⁰^06.^Se^e²⁶^C^F^R^§1^.4¹⁷⁽^e⁾^-¹⁽^d⁾⁽⁵⁾^.
³^A^yⁱ^e^l^{d c}^u^rv^e^{is a}^g^r^a^{ph tha}^t^sh^o^w^{s inte}^re^{st ra}^te^{s plotte}^d^oⁿ^t^h^e^v^e^rtic^a^l^a^x^{is a}^{nd tim}^e^plotte^d^on^the^horiz^oⁿ^ta^{l a}^x^is.
^L^ong^-^t^e^r^m^r^a^te^s^us^ua^ll^y^a^r^e^hig^h^e^r^thaⁿ^s^hor^t-^te^r^m^r^a^te^s^be^ca^us^e^the^rⁱ^s^k^s^pos^e^d^by^inf^l^a^{tion a}ⁿ^{d t}^h^e^pos^sⁱ^ble^de^f^a^{ult of}
^t^h^{e bo}^rro^w^e^{r ri}^{se w}ⁱ^t^h^t^h^{e l}^eⁿ^g^t^h^o^f^tⁱ^m^{e o}^v^{er w}^hⁱ^c^h^credⁱ^tⁱ^s^ext^eⁿ^d^e^d^.^T^h^eref^o^r^e,^m^o^st^o^f^t^h^{e t}ⁱ^m^e,^t^h^{e y}ⁱ^el^d^cu^rve
^slope^{s u}^p^w^a^{rd f}^r^o^m^le^f^t^{to rig}^h^t.
⁴^J^P^Mor^g^aⁿ^C^o^m^p^eⁿ^s^a^{tion a}ⁿ^{d B}^e^ne^f^{it Str}^a^te^gⁱ^e^s^{, “L}^um^{p Sum}^s^unde^r^the^P^e^nsⁱ^on^Pr^ote^c^tⁱ^{on A}^c^{t of}²⁰⁰⁶^,”^Iⁿ^sⁱ^ght^,
^Nov^.¹⁵^{, 2}⁰⁰⁶^;^htt^p^://w^ww^.jp^m^org^a^n.c^o^m^/^pa^g^e^s/^jpm^o^rg^aⁿ^/a^m^/^c^b^s/insig^h^t.

The Internal Revenue Service has published the interest rates for each of the three segments of the
corporate bond yield curve for the months of August, September, and October 2007. The interest
rates are shown in Table 1.
Table 1. Treasury Bond Interest Rate and Corporate Bond Rates
^Corp^{orate Bond Yield Curve}
^{Treasury Bond}^{First Segment}^{Second Segment}^{Third Segment}
^{August 4.93}^5.02^5.18^5.28
^{September 4.79}^4.89^5.06^5.14
^{October 4.77}^4.85^5.02^5.09
^Source:^Int^{ernal Reve}^{nue Servic}^{e, Notices 200}^7-8^{1, 20}^07-^{82, and}²⁰^07-9^1.
The new mortality table mandated by the PPA will go into effect in January 2008. As noted
above, it will tend to increase lump sums by 1% to 2%, depending on the age of the recipient. At
the same time, however, the new interest rate mandated by the PPA will begin to take effect.
Historically, interest rates on corporate bonds have been higher than the interest rates on U.S.
Treasury bonds of similar maturities. Because the present value of an annuity is inversely related
to the interest rate used to calculate it, replacing the Treasury bond interest rate with a corporate
bond interest rate will tend to reduce lump sums. How the PPA will affect the value of any given
individual’s lump sum will depend on the participant’s age, whether he or she is eligible for an
immediate annuity or a deferred annuity, and the difference between the Treasury bond interest ⁵
rate and the corporate bond interest rate in each segment of the yield curve.
The effect of the change from the Treasury bond interest rate to a corporate bond interest rate will
be mitigated in the years from 2008 through 2011 by the phase-in schedule mandated by the PPA.
In 2008 through 2011, the interest rate under IRC §417(e) will be a weighted average of the
Treasury bond rate and the corporate bond rate. In 2008, the Treasury bond interest rate will be
weighted at 80% and the corporate bond interest rate will be weighted at 20%. The corporate
bond interest rate will be weighted at 40% in 2009, 60% in 2010, 80% in 2011, and 100% in

2012.

To illustrate the effect on lump sums of the new mortality table and interest rates mandated by the
PPA, the Congressional Research Service estimated the minimum permissible lump sums under
IRC §417(e) using the pre-PPA mortality table and the Treasury bond interest rate. We then
calculated the lump sums that would result from using the new mortality table and the interest
rates for the three segments of the corporate bond yield curve published by the IRS. Table 2
shows the lump-sum value of an immediate annuity of $12,000 per year received by individuals at

⁵^Bo^t^h^t^h^{e s}^h^ap^{e o}^f^t^h^{e y}ⁱ^el^d^cu^{rve (w}^h^e^t^h^{er i}^t^sl^o^p^e^s^u^p^w^ard^o^r^d^o^wⁿ^w^a^rd^{) an}^dⁱ^t^s^sl^op^{e (st}^eepⁿ^e^ss)^d^e^t^e^rmⁱⁿ^{e t}^h^e
^sp^read^b^e^t^w^een^t^h^{e T}^r^easu^r^y^b^oⁿ^d^rat^e^an^{d t}^h^{e co}^r^p^o^r^at^e^b^oⁿ^d^rat^e^.

age 65, 60, and 55 starting in 2008.⁶ The first row shows the present value of the annuity as
calculated under the rules in effect in 2007: the pre-PPA mortality table and the October 2007
Treasury bond interest rate of 4.77%. The second row shows the present value of the annuity as
calculated under the rules that will be in effect in 2008: the new mortality table and the weighted
average of the Treasury bond interest rate and the three segments of the corporate bond yield
curve. The third row shows the percentage difference between the amounts in rows 1 and 2. The
fourth row shows what the present value of the annuity would be using the new mortality table ⁷
and the fully phased-in interest rates in each segment of the corporate bond yield curve. This
illustrates how lump sums would be affected if the corporate bond interest rates were fully in
effect in 2008. The fifth row shows the percentage difference between the amounts in rows 1 and

Table 2 shows that the effect of the changes made by the PPA on lump sums paid in 2008 is likely
to be relatively small. An individual eligible for an immediate annuity of $12,000 at age 65 is
likely to see his or her lump sum reduced by less than 1%, and those who will be eligible for an
immediate annuity at age 60 or age 55 will see the lump-sum value of their benefits reduced by
less than 2%. If the interest rates from the corporate bond yield curve were fully in effect in 2008,
the reduction in lump sums would be greater. Individuals eligible for an immediate annuity at age
65 would see their lump sums reduced by about 9%, and those eligible for an immediate annuity
at age 55 would see their lump sums reduced by about 12%.
Table 2. Present Value of an Immediate Annuity of $12,000 per Year
^{Age 65}^{Age 60}^{Age 55}
^{1. Pre-PPA}^method^$14^5,19⁴^$16^2,20⁶^$17^7,82⁰
^2.^{PPA with 200}^{8 r}^ules^$14^3,95¹^$16^0,31⁸^$17^4,92⁴
^3.^{% difference, rows1 and 2}^-0.9%^-1.2%^-1.6%
^4.^{PPA with 201}^{2 r}^ules^$13^1,79⁷^$14^4,76⁷^$15^5,87⁰
^5.^{% difference, rows 1 and 4}^-9.2%^-10.8%^-12.3%
^Source:^{Congressional Researc}^h^Service.
Table 3 shows the lump-sum value of a deferred annuity of $12,000 per year received by ⁸
individuals at age 60, 55, and 50 starting in 2008. In these estimates, the deferred annuity is
assumed to be payable at age 65. The first row shows the present value of the annuity as
calculated under the rules in effect in 2007: the pre-PPA mortality table and the October 2007
Treasury bond interest rate of 4.77%. The second row shows the present value of the annuity as
calculated under the rules that will be in effect in 2008: the new mortality table and the weighted
average of the Treasury bond interest rate and the three segments of the corporate bond yield
curve. The third row shows the percentage difference between the amounts in rows 1 and 2. The
fourth row shows what the present value of the annuity would be using the new mortality table
and the interest rates in the three segments of the corporate bond yield curve. This illustrates how

⁶^Aⁿ^im^m^e^dia^t^e^a^nnuity^{is a}ⁿ^aⁿⁿ^u^ity^f^o^{r w}^h^ic^{h the}^pa^rtic^ipaⁿ^{t is e}^lⁱ^g^ible^a^t^his^{or he}^{r c}^u^rre^{nt a}^g^e^.
⁷^T^h^e^m^o^r^t^a^lit^y^ta^ble^us^e^dⁱⁿ²⁰⁰⁷^w^a^s^publis^he^{d i}ⁿ^I^R^S^R^e^v^e^nue^R^u^ling²⁰^01-^62.^T^h^e^m^o^r^t^a^lit^y^ta^ble^{to be}^us^e^dⁱⁿ
²⁰⁰^{8 a}ⁿ^{d la}^te^r^w^a^s^publ^is^he^d^{in I}^R^{S R}^e^v^e^nue^R^u^li^ng²⁰^07-⁶⁷^.
⁸^A^de^fe^rre^{d a}^nnuity^{is one}^f^o^{r w}^h^ic^{h the}^pa^rtic^ipaⁿ^t^w^{ill be}^e^lig^ible^a^t^a^la^te^{r a}^g^e^,^suc^h^a^s^65.

lump sums would be affected if the corporate bond interest rates were fully in effect in 2008. The
fifth row shows the percentage difference between the amounts in rows 1 and 4.
Table 3. Present Value of a Deferred Annuity of $12,000 per Year
^{Age 60}^{Age 55}^{Age 50}
^{1. Pre-PPA}^method^$10^9,89⁹^$85,0⁰¹^$66,4⁶⁴
^2.^{PPA with 200}^{8 r}^ules^$10^9,05⁵^$82,8³⁷^$64,2⁰³
^3.^{% difference, rows1 and 2}^-0.8%^-2.6%^-3.4%
^4.^{PPA with 201}^{2 r}^ules^$97,1⁹⁹^$67,4⁰⁷^$49,6⁸¹
^5.^{% difference, rows 1 and 4}^-11.6%^-20.7%^-25.3%
^Source:^{Congressional Researc}^h^Service.
Table 3 shows that the effect of the PPA on the lump-sum value of deferred annuities is likely to
be relatively small in 2008 but will be slightly greater than the effect on immediate annuities. An
individual eligible for a deferred annuity of $12,000 at age 65 who takes a lump sum at age 60 is
likely to see his or her lump sum reduced by less than 1%, and those who take lump sums at age
55 or age 50 will see the lump-sum value of their benefits reduced by about 3% under the 2008
rules. If the interest rates from the corporate bond yield curve were fully in effect in 2008, the
reduction in lump sums would be about 12% for lump sums taken at age 60, 21% for lump sums
taken at age 55, and 25% for lump sums taken at age 50.

IRC §415(b) limits the annual single-life annuity payable from a tax-qualified DB plan to the
lesser of 100% of average compensation over three consecutive years or $180,000 (in 2007). IRC
§415(b)(2)(B) requires a lump-sum paid from a DB plan to be converted to an actuarially
equivalent single-life annuity to determine whether the distribution exceeds this limit. The lower
the interest rate used in this calculation, the less likely it is that the annuity value of the lump-sum
will exceed the limit. Section 303 of the PPA requires the interest rate used in this calculation to
be no less than the greatest of (1) 5.5%, (2) a rate that results in a benefit of not more than 105%
of the benefit that would result from using the rate defined in IRC §417(e)(3), or (3) the interest
rate specified in the plan.
Section 103 of the PPA prohibits a DB plan from paying lump sums if the plan is funded at less
than 60% of the full funding level or if the plan sponsor is in bankruptcy and the plan is less than
100% funded. If the plan is funded at more than 60% but less than 80%, the plan may distribute
as a lump sum no more than the lesser of (1) 50% of the participant’s accrued benefit, or (2) the
amount of the participant’s benefit that is guaranteed by the Pension Benefit Guaranty
Corporation (PBGC). Section 103 of the PPA requires plan sponsors to notify participants of these
restrictions on lump sums within 30 days of the plan being subject to the restrictions. The
restrictions become effective in 2008, but not before 2010 for collectively bargained plans.

Proposed regulations published by the IRS provide that if a participant requests a prohibited
lump-sum distribution, the plan would have to permit the participant to elect another form of
benefit or to defer payment to a later date. A plan may provide other options, such as paying the
unrestricted portion as a lump sum while deferring the restricted portion to a later date.
Some pension plans—called hybrid plans—have characteristics of both DB and DC plans. The
most popular of these hybrids has been the cash balance plan. A cash balance plan looks like a
DC plan in that the accrued benefit is defined in terms of an account balance. Unlike a DC plan,
however, a cash balance plan must pay a benefit at retirement that is no less than the amount the
employer has contributed to the plan plus the interest that has been credited to those
contributions. Legally, therefore, a cash balance plan is a defined benefit plan. Prior to enactment
of the PPA, there were some circumstances in which employers were required to pay departing
employees amounts that exceeded the nominal values of their cash balance accounts. This could
occur if the interest rate credited to the cash balance plan was higher than the interest rate
required for calculating minimum lump-sum values under IRC §417(e). Section 701 of the PPA
allows lump-sum distributions from cash balance plans to be equal to the employee’s accrued
benefit, expressed as his or her account balance. This provision was effective on the date of
enactment of the PPA.
^P^a^tr^ick^P^u^r^cell
^Specialis^{t i}ⁿ^In^co^m^e^Secu^rit^y
^ppu^rcel^l^@^crs^.^l^o^c.g^o^v^,⁷^-⁷⁵⁷¹