SUMMARY AND L&H’S PERSPECTIVE
mATTHEW aREY, jd – rETIREMENT aDVISOR, pARTNER
This article will look at SECURE Act 2.0’s Theme 2: Preservation of Income.1 Industry experts are looking closely at how retirees afford their retirement. Historically, government and private industry offered “pension plans”—more specifically defined benefit pension plans—which generally paid a long-term employee a portion of their wages throughout retirement—a source of income that the retiree could not outlive. Many in the private, non-governmental sector, were enticed to remain at employers with the potential of earning a private pension and Social Security. As the political and financial discussion around the outlook for the financial stability of Social Security continues, it comes as little surprise that Congress is looking to allow more defined benefit pension like features in defined contribution plans.2
An Overview to the Governmental and Private Retirement Systems
An overview to the American retirement system can be broadly categorized into two major employment groups: (1) government employees3; (2) and private industry employees. A review of retirement benefits for government employees is beyond this article, but an oversimplification of their retirement system is a combination of the following: (1) government pension; (2) Social Security—provided they paid in; and (3) supplemental defined contribution plans, governmental 457 plans—similar to 401(k) plans. For private industry employees, retirees generally have: (1) Social Security; (2) defined benefit pension plans; and (3) 401(k)/403(b) plans.4
Private industry defined benefit pension plans (DB-plans)5, similar to governmental pension plans, are types of retirement plans that promise to pay a vested employee a certain amount every year for the employee’s life (and sometimes the employee spouse’s life). For example, a defined benefit pension plan may promise to pay an employee 50% of their highest average 3-years’ salary at age 67. Assuming the average 3-year salary was $50,000, the employer had a liability of $25,000 for that specific employee every year over their employee’s remaining life. Actuarial assumptions are made regarding funding and investment return, and ERISA requires certain funding from the employer to offset the promised income.6 As life expectancy in the U.S. increased, so did the DB-plan liability. Many employers after reviewing their pension liabilities and other factors no longer offer defined benefit plans. Taking DB-plans’ place has been the defined contribution plan (DC-plans).
DC-plans share similarities to DB-plans. DC-plans are essentially a type of account that can receive, in general, both employee and employer contributions. One major difference between the two types of plans is that employers may provide contributions without taking on an uncertain future liability. For example, an employer is allowed to promise an employee 3% of compensation annually. Take for example, an employee makes $50,000, the employer’s current liability is $1,500 annually.7 A major benefit to an employee in this example is that employees are generally entitled to invest the employer contribution ($1,500—annually), along with their own deferrals, and adjust their investment to their own risk tolerance (either conservative or aggressive). DB-plans have strict investment objectives that generally are more conservative than an average individual investor. Because of the certainty of employer funding and the increased employee variety of investment risk return objectives, many employers have ceased offering DB-plans in favor of utilizing DC-plans.
One of the major disadvantages, however, to a DC-plan is the inability to create a guaranteed lifetime income source inside the DC-plan. For a DC-plan participant, the employee is on their own to request distributions from their accumulated savings. Some may buy contracts, like an annuity, that could pay a lifetime income amount, some may continue to invest in stocks and bonds, and some likely take a combined approach.8 SECURE Act 2.0 legislation streamlined prior rules that made transitioning a participant’s DC-plan assets into a guaranteed source of income difficult and cumbersome. Although lifetime income solutions are being discussed more frequently, each contract needs to be carefully evaluated.
Section 201 – Remove required minimum distribution barriers of life annuities.9
Section 201 eliminates certain barriers to the availability of life annuities in qualified plans (DC-plans) and IRAs that arise due to an actuarial test in the Required Minimum Distribution (RMD) regulations. The removal of this regulation may allow modest increases to a life annuity payment after annuitization, allow for return of premium riders, and allow for period certain payment methodologies.
More innovation in creating lifetime income sources gives investors more investment choices. Allowing life annuities to offer additional escalating amounts to retirees may make life annuities within retirement plans more attractive for the average investor. There is a significant amount of due diligence prior to offering this type of investment contract within a retirement plan (SECURE Act of 2019 provided insight as to the proper fiduciary review prior to utilization of these types of contracts).
Section 202 – Qualifying longevity annuity contracts (QLAC).10
QLACs are generally deferred annuities that begin payment at the end of an individual’s life expectancy. Because payments start late, QLACs can be an inexpensive way for an individual to hedge the risk of outliving their savings. Required Minimum Distribution (RMD) rules were amended to facilitate the intent of QLACs.
QLACs are generally a type of contract that helps protect an individual investor from longevity risk—the risk that an individual will outlive their assets. A QLAC’s payment begins generally when the individual, who has purchased the contract, turns their life-expectancy age. The ability to purchase this type of contract, in anticipation of a longer than average life expectancy, may be important for those individuals who expect to live well-past their average life-expectancy. These types of contracts should be carefully reviewed prior to inclusion in a DC-plan and prior to inclusion in an individual investor’s portfolio. The risks associated with this type of investment can be substantial.
Section 204 – Eliminating a penalty on partial annuitization.11
Special rules apply to RMDs when a qualified account (401(k), IRA, 403(b) holds an annuity. Current law requires the account to be bifurcated between the portion holding the annuity and the rest of the investment account. Section 204 allows for an aggregation for determining RMD calculations—subject to Treasury Regulations.
RMDs are complex. Allowing a streamlined aggregate approach for calculating RMDs when annuity contracts are included as part of the investment account will hopefully allow for increased accuracy in reporting RMDs. (Penalties for non-compliance with RMDs can be draconian—upwards of 25% of the amount that should have been distributed).12
Your L&H advisor is carefully reviewing preservation of income strategies. Should you have any questions please do not hesitate to contact us. Individual investors are encouraged to reach out to L&H as well to better understand your retirement options.
- L&H does not practice law or tax. Please consult with your appropriate tax adviser to review your specific facts and circumstances. Although licensed to practice law, the author of this article, does not provide legal services to clients. Attorney client privilege does not apply to communications.
- Munnell, Alicia H.. 2023. “Social Security’s Financial Outlook: The 2023 Update in Perspective” Issue in Brief 23-9. Chestnut Hill, MA: Center for Retirement Research at Boston College.
- Governmental pensions are not riskless—generally they are backed by the credit of the government or governmental agency that sponsors them.
- For purposes of the oversimplification private industry included non-profit organizations which generally offer 403(b) plans.
- Risks for private pensions DB plans are generally associated with the credit and going-concern risk of the entity promising the benefit.
- ERISA requires certain levels of funding based on actuarial reports for the outstanding pension liability.
- Assuming a non-discretionary, non-elective contribution on an annualized basis.
- The appropriate investment allocation depends on a number of factors none or any of these types of investment strategies maybe appropriate depending on the individual investor’s facts and circumstances.
- SECURE Act 2.0 Section 201; See also Congressional Summary SECURE Act 2022 Section 201 Summary.
- SECURE Act 2.0 Section 202; See also Congressional Summary SECURE Act 2022 Section 202 Summary.
- SECURE Act 2.0 Section 204; See also Congressional Summary SECURE Act 2022 Section 204 Summary.
- SECURE Act 2.0 Section 302 reduces the penalty amount for non-compliance with RMD rules from 50% to 25%..
L&H does not practice law or tax. Please consult with your appropriate tax adviser to review your specific facts and circumstances. Although licensed to practice law, the author of this article does not provide legal services to clients. Attorney client privilege does not apply to communications.
The information presented here is for educational purpose only and is not intended to provide specific advice or recommendations for any individual nor does it take into account the particular investment objectives, financial situation or needs of individual investors. The information provided has been derived from sources believed to be reliable, but the accuracy is not guaranteed and does not purport to be a complete analysis of the material discussed. All examples are hypothetical and are for illustrative purposes only. Guarantees are based on the claims paying ability of the carrier offering the guarantee.