United States: HIPAA/HITECH Omnibus Final Rule: Implications for Research - Retirement Income Team Newsletter - January 2013

ERISA Considerations In The Sale Of Individual Annuity Contracts To Plans

By Frederick Reish

In recent years — perhaps because of the volatility of stock markets or the aging of the baby boomers — we have seen increased activity in the sale of individual annuity contracts to participants in defined contribution plans. More specifically, most of the sales are of individual variable annuity contracts with guaranteed minimum withdrawal benefit riders (GMWBs).

While the desire of participants to obtain insurance company guarantees is understandable, there are a number of issues related to both the sales process and the terms of the contracts when viewed from an ERISA perspective. In this article, I discuss only two of them.

First, the preamble to the DOL's 408(b)(2) regulation indicates that the regulation's disclosure requirements apply to insurance brokers and the sale of insurance contracts to ERISA-governed retirement plans. To complicate matters, insurance agents and brokers have historically relied on Prohibited Transaction Class Exemption 84-24 (and its disclosure requirements) to avoid prohibited transactions in the sale of insurance contracts to retirement plans. Unfortunately, the DOL has not clearly indicated whether an insurance agent or broker must satisfy both disclosure requirements. If both must be satisfied, we are concerned that there may be a significant number of inadvertent violations (and resulting prohibited transactions) in the sale of individual annuity contracts to retirement plans. (In conversations with other ERISA attorneys, there appears to be a consensus that the "safe" position is to satisfy the conditions of both requirements.)

From the perspective of an insurance company, it seems clear that the issuance of an annuity contract to an ERISA retirement plan does not fall within the scope of the 408(b)(2) regulation. That is, it is the issuance of a product and not the provision of a covered service. However, there are other issues for insurance companies.

For example, most annuity contracts designed for the individual market contain provisions that are permissible under the insurance laws but create fiduciary issues for insurance companies when the contracts are held in ERISA retirement plans. That is because of the convergence of two fundamental ERISA concepts. First, an asset held within an ERISA plan is a "plan asset" and, thus, is subject to ERISA's fiduciary and prohibited transaction rules. Second, the exercise of discretionary control over a plan asset may give rise to a fiduciary status, e.g., for the insurance company. (Unfortunately, that can occur even if the insurance company had not focused on the fact that the contract was owned by an ERISA plan.)

From an ERISA perspective, discretionary control can result from the ability of an insurance company to affect the terms of the individual annuity contract. That could include, for example, a provision that permits the insurance company to amend the terms of the annuity contract unilaterally. (Note that there is guidance that permits limited amendment rights if certain procedures are followed.) If an insurance company has broad discretion to amend an annuity contract or a particular provision of an annuity contract (that is, affect the value of a plan asset), the insurance company may become a fiduciary for that purpose. (Note that ERISA requires that a fiduciary exercise its discretion in the best interest of the plan participants.) Furthermore, if an insurance company exercises its discretionary amendment rights, or any other discretionary rights under the contract, for its own interest, there is a risk that the insurance company could have engaged in a prohibited transaction as well as a fiduciary breach. That could result in the insurance company being required to restore any losses or other "amounts involved" to the plan, together with interest and penalties.

What should insurance companies and brokers do with this information? I am not suggesting that the sale of individual annuity contracts to ERISA plans should be avoided, but instead that contracts should be designed, and the sales process undertaken, with ERISA in mind.

Insurance Companies Take Steps To Reduce Their Risks Under Guarantees In Outstanding Variable Contracts

By Bruce Dunne

The 2008-2009 financial crisis, ongoing market volatility and persistently low interest rates have significantly increased the risks and costs to insurance companies of the lifetime income guarantee provisions in their variable annuity contracts. Insurance companies have responded in a number of ways. Some have exited the variable annuity market altogether. Others have redesigned the products they offer by reducing guarantee rates, increasing fees, limiting available investment options and/or tightening asset allocation programs.

A few have taken steps recently to reduce their risks under outstanding contracts by:

• refusing to accept additional purchase payments from existing contract holders;¹
• offering incentive payments to terminate lifetime income riders or exchange into new contracts with less generous benefits;² or
• offering to buy-out contracts in exchange for an "enhanced" surrender value.³

These strategies raise a number of issues, including certain issues under the federal securities laws. As noted by Norm Champ, the Director of the SEC's Division of Investment Management (the Division), these include suitability and the adequacy of risk disclosure.⁴ For variable annuity contracts that involve registration under the Securities Act of 1933 (1933 Act) and the Investment Company Act of 1940 (1940 Act), other issues include determining the appropriate manner of reflecting the strategy in 1933 Act registration statements and complying with 1940 Act provisions governing contract exchanges.

1933 Act Filings

A company pursuing one of these strategies will have to reflect it in the offering documents for the affected contracts. Recent SEC filings suggest that a decision to no longer accept purchase payments from existing contract holders may be included in a 1933 Act Rule 497 supplement,⁵ which typically is not reviewed by the SEC staff and may be used as soon as filed with the SEC, while offers of incentive payments to exchange or buy-out contracts should be filed as 1933 Act Rule 485(a) post-effective amendments,6 which are subject to SEC staff review and become effective after 60 days unless accelerated by the staff.

Suitability

Sales of variable annuity contracts are subject to Financial Industry Regulatory Authority (FINRA) Rule 2111, the general suitability rule, and FINRA Rule 2330, which applies specifically to sales and exchanges of variable annuities. Rule 2330 requires that a selling broker-dealer have a reasonable basis to believe that the customer has been informed of, and would benefit from, the various contract features, and that the particular contract as a whole (including any riders) is suitable for the particular customer. In the case of a contract exchange, the suitability determination must also take into account whether the customer would incur surrender charges, be subject to a new surrender period or increased fees or charges or lose existing benefits, and whether the customer would benefit from product enhancements and improvements in the new contract.

The SEC staff has stated that offers to exchange existing contracts for newer contracts offering less generous benefits, as well as offering incentive payments for the surrender of a contract or the termination of guaranteed benefit riders, raise suitability questions. Susan Nash, the Associate Director of the Division, has pointed out that, while such exchanges might benefit contract owners who do not expect to take advantage of a living benefit, they would not be advantageous for contract owners who expect to use the more generous living benefits of existing contracts. She has urged close scrutiny of exchange transactions from the investor's viewpoint: "what precisely is being given up and are the forgone features of the old contract outweighed by the benefits offered in the new contract?"7 Director Champ has suggested that such exchanges or buy-outs raise suitability questions with respect to both the original variable annuity sale and the exchange "where the original transaction was perhaps premised on the value and importance of the living benefits and the exchange removes or reduces those same benefits."⁸

Disclosure

Before pursuing one of the strategies, a company should consider the potential impact of the presence or absence in its current prospectus of disclosures regarding the risk that it might, under future market or other conditions, cease accepting purchase payments or offer contract holders incentives to surrender certain benefits.

Recent specific disclosures in 1933 Act filings regarding the strategies have included:

• why an offer to terminate a guaranteed benefit rider is being made (e.g., "high market volatility, declines in the equity markets and the low interest rate environments make continuing to provide the [guarantee] costly to us");
• the manner in which an incentive amount will be calculated (including examples);
• how a contract holder should evaluate an offer and the factors to be considered (including circumstances under which te offer should not be accepted); and
• how an offer may benefit both the insurer and the contract holder (e.g., the insurer would benefit financially because it would no longer incur the cost of maintaining expensive reserves for the guarantees, and the contract holder would benefit by receiving an increase in the surrender value of the contract and by reduced fees under the contract).

Exchange Offers

An offer to exchange a registered variable annuity contract for another such contract issued by the same or an affiliated insurance company is subject to Section 11 of the 1940 Act. Under Section 11, which is intended to prevent "switching" of investment company securities for purposes of generating additional charges, the exchange offer must either be approved by the SEC or qualify for the exemption from this requirement provided by Rule 11a-2. The Rule 11a-2 exemption requires that the exchange be made on the basis of relative net asset values and imposes certain limits and conditions on associated administrative fees and sales charges. To avoid having to obtain an SEC exemptive order, an insurer making an exchange should carefully comply with Rule 11a-2 requirements, including considering under what circumstances offering incentive payments could be viewed as making an offer on a basis other than relative net asset values.

Conclusion

An insurer that wishes to take steps to reduce the risks of the lifetime income guarantees under its outstanding variable annuity contracts should consider whether its proposed course of action is permissible under the terms of the contracts, the impact of disclosures in its existing prospectuses, the new disclosures that will be required and the suitability and other compliance issues that may arise under the federal securities laws. In addition, if the insurer has sold the contract to retirement plans, it should also consider the ERISA issues addressed in the accompanying article by Fred Reish.

Footnotes

^{1 See Prudential Annuities Life Assurance Corporation Variable Account B, Prospectus Supplement dated Aug. 23, 2012 ("Restrictions on Additional Purchase Payments") (File No. 333-152411).}

^{2 See Separate Account VA B of TransAmerica Life Insurance Company, Post-Effective Amendment No. 41 (filed Feb. 24, 2012) (File No. 33-56908).}

^{3 See Hartford Life Insurance Company Separate Account Three, Prospectus Supplement dated Dec. 28, 2012, ("Enhanced Surrender Value Offer for Eligible Contracts with the Lifetime Income Builder II Rider" (filed Nov. 1. 2012) (File No. 333-119414).}

^{4 Norm Champ, Director, Division of Investment Management, SEC, "Remarks to the ALI-CLE Conference on Life Insurance Products" (Nov. 1, 2012). The Director also indicated SEC staff concern whether particular actions, such as refusing additional purchase payments, are permitted under the terms of the applicable contract.}

^{5 See note 1 above.}

^{6 See notes 2 and 3 above.}

^{7 Susan Nash, Associate Director, Division of Investment Management, SEC, "Remarks to the IRI 2012 Government and Regulatory Affairs Conference" (Jun. 26, 2012).}

^{8 See note 4 above.}

Applying The Qualified Joint And Survivor Annuity Requirements To GMWBs

By Bruce Ashton

A vexing question for providers of guaranteed minimum withdrawal benefit (GMWB) features is whether (and how) the qualified joint and survivor annuity (QJSA) rules of the Internal Revenue Code apply to these products. By GMWB, we mean an insurance company guarantee attached as a rider to an investment (such as a target date fund inside a group variable annuity), under which the insurance company guarantees lifetime benefits to a retiree. The guarantee applies if a participant's defined contribution or IRA account runs out of money before the retiree dies, so long as the retiree observed certain withdrawal restrictions from his account. (This article focuses only on GMWB features offered in qualified retirement plans, principally 401(k) plans.)

The requirement that distributions from certain qualified plans be made in the form of a QJSA, unless the participant's spouse consents to a different form, was added to the Internal Revenue Code in 1984, long before GMWBs were conceived. Code section 401(a) (11) applies to distributions from defined benefit pension plans and money purchase pension plans at the "annuity starting date" (generally, the date of retirement). Section 401(a)(11) also applies to participants in defined contribution plans who elect to take a distribution in the form of a life annuity. In this sense, the QJSA requirement does not apply to the entire 401(k) plan, only to specific, affected participants.

The central question, then, for GMWB providers is whether the GMWB constitutes a life annuity.

In a traditional life annuity, an individual pays a premium to the provider that in part represents the principal amount to be paid when annuity payments start. The annuitant retains no control over the funds; and if he dies before the funds run out, there is no residue left for his beneficiaries. Of course, if he outlives his life expectancy, he continues to be paid.

In contrast, in the case of a GMWB, when a participant purchases a GMWB guarantee, he pays a smaller premium, retains control over the funds in his account and, when he retires, withdraws his own funds from his account. There are restrictions on how the funds must be invested and how much the retiree may withdraw each year. If the retiree dies before the funds run out, the balance goes to his beneficiaries, and the insurance company pays nothing. In this sense, the GMWB guarantee is more akin to disability insurance. That is, under disability insurance, payments are made by the insurance company only upon the happening of the covered event – which is also the case under the GMWB guarantee.

So how does this impact the QJSA analysis? To the extent the IRS has looked at the issue, it has done so in private letter rulings (PLRs). PLRs may be relied on only by the individual taxpayer to whom they are issued and do not constitute legally binding precedent for other taxpayers. That said, PLRs often reflect the thinking of the IRS on key issues but cannot be considered authoritative guidance.

In the case of GMWBs, the IRS has said in one PLR that the "annuity starting date" is the date when a participant begins to take systematic withdrawals. If those withdrawals begin while the participant's benefit remains in the plan, then – according to the IRS position in this PLR – the participant must take distributions under the joint and survivor requirements of the GMWB feature unless his spouse consents to a different form of distribution. Consider, for example, a GMWB that permits distributions at 5 percent of the benefit base on a life only basis and 4.5 percent on a joint and survivor basis. If the IRS position in this PLR were to be applied, the practical impact would appear to be that the participant must take distributions at 4.5 percent absent spousal consent. This requirement would only apply to the affected participant and not to the entire plan.

Suppose, however, that the participant rolls his entire account balance, including the GMWB guarantee, to an IRA before beginning systematic withdrawals. The IRS position suggests that the QJSA rules do not apply to IRAs. Thus, in the case of a rollover, there is no "annuity starting date" so there is no requirement for the spouse to consent to the lump sum distribution to the IRA. And thereafter, the retiree is able to withdraw funds without requiring spousal consent.

The analysis of the QJSA rules in the GMWB context is conceptually difficult. To the extent there is an annuity element to the guarantee, it would seem to apply only when the insurance company becomes obligated to make payments. Prior to that time, the retiree is withdrawing his own funds, so even at the point when systematic withdrawals begin, it is difficult to say that the arrangement constitutes an annuity. We are not suggesting that the interests of non-participant spouses should be ignored, but we are concerned about the application of rules designed for significantly different situations to products that did not exist when the rules were enacted.

Proposed IRS Guidance Would Facilitate Partial Annuity Distributions From Pension Plans, But Raises Concerns For Some Plan Sponsors

By Joshua Waldbeser

When employees covered under a defined benefit pension plan retire, they may be faced with an unenviable choice – if the plan allows participants to elect either a lump sum distribution or a joint and survivor annuity, they must decide whether they prefer the liquidity and portability of the lump sum, or the guaranteed lifetime income stream of the annuity. One solution to this "all-or-nothing" proposition is for the plan to offer "split" benefits payable partially in a lump sum (or other accelerated form) and partially in an annuity form. Unfortunately, a lack of clarity in existing guidance has discouraged some plan sponsors from offering this feature.

Specifically, current Treasury Regulations under Internal Revenue Code (Code) Section 417 require that the present value of benefits and distributions cannot be less than that determined by applying certain actuarial factors set forth in Section 417(e). This anti-abuse rule is referred to as the "Minimum Present Value" requirement. However, it does not apply to the amount of a distribution that is paid as an annual benefit which does not decrease during the life of the participant, such as a qualified joint and survivor annuity. Pension plans apply factors other than the statutory factors for this latter purpose.

Unfortunately, the current regulations do not provide clear guidance in cases where benefits are distributed partially as lump sums and partially as "non-decreasing" joint and survivor annuities. The IRS has publicly (although not through formal guidance) taken the position that the entire benefit is a single "distribution" that is wholly subject to the Minimum Present Value requirement. There are two practical problems with this result:

• First, it is counterintuitive (and, perhaps, inequitable) to apply the Minimum Present Value requirement to a partial annuity when it does not apply to a "full" survivor annuity. For example, consider a pension plan that offers a protected lump sum distribution form, which is merged into another plan where the lump sum is eliminated for future accruals. Under the IRS' stated position, the annuity portion of a participant's benefit (under the "acquiror" plan) would be subject to disparate treatment than would apply if the plans had not been merged but the accruals were otherwise the same.
• Second, applying the Minimum Present Value requirement to partial annuities when it does not apply to "full" annuities creates a significant administrative burden for plan sponsors and providers, mandating that they deal with another complex permutation in valuing optional benefit forms.

It is expected that partial annuity benefits would be a popular choice for participants when and if offered. To encourage plan sponsors to make them available, and thus avoid having participants elect full lump sums to the possible detriment of their retirement security, the IRS issued a proposed regulation (77 FR 5454, Feb. 3, 2012) to deal with these problems. The proposed regulation would allow pension plans to be amended to treat partial annuity and lump sum benefits as separate distributions under Code Section 417. This would avoid the problems noted above. This relief would be available to "bifurcated accrued benefits," which are

• Separately determined portions of an accrued benefit, for which different distribution forms are available for the separate portions;
• Proportionate benefits for which (i) one form can be elected for a portion, with another form for the remainder (determined on a pro rata basis) or (ii) either form can be elected for the entire benefit; or
• Specified amounts distributed as lump sums with a separate election for the remainder, provided that the remainder cannot be less than the amount that would be paid if the entire benefit was distributable in a lump sum (applying the statutory factors under Code Section 417).

Industry response to the proposed regulation has been generally positive. However, there is a concern – noting the ambiguity in existing guidance, commentators have pointed out that some plans have historically treated partial lump sums and annuities as separate distributions. Thus, notwithstanding the IRS' informal position, they have not applied the Minimum Present Value requirement to the annuity portions. This is particularly prevalent in the "merged plan" scenario noted above.

For this reason, commentators have requested clarification in the final regulation that it will not be interpreted as meaning that this approach was impermissible during prior periods. They have also suggested that the IRS indicate, even if only informally, that it will not challenge this interpretation prior to the final regulation's effective date to the extent it was made in good faith.

We anticipate that the IRS will review this concern and may make adjustments in response. In any event, we believe that the final regulation will be issued in 2013 and, as proposed, would generally apply after that date. Upon the issuance of the final regulation, defined benefit plan sponsors will then be better able to determine whether offering partial annuity benefits would be helpful and appropriate.

Projections Of Retirement Income

By Frederick Reish

The Department of Labor has recently published its rule-making agenda for the 2012-2013 fiscal year. While several of the regulatory projects will impact retirement plans and their service providers, one proposed regulation is of particular importance to the retirement income community. That is, the DOL is working on guidance that could require ERISA-governed defined contribution plans to provide retirement income projections to participants. More specifically, the DOL said in its agenda:

We believe that, if the DOL develops and issues a proposed regulation in this area, it will have a significant impact on ERISA-governed, participant-directed plans. That is primarily because it will change the focus of 401(k) and 403(b) plans from account balances to retirement income. In other words, we believe that the effect will be to focus participants and plan sponsors on the fact that account balances will ultimately be used to provide retirement income. That income may come from the plan or it may come from a rollover IRA, but it will be withdrawn on a periodic basis to support the retiree.

We believe that change of perspective would be a significant improvement in terms of focusing participants initially on the need to view retirement accumulations as income vehicles and, ultimately, on the need for secure lifetime income in retirement.

If the DOL ultimately mandates retirement income projections, it is likely that private sector service providers (for example, recordkeepers and advisers) would provide retirement income adequacy benchmarks (e.g., 80 percent of final pay including Social Security retirement income), and would provide gap analysis to assist participants in determining the increases in deferrals, if any, that are needed to obtain the objective of retirement income adequacy.

This is an issue that insurance companies, investment managers, plan sponsors and service providers should follow closely.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.