United States: IRS Proposes Regulations on Phased Retirement Under a Pension Plan

Originally published November 19, 2004

On November 10, 2004, the Internal Revenue Service published proposed regulations for phased retirement. The proposed regulations would permit certain distributions to be made from a defined benefit or money purchase pension plan to an eligible employee who is at least age 59½ if the employee chooses to reduce his work schedule as part of a bona fide phased retirement program. The proposed rules, if they become final, would be a significant change from current regulations, under which a participant cannot receive a distribution from a pension plan unless the participant has completely retired.

Under the proposed rule, a full-time employee eligible for retirement may have the option of reducing his work hours and participating in a phased retirement program, instead of fully retiring. If an employee elects to participate in a phased retirement program, the employee will be treated as having the dual status of being partially retired and partially in service. A partially retired employee will be eligible to receive a pro rata portion of his pension that is proportionate to the reduction in his work hours. Also, the partially-retired employee will be entitled to continue participating in the pension plan. At full retirement, the individual will be entitled to receive his accrued benefit under the pension plan offset by the phased retirement benefit already being distributed.

The new rules, if adopted in their current form, will add flexibility, but also complexity, to the administration of pension plans with respect to a phased retirement program. A more detailed description of the proposed regulations is provided below, though we have omitted discussion of some, more minor, rules.

The proposed regulations were issued in response to public comments that IRS received in response to Notice 2002-43 (July 8, 2002), in which the agency requested comment on a variety of issues regarding phased retirement programs. The preamble to the proposed regulations states that the commentators who responded to Notice 2002-43 generally responded favorably to the concept of a proposal that facilitated phased retirement arrangements.

The rule is proposed to be effective for plan years beginning on or after the date of publication of final regulations. The proposed regulations may not be relied upon before they are adopted as final regulations.

The proposed regulations permit an employer to adopt a written program pursuant to which an employee may reduce the number of hours he customarily works as of a retirement date determined under the program and receive phased retirement benefits from a defined benefit or money purchase pension plan. An employee may be eligible for phased retirement benefits under the employer’s phased retirement program if the employee:

• is at least 59½ years old,

• participates voluntarily in the program,

• is a full-time employee otherwise eligible for retirement benefits,

• agrees to reduce his hours by 20 percent or more, and

• is not a key employee (as defined in section 416(i)(1)(A)(ii) or (iii) of the Internal Revenue Code of 1986, as amended ("Code")).

During the phased retirement period, an employee will receive a pro rata portion of any annuity or installment distribution, but will not be eligible to take a lump-sum distribution or other eligible rollover distribution.

Some commentators proposed alternatives to the pro rata approach that would have allowed for the payment of full benefits upon the commencement of phased retirement or the attainment of a particular age. The Service rejected these proposals and adopted the pro rata approach on the grounds that it is more consistent with the principle that pension benefits are to be paid only after retirement. Accordingly, the regulations as proposed would prevent plan participants who are only partially retired from receiving full pension benefits.

An employee who elects to take a phased retirement distribution will be entitled to continue participation in the plan as if he was still working on a full-time basis, except for an adjustment to the service credited. The regulations make clear that the requirement that the participant be treated as full-time requires that the adjustment applied to determine the reduced service to be credited to him is also applied to increase the compensation credited to him during the phased retirement period. Also, upon full retirement, the participant will be entitled to the same early retirement benefits, retirement-type subsidies, and optional forms of benefits as if he had not elected phased retirement.

The years of service credited under the plan for the phased retirement period are determined by multiplying the number of full plan years by an adjustment ratio. The adjustment ratio is calculated by using either the ratio of the employee’s actual hours worked during a year to the number of hours he would have worked under a full-time work schedule, or the ratio of his actual compensation during the year to the compensation that he would have been paid if he had maintained a full-time work schedule.

• Highly compensated employees: An employee who is a highly compensated employee under Code section 414(q) will continue to be treated as a highly compensated employee while participating in the phased retirement program.

• Death benefits: If an employee dies after the starting date for the phased retirement program, the employee will be treated as a retiree to the extent of his phased retirement benefit and as an active employee to the extent of the retirement benefit that would be due upon full retirement.

• Ancillary benefits: Other ancillary benefits provided under the plan can be provided during phased retirement.

The proposed regulations do not define when full retirement occurs. However, the proposed regulations do provide guidance on how pension benefits should be computed and paid once full retirement has occurred. In general, at full retirement, an employee’s total accrued benefit under the plan (including the employee’s accruals during the phased retirement period) is offset by the portion of the employee’s accrued benefit that is being distributed as a phased retirement benefit. Thus, the employee’s final retirement benefit is comprised of the phased retirement benefit and the balance of the employee’s accrued benefit under the plan, i.e., the net accrued benefit.

Example 3: The employee described in Example 1 above fully retires three years after electing to participate in the phased retirement program. Over the three-year period, the employee received 50 percent of the compensation that he would have received if he were working full-time. The employee is entitled to an adjusted benefit accrual based on the additional one-and-a-half years of service credited during the phased retirement period (three years times the employee’s work schedule fraction of 50 percent). If the employee’s highest final average salary would have been $95,000 absent the election to participate in the phased retirement program, and the employee had 20 years of service prior to electing to participate in the phased retirement program, the employee’s total accrued benefit as a single life annuity commencing at normal retirement would be $30,637.50 per year ($95,000 times 1.5 percent times 21.5 years of service). The offset of the employee’s phased retirement benefit of $12,750 per year (from Example 1) is applied, and the employee’s retirement benefit as a single life annuity commencing at normal retirement age is $17,887.50 ($30,637.50 minus $12,750).

Upon full retirement, a participant in a phased retirement plan will be entitled to elect an optional form of benefit with respect to the net accrued benefit. Likewise, upon full retirement, the participant’s phased retirement benefit can continue unchanged or the plan may allow the participant to make a new election with respect to that benefit. By allowing for these elections, and by providing partially retired employees with the same benefits as full-time employees, the regulations attempt to ensure that a participant is not disadvantaged by reason of choosing phased retirement.

With some limited exceptions, the proposed regulations require annual testing to ensure that employees in phased retirement are working at the reduced schedule, rather than full time. A plan must provide for an annual comparison between the number of hours actually worked by an employee during a testing period and the number of hours the employee was reasonably expected to work. If the actual hours worked during the testing period are materially greater than the expected number of hours, the employee’s phased retirement benefit must be reduced prospectively. An employee’s hours worked are considered to be materially greater than the expected work schedule if they exceed either 133.3 percent of the work schedule or 90 percent of the hours that the employee would have worked under a full-time schedule. If the phased retirement benefit is reduced under this rule, an adjustment to the offset is made when the participant later fully retires.

No testing would be required, however:

• during the first year of the employee’s phased retirement;

• if the employee enters into an agreement with the employer to retire within two years;

• if the employee is within three months of reaching normal retirement age; or

• if the amount of compensation paid to the employee during the phased retirement period is proportional to the amount of compensation that would have been paid if the employee had worked full-time.

Although the regulations do not address the scenario where an employee retires and is then rehired under a new contractual arrangement, the testing requirements may make it more difficult for a retired employee to receive a full pension distribution if he is rehired as a consultant, leased employee or other type of independent contractor and continues to work the equivalent of full-time hours. The preamble to the proposed regulations notes that the rules "do not address when a full retirement occurs and specifically do not endorse a prearranged termination and rehire as constituting a full retirement." It is possible, however, that the Service will treat a "retire-and-rehire" arrangement as an election to participate in a phased retirement program instead of a full retirement, and may allow the retired worker to receive distributions only on a pro rata basis.

The preamble to the regulations notes that other types of retirement plans, including 401(k) plans and stock bonus plans, may be subject to less restrictive rules regarding in-service distributions, particularly to the extent the distributions are not attributable to elective deferrals.

The proposed phased retirement regulations do not apply to these types of retirement plans. The proposed regulations do not address any potential age discrimination issues, other than through the requirement that participation in a bona fide phased retirement program be voluntary.

Treasury and IRS officials have requested comments on the guidance provided in these proposed regulations. Comments are specifically requested on the following: whether to extend eligibility to participate in a phased retirement program to employees that reduce their workload using a standard other than counting hours; whether to incorporate less complex alternatives for testing the hours an employee works and adjusting the phased retirement benefit when the hours are excessive; whether to permit the offset of additional payments made before a reduction in phased retirement benefits to be calculated without regard to any early retirement subsidy; whether there are facts and circumstances under which the age and service conditions for a particular employer’s phased retirement program should be disregarded in applying the nondiscrimination in benefits, rights and features test under Treas. Reg. § 1.401(a)(4)-4; and whether to adopt any special rules to coordinate the distribution and accrual requirements in the regulations with a plan’s provisions regarding employment after normal retirement age.

Comments on the proposed regulations must be submitted by February 8, 2005.

© 2004 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.