A number of class-action lawsuits are currently testing actuarial equivalents in pension plans. This important issue may be resolved in the circuit courts or go all the way up to the Supreme Court.
What is actuarial equivalent anyway?
Unless you are an actuary, you might not know what actuarial equivalent means. Actuarial equivalent means that the present value of the total amounts expected to be received under two different forms of payment are equal, based on mortality and interest assumptions specified under the pension plan.
Life annuity vs. joint and survivor annuity
Pension plans specify a defined benefit they are providing to participants, and it’s generally in the form of a life annuity. A life annuity is a benefit payable for as long as the participant lives, with no payments upon death to a beneficiary.
Current Federal law requires that a pension plan provide a joint and survivor annuity for married participants, unless both the participant and his/her spouse select otherwise. A joint and survivor annuity is expressed as a percentage of the benefit paid during the retiree’s life, which is paid to the spouse for life after the retiree dies. For example, a 50% joint and survivor annuity provides a surviving spouse with 50% of the amount that was paid during the retiree’s life.
When retirees elect to receive joint and survivor annuities, they generally receive a lower monthly pension payment than had they chosen the life annuity benefit. This reduction in benefits is in exchange for their spouse continuing to receive payments after their death.
What are “reasonable” actuarial assumptions?
Treasury regulations publish annual applicable mortality tables and monthly applicable interest rates for determining lump sum payments. A recent court case considered these tables and rates as also being reasonable actuarial assumptions for calculating actuarial equivalent conversion factors, and thus are permitted (but not required) to be used. However, a plan is permitted to use alternative actuarial assumptions as long as they are reasonable. Unfortunately, the term “reasonable” is not defined.
Mortality rates have improved over time with advances in medicine and better lifestyle habits. People who have recently retired are expected to live longer than those who retired in previous generations. Older mortality tables projected that people will die at a faster rate than current mortality tables. Using an older mortality table with accelerated death rates increases the present value of optional benefits. Because using an older mortality table projects a greater likelihood of the survivor benefit being paid, the “cost” of this survivor benefit is larger than it would be if a more recent mortality table is used with the joint and survivor annuity being smaller than it would be otherwise.
Similarly, when a higher interest rate is used, the amount of the monthly benefit under an early retirement annuity usually decreases. Using an interest rate that might have been appropriate in the 1980s (e.g., 8.0%) will result in a much lower early retirement benefit than if a current rate (e.g., 4.0%) is used. Class action suits have been filed challenging the reasonableness of such interest rates because they result in lower early retirement benefits than if more current tables are used.
The regulations, like the statute, do not explicitly require disclosure of the method of actuarial reduction in the Summary Plan Description.
Federal law provides that an employee’s right to his or her vested retirement benefit is non-forfeitable. The Treasury regulation for the Tax Code provision corresponding to ERISA states that “adjustments in excess of reasonable actuarial reductions can result in rights being “forfeitable.” The current low interest environment, recent court cases, and the number of participants reaching retirement age have created more interest in how retirement benefits are valued. Retirement plans that have not been amended to reflect more current interest and mortality will certainly be tested. As a result, the number of class action lawsuits will escalate. Random IRS or DOL plan audits may also start addressing this issue.
Plan Administrators may want to consider speaking with their actuary and ERISA attorney and review the reasonableness of the actuarial assumptions in their plans and the information provided in the Summary Plan Descriptions.
William Nusblat is a Vice President, Consulting with BPAS Actuarial & Pension Services.