Defined benefit (DB) plans may offer their participants several benefit form options at retirement. Typically these options are single life annuities and joint life annuities for those with a dependent. Another type of benefit a DB plan may offer is a one-time lump-sum payment in place of an annuity over the retiree’s lifetime. However, even though the one-time lump-sum benefit form is offered by the plan, there may be restrictions on this benefit form for certain participants defined as restricted employees. This article will help you identify the restricted employees and explain how their lump-sum benefit form option may be affected.

Restricted employees are highly compensated employees (HCE) who are on the “High 25” list. The “High 25” list represents the 25 highest paid employees historically.

HCEs are defined by either of the following:

• Owns more than 5% in the current or prior year (Ownership generally is determined by direct ownership of the employer and attribution from their spouse, parents, children, and grandchildren, if applicable.)
• Earned more than $125,000 from the employer in the prior year. (For the 2020 plan year, $125,000 is the threshold for 2019 earnings. This limit has been increased to $130,000 for 2020 earnings.)

To compile the “High 25” list, salary should be reviewed for each employee through the current plan year even if the plan is frozen. The highest one-year salary for each employee is determined and the 25 employees with the highest salaries form the list. Current and former employees are included and employees remain on the list until they are no longer among the highest 25. Termination (including death) or retirement does not remove an employee from the list.

Now that you can identify the restricted employees, let us review the restriction as it pertains to the lump-sum option. Restricted employees have a restriction on the annual distribution they can receive according to Treasury regulation section 1.401(a)(4)-5(b). This regulation states that a DB plan has the effect of discriminating significantly in favor of HCEs and former HCEs unless it incorporates certain provisions restricting distributions of benefits to or on behalf of a restricted employee. The restriction indicates that in any year, the payment of benefits to a restricted employee shall not exceed the annual amount they would have received if they chose a single life annuity payment form.

However, each of the circumstances below is an exemption from the restriction:

• The value of the plan assets is equal or greater than 110% of the current liability after the distribution to the restricted employee
• The value of the distribution to the restricted employee is less than 1% of the current liability prior to the distribution

Current liabilities and the value of plan assets may be determined by using a reasonable and consistent method. The Highway and Transportation Funding Act (HATFA) Funding Target appears to be an acceptable method for current liabilities. For the value of plan assets, market or smoothed assets appear to be an acceptable method.

For example, a pension plan offers its employees an option of a single life annuity or a lump sum at retirement. A restricted employee would not have any restrictions on the single life annuity, but would have restrictions on the lump-sum option unless an exemption from above applies. The restricted employee can still elect the lump-sum option, but would not receive the entire lump sum in the first year. Rather, they would receive annual payments that are no larger than the actuarial equivalent single life annuity of their benefit. The restriction will stay in place until the employee is no longer a restricted employee or until the plan funding improves to greater than 110% of the current liability. At this point, the remaining amount of the lump sum, including interest, could be distributed.

The restricted benefit may also be distributed in full if the restricted employee can secure repayment to the plan of the restricted amount by:

• Depositing in escrow with an acceptable depository property that is greater than or equal to 125% of the restricted amount
• Providing a bank letter of credit of greater than or equal to 100% of the restricted amount
• Posting a bond greater than or equal to 100% of the restricted amount

DB plans that offer a lump-sum option should have a good understanding of who a restricted employee is and how they are affected. An effective way to keep track of the restricted employees is by creating a “High 25” list and reviewing it annually. If a participant is on the “High 25” list and also an HCE, they are a restricted employee and the restrictions above may apply.