Retirement Deduction Limits and Employee Risk

A while back I read a blog post titled “The Beer Napkin Annuity” (BNA) that I found intriguing (if nothing else, the name is catchy). The basic premise was that perhaps we could adjust our retirement tax deduction rules to transfer some deduction opportunities traditionally reserved for defined benefit (DB) plans to defined contribution (DC) arrangements if the DC benefits had mandatory annuitization.

Background: There are two different annual deduction limits that apply when employers sponsor DB and/or DC retirement plans. Combined DC limits per participant are limited to $49,000 in 2010 (with catch up for older employees), while DB deductions can be much higher. If an employer does not offer a DB plan, then the DB deduction opportunities remain unused.

Thoughts: The BNA authors propose that some of the DB deduction limit be available to fund a DC benefit that must be annuitized so that participants cannot take the benefit as a lump sum. Instead they get a guaranteed stream of income, likely purchased through an insurance company (with balances invested by the participant) so that the plan sponsor relieves itself of some of the financial risk. The account balance at retirement would then be converted to an annuity stream of payments payable from the insurance company. The rationale is that these DC benefits with guaranteed income streams behave similar to DB benefits (which were traditionally paid as lifetime annuities) and thus could be deductible under the annual DB limits and not count towards the annual DC limits.

I think that this is a novel idea, but it overlooks one of the main reasons for a separate DB deduction limit: In DB plans, the plan sponsor bears both the investment risk and the longevity risk of the plan assets. As long as there is no guaranteed investment return on the BNA, plan participants bear the risk of investing their BNA deferrals individually.

I really like the fact that the BNA encourages annuitization by giving participants a one-time irrevocable choice to put their money towards  a lifetime income stream versus a traditional 401(k) account. The alternatives of (1) not having an annuity option (the current norm) or (2) forcing participants to annuitize portions of their 401(k) accounts are both unappealing. Perhaps a separate deduction limit for a BNA-type benefit should be considered?

However, I don’t think that a BNA-type benefit should get to “use up” part of the current DB deduction limits. The DB deduction opportunities should be reserved for those plan sponsors willing to bear the financial risk of providing their employees with a guaranteed benefit.

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