Phased Retirement: A Conflict in the Works?

Beginning in 2007, the Pension Protection Act of 2006 (PPA) permits in-service retirement plan distributions to employees 62 and older. The act does not mention the IRS regulations proposed in 2004 (see Watson Wyatt Insider, December 2004), which would permit phased retirement distributions to employees 59½ and older, as long as certain conditions were met. The PPA provision and the proposed guidance set out different rules, leaving the status of the proposed regulations unclear.

Phased Retirement Under the Proposed Regulations

Many employers and employees are interested in phased retirement, generally defined as an employee working a reduced work schedule while collecting some or all of his pension benefit. Such arrangements are ideally suited to defined benefit plans, except that current IRS rules prohibit in-service distributions from defined benefit and other pension plans before the participant reaches normal retirement age (NRA). So in 2004, the IRS proposed regulations allowing phased retirement as long as employers and employees met several requirements, including a reduced work schedule, an age limit of 59½, annualized compensation and special nondiscrimination rules. The regulations would also prohibit phased retirement for key employees (generally officers who meet certain conditions under the Internal Revenue Code).

The business community generally was less than enthusiastic about the proposed regulations, which many considered administratively burdensome. In addition to addressing phased retirement, the regulations also, somewhat controversially, changed the requirements for a plan’s definition of NRA. Under the proposal, the NRA would have to be reasonably representative of a typical retirement age for the covered workforce. Apparently targeting hybrid plans — some of which define NRA by years of service rather than age — the proposal would essentially impose a minimum age for NRA. This restriction drew significant opposition from the business community, which viewed it as inappropriate to limit the NRA to participants’ typical retirement age, especially given that offering a phased retirement program would likely change employees’ retirement patterns. 

Phased Retirement Under the PPA

The PPA expressly permits distributions “to an employee who has attained age 62 and who is not separated from employment at the time of such distribution.” This provision is simultaneously more liberal than the proposed regulations, in that it imposes virtually no administrative requirements for in-service distributions, and more restrictive, in that phased retirees must be at least 62, rather than 59½.

Legal Uncertainty Ahead

The IRS may not be able to impose any restrictions on phased retirement after age 62, and it is similarly unclear whether the IRS will now permit in-service distributions before age 62. The proposed regulations are not on this year’s guidance priority list, but IRS officials have informally indicated that they’re still working on them.  The uncertainty surrounding the phased retirement regulations also affects the proposal to limit a plan’s NRA. While the proposed regulations remain in limbo, the IRS isn’t likely to try to separately finalize the restriction on NRA. The issue is further complicated by the recent Laurent v. PwC decision, which held that an NRA defined by the participant’s length of service may not be younger than 65. 

Finally, many employers may not be interested in adopting a phased retirement program under the PPA since the age limit is so high. However, the provision may have a silver lining. To avoid the prohibition on in-service distributions, some employers allow employees to fully retire and then rehire them after some specified period of time, such as six months. The minimum period before rehire is used to demonstrate that the former employee had a bona fide retirement, so the retirement distribution is not considered in-service. Under the PPA, employers could immediately commence benefits for employees 62 and older.