Phased Retirement Initiative

Legislative and Regulatory Overview

In recent years, an aging workforce, increased life expectancy and tight labor markets have prompted workers and employers to seek alternatives to traditional retirement. Many workers approaching retirement age are looking to make a gradual transition into full retirement by reducing their hours or responsibilities – a process often referred to as "phased retirement." As workers and employers have explored phased retirement options, they have encountered legal and regulatory requirements that hinder phased retirement programs.

One of the biggest obstacles is a provision in current IRS regulations that prohibits distributions to active employees younger than normal retirement age. This is intended to ensure that retirement benefits are preserved for an individual’s retirement years, but it also has the effect of driving employees into retirement so that they can receive their pension benefits. If these retirees wish to phase into retirement, they often do so by seeking flexible work arrangements with other employers.

Over the past decade, lawmakers and federal government agencies have held hearings, introduced legislation and proposed regulations to address the issues around phased retirement. Below is a brief summary of the activity to date.

Legislative Activity

Legislative interest in phased retirement dates back to the 1999-2000 legislative session, when the Senate Select Committee on Aging held a hearing on phased retirement issues and Senator Charles Grassley (R-IA) and Representative Earl Pomeroy (D-ND) introduced the Phased Retirement Liberalization Act. The act would have permitted in-service distributions for employees who were at least 59-1/2 years old or had attained 30 years in the employer’s service. The legislation did not progress through the legislative process.

In 2006, Congress addressed the issue of in-service distributions again as part of the Pension Protection Act of 2006. A provision in the act permits in-service distributions for workers who are aged 62 or older. In April 2008, Senators Gordon Smith (R-OR), Herb Kohl (D-WI) and Kent Conrad (D-ND) introduced the Incentives for Older Workers Act (S.2933). The act, which does not address in-service distributions for workers who are younger than 62, would provide incentives for older workers to remain in the workforce and address phased retirement by:

• Prohibiting average compensation taken into account for employees who worked full-time before entering a phased retirement period from being reduced due to phased retirement. Under the act, a phased retirement period would be defined as a period during which the individual was employed on substantially less than a full-time basis or with substantially reduced responsibilities.
• Allowing individuals who delay their Social Security retirement benefits to earn delayed retirement credits until age 72 – an increase from age 70 under current law.
• Reducing the amount of Social Security benefits workers under the normal retirement age lose when they exceed the earnings threshold. Under current law, such workers lose $1 for every $2 earned above the threshold. Under the act, they would lose $1 for every $3 earned above the threshold.
• Creating a National Resource Center on Aging and the Workforce within the Department of Labor to focus on issues related to age and the workforce, acting as a national clearinghouse for information, identifying best practices, creating tool kits, distributing information and providing technical assistance.
• Removing the penalty for part-time service under the Civil Service Retirement System.
• Requiring states to include at least one older worker representative on state and local workforce investment boards and set aside 5 percent of Workforce Investment Act funds for older workers.
• Expanding eligibility for the Work Opportunity Tax Credit to employers who hire low-income older workers.
• Clarifying that certain defined benefit plans may have a normal retirement age that is the earlier of (1) attainment of a specified age or (2) at least 30 or more years of service.

The Incentives for Older Workers Act is unlikely to receive much attention this year. However, phased retirement and other issues related to older workers may receive increased legislative attention as the baby boom generation reaches retirement age.

IRS Activity

In 2002, the IRS requested comments on phased retirement. In November 2004, the IRS released proposed regulations to permit bona fide phased retirement arrangements in qualified defined benefit or money purchase pension plans. The proposed regulations would allow employers to provide phased retirement programs that include in-service distributions from a qualified pension plan for participants who had not attained the plan’s normal retirement age. But, they would also impose significant administrative burdens on plans that offer phased retirement arrangements.

Under the regulations, in-service distributions could be provided to participants younger than normal retirement age who participate in a "bona fide phased retirement program" – a formal, written program under which employees could reduce their working hours and receive phased retirement benefits. Phased retirement distributions would be subject to several restrictions – including a pro-rata restriction that would link the participant’s distribution to the reduction in work hours. For example, participants who cut their hours in half could receive up to 50 percent of their accrued benefit.

Employee participation in bona fide phased retirement programs would have to be voluntary. Participants would have to be at least 59 years old (the minimum age at which penalty-free distributions could be taken from a 401(k) account) and they would have to reduce their working hours by at least 20 percent. All the plan’s benefit options must be offered when phased retirement begins – except for lump sum distributions, which would be prohibited. If early retirement subsidies are available under the plan, the subsidy must be offered as part of the phased retirement benefit.

The proposed regulations require at least annual, prospective adjustment of the phased retirement benefit to reflect any material differences between the actual hours worked and those the employee signed on for under the program.

Phased retirement would not be available to key employees. Participants who were highly compensated employees (HCEs) before entering phased retirement would continue to be treated as HCEs, regardless of their compensation during phased retirement. The participant’s ultimate retirement benefit generally would be determined without regard to phased retirement benefits paid to date, including selecting a different optional form of payment, although material differences between scheduled and actual hours may be taken into account. For example, a participant who signs on to a 60 percent work schedule but who actually works 80 percent of pre-phased retirement hours can have his or her ultimate retirement benefit adjusted by the 20 percent difference.

The proposed regulations would consider a bona fide phased retirement program to be a separate optional form of benefit under the plan, which would be subject to nondiscrimination testing and protected by the anti-cutback rule. Thus, employers would not be able to experiment with phased retirement arrangements and later remove them completely from the plan. Employers should keep these issues in mind when determining which employees would be eligible for phased retirement. Payment of a wage differential, such as paying 80 percent of full-time wages to a phased retiree working a 60 percent schedule (and receiving 40 percent of his or her accrued benefit), would not be subject to nondiscrimination testing. The regulations also would require extensive disclosure provisions to inform participants that they could lose some rights as a result of participating in the plan’s phased retirement program.

The proposed phased retirement regulations also introduced a potential change to the definition of normal retirement age that could affect cash balance and other hybrid plans.

At the IRS’ public hearing on the regulations, many witnesses testified that the administrative burdens and lack of flexibility would deter employers from implementing phased retirement programs. The IRS has finalized the portion of the regulation addressing normal retirement age, but it has not finalized the portion addressing bona fide phased retirement programs.

Outlook

In January 2009, a new President and a new Congress took office and prepared to look at these issues in a new light. As the baby boom generation moves into retirement, workers and employers will seek workable phased retirement arrangements, which will likely drive additional interest in these issues from Congress and the IRS.