Coalition Seeks Additional Guidance Under Proposed Roth Contribution Regs

Mr. Harlan M. Weller

We are writing on behalf of the Committee of Annuity Insurers (the "Committee") to follow up on our recent meeting regarding the manner in which the separate accounting requirement of the proposed regulations under section 402A applies in the case of an "enhanced" benefit provided by an annuity contract in the common situation where the amount of the benefit depends on the value of the entire contract, i.e., the value of both the Roth and non-Roth account.¹ As an initial matter, we would like to thank you and your colleagues for your careful review of our April 26th comment letter and the time that you spent meeting with us.

During our meeting, there appeared to be little or no disagreement that the separate accounting requirement would be satisfied if (1) all of the charges imposed for an enhanced benefit were assessed against only one of the accounts (i.e., either the Roth or the non-Roth account) and (2) any distribution attributable to the enhanced benefit was given the same tax character as the account against which the charges were assessed. The inclusion of an example to this effect in the final regulations would be very helpful. Such an example would illustrate the principle that the tax character of an enhanced benefit is determined by reference to the source of funds used to purchase the benefit -- the same principle that is reflected in the "charges method" of accounting for enhanced benefits that we described in our April 26th comment letter.

In our view, this principle should apply equally in cases where the charges for an enhanced benefit are assessed entirely against one account and in cases where charges are assessed against both accounts. The only difference is that in the latter case the tax character of the benefit payment would be allocated between Roth and non-Roth treatment in accordance with the relative levels of the charges assessed against each account,² and in the former case the tax character of the benefit payment would be allocated entirely to the one account against which charges were assessed. In either case, the tax character of the benefit payment is determined by direct reference to the source of funds used to purchase it. Here, too, inclusion of an example illustrating this point would be very helpful, since the charges for many enhanced benefits are imposed on a pro rata basis against each of the sub-accounts comprising the policy value.

The "relative account balance" and "relative net contribution" methods that we described in our April 26th comment letter attempt to implement this same principle with respect to charges, but in a simpler manner. In lieu of actual charges, these methods use relative account balances and contributions as proxies for charges, which, in our experience, are almost invariably assessed as a uniform percentage of the contract's cash value. We suggested these accounting methods as potential alternatives to a pure "charges" methodology for a variety of reasons, including the fact that charges for an enhanced benefit may not be explicitly stated in the contract or may not have been tracked in the past, and because consumers might better understand one of the simplified approaches.

We certainly appreciate the fact that you and your colleagues have concerns over potential abuses where a simplified method is used, such as where a taxpayer might use withdrawals from one account to artificially inflate the proportion of an enhanced benefit that is characterized as a Roth distribution. However, we suggest that applying either of the simplified methods without an appropriate adjustment in such a context would fail the separate accounting requirement because, in that context, the method would fail to reflect the economics of the arrangement, i.e., the manner in which charges were assessed.³ In that regard, we believe it is important to reiterate that the approach we suggested in our April 26th comment letter would involve the inclusion of specific illustrative examples in the final regulations, but those examples would not be "safe harbors" that taxpayers could rely upon in all instances. Rather, their use would be subject to the requirements of the general rule we have proposed that elaborates on the separate accounting requirement, pursuant to which an accounting method would be considered appropriate only if, inter alia, it accurately reflects the economics of the arrangement. Thus, the use of withdrawals or similar mechanisms to arrive at a result that is inconsistent with the economics of the arrangement, i.e., the charges, would be prohibited under the general rule we have proposed.

Finally, the "net amount at risk" method that we described in our comment letter is consistent with the principle that the tax character of an enhanced benefit should be determined by reference to the charges for that benefit. One way of thinking about the "net amount at risk" method is that two enhanced benefits are, in effect, created -- one for the Roth account and one for the non-Roth account -- and each account is charged only for the enhanced benefit for that account. The only interaction between the two accounts is that the enhanced benefit payable under one account may be offset (or reduced) based on the performance of the other account. Offsets are common features of many retirement plan arrangements and an offset should not cause an arrangement to run afoul of the separate accounting requirement.⁴

In closing, the Committee believes that it is important for the final regulations to provide guidance on the manner in which the separate accounting requirement can be satisfied in the context of enhanced benefits whose values are affected by both the Roth and non-Roth account under a single annuity contract. In that regard, while it might be possible to avoid the issue described herein by structuring an enhanced benefit so that its value is affected by only the Roth or the non-Roth account (but not both), this would require new annuity products and pricing assumptions to be developed. Moreover, the existing product designs can provide reduced costs and easier-to-understand benefits for consumers relative to the foregoing alternative or the use of two separate annuity contracts. Thus, we believe that final regulations should facilitate the availability of enhanced benefits in the manner we described. As we have discussed, such benefits provide consumers with valuable guarantees that protect against economic erosion of their retirement savings and retirement income. These guarantees encourage investments in equity markets that provide the potential for higher rates of return and, thus, better retirement preparedness.⁵ As a result, it is not surprising that such benefits are extremely popular, as evidenced by the facts that, as of the end of last year, 85% of all variable annuity contracts sold offered one or more "living" enhanced benefits and that return of premium death benefits are virtually standard product features. In light of the public policy functions served by enhanced annuity benefits and their increasing popularity among consumers, the Committee urges the Treasury Department to clarify their treatment in the final regulations.

We again would like to thank you and your colleagues for the time and effort you have devoted to considering this important issue. If you have any questions or if we can be of any further assistance in your consideration of this issue, please do not hesitate to contact any of the undersigned at 202-347-2230.

² Thus, the proportion of the benefit paid in excess of the account value that would be characterized as a distribution from the Roth account would equal the ratio of the charges assessed against the Roth account to the total charges assessed for the benefit. The charges method creates some transition issues because companies may not have tracked charges in the past, and the Committee's April 26th comment letter (at page 12) suggests a means of addressing the transition.

³ Another approach might be to impose some type of "look-back" rule under which withdrawals taken within a certain proximity to a benefit payment would be disregarded in determining the tax character of that payment. We note that the IRS and Treasury Department recently took a similar approach in the context of annuities involved in Roth IRA conversions. See Rev. Proc. 2006-13, 2006-3 I.R.B. 315 (describing safe harbor methods for valuing annuities involved in Roth IRA conversions, one of which requires that certain charges assessed within a stated proximity of the conversion be added back to the contract's cash value when determining its fair market value).

⁴ The mere fact that the offset may be affected by a participant's actions, e.g., through withdrawals, should not affect this analysis. For example, as long as a withdrawal proportionately reduces the benefit payable and the net amount at risk, the proportion of a death benefit payable that will be characterized as Roth or non-Roth will be unaffected by the withdrawal. It would be a relatively simple matter to include an example of an enhanced death benefit using the net amount at risk method incorporating these facts, which are common in the industry.

⁵See Department of Labor, Default Investment Alternatives Under Participant Directed Individual Account Plans, 71 Fed. Reg. 56806 (proposed Sept. 27, 2006) (extolling the public policy benefits of equity versus fixed income investments for purposes of retirement preparedness).