This summer, several large Lancaster-area employers have offered terminated employees, who had a vested benefit in their defined benefit plan, a lump sum payout or even an early immediate annuity for their promised pension benefit.
By Robin Russo, CFP®
Why this sudden rash of offers?
Historically, typical pension plans did not offer lump-sum payments, except perhaps to those with a very small vested balance. Today, well-funded pension plans may choose to offer lump-sum payments to terminated employees as a way to rid themselves of the risk of providing benefits far into the future. This is a risk transfer from the employer to the terminated employee.
Does the offer benefit the previous employer or the terminated employee? Or could it benefit both? To answer this question you have to understand how a lump sum must be calculated as a result of the Pension Protection Act of 2006.
Under the Act, the mortality table and the interest rate specified by the IRS for converting an annuity to a lump-sum payment changed effective January 1, 2008. The new mortality table reflects longer life expectancy. Additionally, the interest rate used to convert to optional forms of payment, such as the lump sum, now incorporates three corporate bond yield curve interest rates: One segment rate the first 5 years of expected payments, the second for the next 15 years of expected payments, and the third segment rate for all years of expected payments over 20.
The change in these three interest rates is the lever that determines if the lump sum is more or less beneficial to the employer. It’s an inverse relationship. Higher interest results in a lower lump-sum payout. A lower interest results in a higher lump-sum payout. These interest rates increased slightly in 2013, reducing the lump-sum calculation for the employer for lump-sum payments offered in 2014. The interest rates are expected to reverse and decrease slightly through the end of 2014, thus increasing the lump-sum payments calculation in 2015. So employers have a somewhat of a brief sweet spot in interest rates and are taking advantage of it.
If you have been offered a lump-sum payout, should you take it?
Perhaps you would be offered a better payout next year based on this year’s rates… perhaps not. These offers are voluntary on behalf of the employer and the employer may decide not to repeat. Interest rates are still at historic lows, so the lump-sum payouts are favorable. This is a very individual decision and depends on your personal circumstances, such as your health and expected longevity, other guaranteed income streams in retirement, your investment assets, your comfort and ability to invest a lump sum, your desire to leave a portion of your retirement funds to your heirs, and your particular federal income tax circumstances.
The following is a simple comparison of the annuity versus the lump-sum decision.
| Annuity | Lump Sum |
| Monthly payment guaranteed. Must take along with the tax burden whether you need it or not. Annuity payments are considered ordinary income, subject to federal income tax but not state income tax in PA. You will have that monthly income as long as you live. | No exact payment guaranteed or required. When rolled to an IRA can be flexible about distributions and the tax burden that accompanies them. Distributions without penalty can be taken at age 59 ½ but can be deferred until age 70 ½. Distributions are ordinary income, subject to federal income tax but not state income tax in PA. |
| Not subject to market risk. No investment required. No investment fees. | Subject to market risk. You are going to have to invest the lump sum in an IRA and manage it, either on your own or with assistance. You will pay some investment management fees. |
| No cost of living increases. Over time the purchasing power of the static monthly amount will erode. | More protection from inflation. It is possible for your investment to keep pace and exceed inflation with stock market exposure. |
| No benefit to your heirs. The monthly stream stops when you die unless you are eligible for and select a Joint and Survivor annuity at a reduced monthly amount. | Benefits your heirs. If you die before spending all your IRA assets, you can leave them to a beneficiary. The assets get rolled over to a beneficiary IRA and can be used for that person’s retirement or when needed. Only a small annual distribution is required. |
Summary – Pros & Cons
Annuity
- Guaranteed Income, Every Month, Until You Die
- Purchasing Power Risk
- No Control Over Income Tax Exposure
- No Flexibility
- Over When You Die
Lump Sum
- Stock Market Risk
- Inflation Hedge
- Can Control Income Tax Exposure
- Flexible Distributions
- Can Leave Excess to Heirs
Rick’s Tips:
- Well-funded pension plans may offer lump-sum payments to terminated employees.
- Current low interest rates make lump-sum payments attractive for employees.
- Seek expert counsel before choosing a lump-sum payment. The decision is irrevocable!
