The fifth anniversary of the Pension Protection Act (PPA) passed by in August with barely a mention in the financial press. Many people barely remember the Act or are aware of the impact it could have on their retirement. Those that are retiring this year or may have already retired but haven’t decided what to do about their pension should be paying attention. A major provision in PPA could significantly affect your lump sum pension payout before the end of this year.
PPA was passed in August 2006 to address private pension plans that were seriously underfunded. In simple terms, a pension plan must actuarially calculate how much money should be in the plan today to pay out all future benefits that have been earned by their participants. This requires calculating earned benefits and projecting how much the money already deposited into the plan will earn until those benefits are paid out. Actuaries were allowed to use the rate on 30-year Treasury bonds to calculate the required pension fund balance. Any short fall is to be made up by deposits from the employer to make sure the balance stays on track to pay benefits.
New rules established in PPA mandated a change from using the 30-year Treasury bond rate to higher corporate bond rates. The change is to be gradually phased in from 2008 and will be completely changed over by January 1, 2012. Starting next year, all pension calculations will be based entirely on corporate bond rates. This effectively lowers the amount of money that will be required in the pension fund. It also has a sizeable impact on the lump sum payout you would receive!
The amount of lump sum payouts has been coming down since the change-over started in 2008. Vanguard estimates that a $10,000 annual pension benefit for a 65 year old would have required a lump sum payment of $127,059 before the new rule started. That same benefit in 2011 would only require a lump sum of $120,282 and will drop to $119,197 in 2012. Younger workers would see even larger reductions.
Employers have been eagerly anticipating these changes as they seek to replace defined benefit pension plans with defined contribution plans like 401(k)s and 403(b)s. Defined contribution plan give an employer more flexibility over contributions year-to-year. Longer life expectancies have also significantly raised the cost of a defined benefit pension over the past 30 years. Many experts believe employers will be offering more lump sum payouts to take advantage of the new rules and rid themselves of the pension obligation. More than 100 major companies have shut their pension plans to new workers, frozen benefit accruals for current employees, or terminated their pension plans altogether since PPA was passed in 2006.
If your employer offers you a lump sum payout, consider the option carefully. You are essentially transferring investment risk from your employer to yourself. You need to be a skilled investor or plan to hire a wealth manager to help you manage this lump sum of cash. Lump sum payouts should be transferred to an IRA to avoid immediate taxation and potential early withdraw penalties. Make sure you understand the paperwork you are signing to initiate the payout to avoid a nasty surprise at tax time.
Offers of a lump sum payout in 2011 should be acted on before the end of the year to avoid the reduction under the new PPA rules. You will be giving up the guaranteed monthly income offered under the pension for a lump sum of cash today. However, you can always buy an immediate annuity later which offer a guaranteed income if you decide you don’t want to manage the money yourself. Immediate annuity payments are based on life expectancy and current interest rates. These payments may not be as attractive in today’s low interest rate environment. Should interest rates recover over the next few years, it may be worth considering for some or all of the lump sum you’ve left growing in your IRA.
- Consider carefully any lump sum pension payout offered by your employer but do so quickly before the end of 2011.
- Taking a lump sum payout from your pension doesn’t mean you give up a monthly income guarantee. You can always buy an immediate annuity with the money later and create your own private pension income.
- Managing a lump sum payout on your own is not for the novice investor. Seek the help of a qualified wealth manager to create an investment strategy based on your own unique goals and risk tolerance.