You may have thought about taking your pension plan balance as a lump-sum payout rather than as an annuity income stream when you retire. Before you make your decision, consider that the Pension Protection Act of 2006 (PPA) could result in a drastic reduction of the amount you had anticipated receiving in a lump-sum payment. Furthermore, if you have already taken a lump-sum payment, you may be required to repay a portion of the amount to the pension plan.
Why Take a Lump Sum?
A steady check each month for the rest of your life after you retire sounds good, right? All you would have to do is stroll back and forth from the mailbox or simply watch the funds flow electronically into your bank account … then you can slouch back in your hammock and relax.
However, there are several reasons why plan participants opt to cash out of their pension plans. Consider the following three:
- Your employer is not financially stable. The Pension Benefit Guaranty Corporation (PBGC) is supposed to make sure that you receive your pension benefit if your employer goes belly-up. However, you could end up with a smaller payout than your employer had promised if the plan is taken over by the PBGC. Then you might have to cut back on expenses, such as the cruises you had hoped to take, gifts for the grandchildren or basic living needs. Taking a lump sum could help to ensure that you receive your full pension benefit. (See The Pension Benefit Guaranty Corporation Rescues Plans for more on the PBGC.)
- Like many soon-to-be retirees, you plan to start a business that will require a large sum of money. If your only source of capital is your pension balance, you may decide to cash out.
- You think you could do a better job of investing the funds than the pension plan money managers do.
Who Is Affected?
Are you among the 44 million employees and retirees who have retirement plan assets in defined-benefit pension plans? If so, it is in your best interest to pay attention to these changes. (It is not in your best interest if the pension plan in which you participate does not offer the option to take your benefits as a lump-sum payment. In this case, the changes will not affect the amount of your annuity payments.)
What's In The New Law?
The PPA includes two significant changes that affect lump-sum distributions. These are as follows:
- It changes the way companies calculate how much to pay retirees who take their pensions in a lump-sum.
- It puts a cap on the amount you can receive when you convert your pension to a lump-sum payout.
How This Could Affect You
When you're ready to retire, your company will use your pension annuity payments to determine how much your balance is worth as a lump sum in today's dollars. The calculation is based on future investment returns and your life expectancy. A higher investment return will require a smaller lump sum.
For example, let's assume you can get a $3,000 per month pension, and your life expectancy is 20 years. To determine the lump-sum payout, your employer will use the 240 payments and discount its value by the appropriate interest rate. If your employer can get a 5% return over the next 20 years, it would offer you $454,576 today. But if it can get a 6% return, your employer will only have to offer you $418,742.
This is exactly what has happened under the new law.
Perhaps you are retired and took your lump sum before the new regulation became law in August 2006. Consequently, you may think you have nothing to worry about. Think again.
This provision is retroactive to January 1, 2006, so you might have to return some of that lump sum to your employer.
Starting in 2006, the largest annual pension a retiree age 62 to 65 can receive is $175,000. The limit is lower for younger workers and increases within inflation. This means smaller lump-sum payouts.
Of equal importance is a new provision where, starting in 2008, the assumptions used to calculate lump-sum distributions will change over a five-year period from the 30-year Treasury bond rate to the corporate bond interest rate. Because corporate bonds have greater risks than Treasuries, their yields are historically higher. Consequently, your employer will offer you a smaller lump-sum payout than you may have expected. This change will phase in from 2008 through to 2012.
What You Can Do
Take Annuity Payments
You could, of course, just take your pension in monthly payments over your lifetime. This is often seen as the safer route because it will not expose you to the following two risks:
- You pick lousy investments for your lump sum.
- You run out of money before you die.
On the other hand, if your employer files for bankruptcy and the plan has to be taken over by the PBGC, that may result in your pension payments being reduced.
Contribute More to Other Plans
Still working? There are at least three good reasons to contribute as much as you can to your 401(k) plan and IRAs. The amount you accumulate could:
- Offset the reduction in your lump-sum payout;
- Serve as a cushion in case your company freezes the plan, preventing you from accruing additional benefits under the plan;
- Make up for the possibility of lower payout each month if the PBGC takes over the plan and has to reduce your pension.
If your pension is reduced by the recent law, you might be entitled to recover some of the lost benefit as an annuity in addition to the lump-sum payment. Check your summary plan description agreement, or check with your plan administrator to determine the terms of your plan.
These recent changes should make you sit up and take notice as you get closer to retirement. Think everything through carefully before you make a decision that you, and possibly your spouse, will have to live with for the rest of your lives.
Furthermore, even if you have always made your own investment decisions and been successful, this might be a good time to get a second opinion from a professional.
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