By Eric L. Reiner
For several reasons, more participants in traditional defined benefit plans will soon be confronting an important choice, and they need your help. Should they take the lifetime pension they were promised, or a lump-sum payout instead?
Boomer participants are going to be retiring in droves now that the leading edge of their ranks—those born in 1946—is age 65. Meanwhile, cuts by tightfisted state and local governments could force public employees into retirement, or worse, unemployment. Although these workers’ ability to take a lump sum is often limited, some 79% of them have pensions, according to the Bureau of Labor Statistics’ March 2009 National Compensation Survey.
Then there’s a new pension law for private-sector (corporate) plans that becomes effective next year. It generally reduces lump-sum payouts, assuming interest rates remain at current levels. “That will make it less expensive for plan sponsors who want to terminate their plans to do so, and many of them are going to terminate their plans in 2012,” says James A. van Iwaarden, a consulting actuary and the president of Van Iwaarden Associates in Minneapolis. Typically, the sponsor freezes the plan before terminating it, he adds.
Fortunately for advisors, the wave of terminations is likely to continue for some time. For a plan to be terminated, it must be 100% funded—i.e., its assets must equal the value of the benefits promised the workers—and currently many plans are underfunded, explains Mary Ann Dunleavy, a consulting actuary at Horizon Actuarial Services LLC, in Silver Spring, Md. It’s going to take a while for plans that were severely hurt by the market downturn of ’08-’09 to get to full-funded status, she says. Which just means the opportunity to provide advice extends beyond 2012.
Capitalizing on these trends means doing two things. First, advisors must become familiar with the impending law change and its impact. Near-retirees can benefit from your expertise in this area now. Second, planners must get to know the issues surrounding the lump-sum-versus-pension decision that more clients, and prospects, will face.
New in 2012 for Corporate Pensions
The change to private pensions owes to a provision tucked inside the Pension Protection Act of 2006, notes Evan Inglis, the chief actuary at Vanguard.
To calculate the minimum lump sum that may be offered to participants who are retiring, separating from service or having their plan terminated out from under them, the sponsor computes the present value of the pension payments the plan is obligated to make to the participant, based on his or her life expectancy.
From our introductory finance classes, we recall that a present value—in this case, the lump-sum payout—is inversely related to the interest rate used in the discounting process. A lower discount rate produces a higher payout; a higher rate yields a smaller one.
Lump sums from corporate pensions are actually computed with a trio of discount rates, one each for the short, intermediate and long term. The short-term rate is used for discounting pension payments due to the participant within five years. This is known as the first segment. An intermediate-term rate discounts pension payments expected to occur in the second segment, years six through 20. Payments after that fall into the third segment and are discounted at the long-term rate.
The sponsor calculates the present value for each segment using its particular discount rate, then adds the present values together to arrive at the lump-sum benefit.
Beginning in 2012, the segment rates, which are published by the Internal Revenue Service, will be based solely on the yields of corporate bonds rated single-“A” or higher. Since 2008, the rates have been a weighted-average blend of corporate yields and the 30-year Treasury yield.
The accompanying chart looks at a recent month’s rates. The two columns show the potential difference in discount rates come 2012. Under current conditions, the rate for the short-term segment would fall with the banishment of the long Treasury from the math, while the second and third segments’ rates would rise.
How the Yield Curve Influences Payouts
For any particular participant, the net effect of the rule change hinges on age, along with such uncontrollable factors as the shape of the yield curve and the level of interest rates.
To illustrate, consider a 40-year-old worker whose plan is ending. His pension benefits are payable more than two decades hence. All of them therefore land in the third segment and its rate ought to be higher in 2012 when it becomes corporate-only, assuming no change in interest rates generally. A smaller payout results.
On the other hand, says Inglis, with a participant about to retire, the first five years’ payments lie in the first segment. Its rate figures to be lower next year under the new rules, which would increase the present value of those benefits, again assuming not much change in interest rates overall. Payments falling in later segments, though, would have reduced present values.
“When the yield curve is steep like it is today, a younger participant will be much more negatively impacted by the new rules than an older one,” Inglis concludes. If the yield curve were to invert—which might happen if runaway inflation ignites, as some fear—the relationship would flip.
Clients near retirement may wish to know how the change will affect their lump sum if they decide to work a little longer. Inglis says, “Advisors can point out that when interest rates are low, lump sums are more attractive relative to a period of high rates. But predicting interest rates is like predicting anything in the financial markets—not easy.”
The new rule takes effect at the beginning of the 2012 plan year. Since sponsors usually know the rate for their new plan year in advance, “clients who are retiring close to the break in plan years should ask their sponsor for an estimate of the lump sum in both the current year and the next year,” advises van Iwaarden. That will facilitate a direct comparison.
One Fat Check, or a Lifetime Income?
Deciding whether to take the pension or the lump sum hinges on many variables, according to David M. Hill, a financial advisor at Brinton Eaton, a wealth advisory firm in Madison, N.J. “There is no cookie-cutter solution. It’s a client-by-client decision,” he says.
In some cases, there frankly isn’t much to think about. “We’ve unfortunately seen clients whose finances dictated taking a lump sum and taking the tax hit as well,” says James Holtzman, an advisor and shareholder at Legend Financial Advisors Inc. in Pittsburgh. Participants who don’t roll their lump sum to an individual retirement account or other tax-deferred vehicle owe tax on it.
When analysis is necessary, Hill starts by running lifetime cash-flow projections to determine whether the client’s other assets and income sources will meet her needs. If not, the pension could be used to fill the budget gap, keeping in mind that it is fixed, and expenses may not be. When only part of the pension payment is needed, a partial annuitization of pension benefits may be the answer, if the plan allows it.
It comes down mathematically to whether the pot of cash could be invested to generate a greater inflation-adjusted retirement income than the pension would provide. Wichita, Kan., planner Richard Stumpf, owner of Financial Benefits Inc., told one client who retired in May, “There is nothing I can do that will provide as high a level of guaranteed income as your pension, and we need to guarantee your income using the highest-paying vehicle.”
According to van Iwaarden’s models, for a given principal, the income from an annuity can be as much as double that provided by the typical 4% withdrawal strategy. See http://pensionblog.com/2010/05/12/lifetime-income-from-dc-plans.
Similarly, the American Academy of Actuaries told the Department of Labor last year that to achieve a given retirement income, “50% to 75% more money would need to be set aside than if an individual participated in a [longevity] risk-pooling arrangement” such as a pension or annuity. (The organization’s 21-page letter to the department, at www.actuary.org/pdf/pension/aaa_rfi_050410.pdf, is a good resource for lifetime-income issues.)
But a pension leaves nothing for heirs. Clients who don’t need their pension for income often choose the lump-sum benefit precisely because any unspent funds at death can pass to family members. That’s important to many clients, Stumpf says.
Besides legacy objectives, the client’s personal traits can inform the decision. “If the client is a high spender, the annuity could be the right choice,” Hill says. Its fixed nature can stabilize the client’s spending.
The vast majority of participants take the lump sum. But investing it subjects the retiree’s cash flow to market volatility, Hill points out, and some clients can’t handle that emotionally. For them, a steady pension check means sleeping better at night and with luck, loving you for the advice.