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Lump-Sum or Annuity?

Almost weekly, the press announces another large corporation deciding to terminate their defined benefit retirement plans. Use this framework to help your clients make the best distribution decisions.

Susan Chesson, MBA, CTP and Helen Modly, CFP, CPWA, 07/17/2014

For years, lucky lottery winners have faced the decision of how to take their payout, and the news is rife with stories of winners striking it big, taking the lump-sum, and then blowing through the windfall in a matter of months. That’s a sobering thought for the thousands of participants in recently terminated defined benefit plans who face a similar decision: take a lump-sum today or commit to an annuity provided by a third party insurance company. 

What is driving this trend to terminate defined benefit plans? According to testimony from Steven A. Keating provided to a Department of Labor hearing, “the goal is to eliminate or to reduce balance sheet risk, longevity risk, investment risk, interest rate risk, and/or other risks borne by a plan sponsor.” The term used by pension consultants is “derisking,” which clearly spells out to plan participants that they are incurring the offsetting funding, credit, and investment risks. 

While there is no one-size-fits-all answer, we have found this framework helpful when reviewing the situation for our own clients.  

Retired Participants
Clients who are already retired and are already taking monthly distributions “in pay status” typically prefer to continue the monthly income stream and, therefore, take the replacement annuity.   

Participants Approaching Retirement Age
Clients within five years of retirement, typically age 60 or older, will require more in-depth analysis. If lump-sum distribution is large, relative to their other investment accounts, the decision will be as much emotional as financial, since the employee may have stayed with that one employer, in part, for the security of the pension benefit. 

The Under-60 Population
This group typically will benefit most from taking the lump-sum distribution. Rolling the lump-sum directly into an IRA offers complete flexibility for financial planning and investment management. Participants in their 40s or 50s may choose to spend some of the distribution to start a business, pay off debts, or fund college expenses.  

Other Factors To Take Into Consideration

Distribution Process: Clients who elect to take the lump-sum should in all cases roll it directly into an IRA using the direct institution-to-institution transfer method to avoid the risk of owing income taxes or a 10% early distribution penalty.

IRA Flexibility: Clients under the age of 59 ½ should strongly consider taking a lump-sum distribution if they anticipate incurring any expenses that qualify for distributions exempt from the 10% penalty, such as qualified higher education expenses, first home purchase, or unreimbursed medical expenses. 

401(k) Rollover: A client under the age of 59 ½ with access to a 401(k) plan that accepts rollovers from other retirement plans may wish to consider this option. 401(k) participants separated from service are able to access their accounts at age 55 without a 10% penalty, assuming their distributions do not qualify for any of the penalty exceptions listed above. The disadvantage is a possible lack of investment flexibility available to 401(k) participants in most corporate plans. 

Social Security: By taking the lump-sum to cover initial retirement income and expense needs, a client with longevity risk might be able to wait until age 70 to take the largest social security benefit available to them, which is effectively a government insured, inflation-adjusted annuity. 

Individual Spending/Saving Habits: For spendthrift retirees (or their spouses) who are unable to control their spending, taking the annuity is the more rational option.  They will have monthly income for life and survivor benefits, if selected.  For clients under the age of 59 ½, it is unlikely that the lump-sum, evaluated after-tax and a 10% penalty, will be an economically rational decision to supplement current income or pay down debt.  For clients who are comfortable with investing and have controlled spending habits, taking the lump-sum distribution and investing it for the long-term will most likely provide the greatest benefit. 

Life Expectancy: The lump-sum contribution is calculated using average life expectancies and a blend of current Treasury bond rates based on the age of the participant (and duration of the liability). For participants in poor health, but who are comfortable investing money for the long-term and do not anticipate reaching average life expectancy, the lump-sum option is likely the better alternative. Participants in good health will reap relatively more value from the monthly payment stream. However, they too should consider the lump-sum payment. This will allow them the flexibility to invest the funds and then draw on them for retirement income. 

Legacy:  A participant who wishes to leave assets to their beneficiaries should take advantage of the lump-sum payout. Lifetime pension or annuity payments stop at death and are of no benefit to the participant for legacy planning. A well-managed portfolio, on the other hand, could be left to heirs or, for those with philanthropic goals, left tax efficiently to a charity. 

Estate Planning: An increase in immediate wealth could give rise to a need for some specialized estate planning, such as the establishment of trusts to appropriately fund legacy goals for blended families, special needs trusts, or credit protection for participants and their families. 

Credit Risk: Private insurance companies pay out third-party annuity payments. If that insurance company were to fail, creditors would be reliant on a state fund for protection. Depending on the state where your client lives, that lifetime coverage would range from just $100,000 to $500,000. In contrast, employer pension plans are required by law to pay premiums into a federal agency, the Pension Benefits Guarantee Company. When an employer files for bankruptcy, the pension plan is taken over the PBGC. Some level of benefits will continue to be paid out to retirees, albeit subject to an annual cap (currently $59,318 per year). 

A Major Transition
The trend to derisk pension plans, and to offer lump-sum payouts or third-party annuities to participants of terminating defined benefit plans is well underway. Currently in the DC Metro area, employees and alumni of Fannie Mae, Freddie Mac, and Lockheed Martin--to name but a few--are facing this decision. The choice should be evaluated in the full context of the client’s current financial position and life goals, since the opportunity to take the lump-sum payment is a one-time event.

In sum, any client facing this decision should consult an advisor. This is a major transitional moment in a person's life--much like a marriage, birth, death, inheritance, or divorce. Anyone in this situation would be well served to reevaluate his or her financial plan.

Helen Modly, CFP, ChFC, is executive vice president and director of investment services for Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. Modly has more than 20 years of experience providing wealth-management services. She is a member of NAPFA and FPA. She can be reached at info@focus-wealth.com.

Susan Chesson joined Focus Wealth Management after a 20-year career in corporate treasury, fixed income investing and banking operations. While managing multi-billion dollar portfolios was interesting (and stressful), she was always more interested in personal financial planning and finally left the corporate world in 2010 to spend a year studying for the Executive Certificate in Financial Planning at Georgetown University.

The authors are freelance contributors to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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