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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. 

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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