Pension Lump Sum Payouts to Decline

Lump sum pension payouts are likely to fall for many retirees over the next few years. The Pension Protection Act of 2006 changed the rules for computing payouts, and they apply retroactively.

The new rules affect people in old-fashioned defined benefit pension plans. These are the plans that guarantee annuities to members at retirement. Members of those plans often have the option of taking a lump sum payout instead of the fixed payments.

Previously, the lump sum payouts were computed using a treasury bond interest rate. The new law requires the pension funds to use a corporate bond rate to compute the lump sum. The corporate yield is higher than the treasury rate. Using the higher rate will result in a lower lump sum payout, because the plan is assuming that the retiree will earn a higher rate of return on the money.

Another change is in the life expectancy table to be used when computing the lump sum. The new table assumes longer life expectancy. That actually boosts payouts, because people need more money if they will live longer. The net effect of both changes is that plan members who opt for a lump sum are likely to receive a lower amount than under the old rules.

The new rules begin to take effect in 2008 and are phased in over five years. Because of the phase-in, the rules actually boost lump sums in 2008 for at least some retirees. That is because the life expectancy tables are initiated without a phase in, but the interest rate change is phased in. The result is a higher lump sum in 2008 under the new rules than would have been paid under the old rules but lower payouts in subsequent years. But some higher income retirees face the changes in 2006 and later.

Defined benefit plan members who plan to retire in the next few years should consider their options carefully. Those who want a lump sum might choose to retire in 2007 or 2008 if they have flexibility. Those who retire later should reconsider taking a lump sum.

There are several reasons why a retiree might want to forego a guaranteed retirement income and take a lump sum.

One reason to take a lump sum is concern about the financial health of the pension plan sponsor. Some sponsors in airline, steel, and other industries have filed for bankruptcy protection and had their pension plan obligations discharged. That is not a big problem if the annuity is no more than the maximum amount guaranteed by the Pension Benefit Guaranty Corporation. But it does spell trouble for higher income retirees.

A lump sum also is favored by retirees who believe that they will be able to earn a higher return on the money than the rate assumed in the plan’s computations. If they deliver, then they will have more money to spend in retirement or to leave to their heirs.

Retirees with poor health or ancestors with short life spans might take lump sums. They would receive less money over their lifetimes from an annuity if indeed they expire before life expectancy, and none would be left for heirs.

Some retirees choose a lump sum because they have large cash expenses in the first few years of retirement. They want the lump sum to pay those expenses instead of having to borrow money and repay the loans from their annuities over time.