By Dan Cassidy
Published in Benefits Magazine
Americans love choice. We want the freedom to choose everything—what car to buy, where to live, what color to paint our houses. In retirement plans, 401(k) plans tapped into this desire by offering investment choice. Now, many defined benefit (DB) plans offer participants choice as a normal part of their plan provisions: Elect a lump-sum payment or begin an annuity payment.
This choice, lump sum or annuity, is central to companies looking to transfer risk out of their pension plans, as seen in two recent jumbo derisking situations at GM and Ford.
Combined with the expected uptick in pension plan terminations in the future, participants all over the country will face this decision—lump sum or annuity? How will participants make this decision? What factors will they consider? How can plan sponsors help participants make an informed decision? What other design features could plan sponsors adopt to help participants have a successful retirement outcome?
This article will address these questions after a review of lump sum payments in general.
Lump Sum Overview
Pension plans traditionally provided benefits in the form of lifetime payments—annuities. Typically, a retiree and his or her spouse would receive a monthly check as long as one of them was alive. Payments would stop after the second person died.
In recent years, there has been a trend to provide an alternative form of payment , one where the participant would receive a single payment—a lump sum—that is the “actuarial equivalent” to the annuity. The pension plan basically is telling the participant, “The plan will give you $10,000 in one payment, or you can continue to receive the $1,000 per year.”
Increasingly, pension plans have adopted lump-sum options. Factors that have contributed to this include:
*Popularity of 401(k) plans: 401(k) plans typically pay the entire account balance out in one single payment that many people roll over to an individual retirement account (IRA). This gives the participant control over his or her retirement assets—a highly valued feature.
*Conversion to cash-balance plans: Many pension plans have been converted to a type of design that communicates the value of the benefit in a lump-sum form—a cash-balance plan. While still a pension plan, cash-balance plans emphasize the lump-sum value over the annuity value.
*Conversion interest rate: The Internal Revenue Service (IRS) stipulates the acceptable methods for converting from an annuity to a lump sum—i.e., how to calculate the actuarial equivalence. In the past, plan sponsors were not willing to provide lump-sum options because the interest rates used in the calculation produced a higher lump-sum amount. Recently, the IRS changed the interest rates plan that sponsors could use, which lowered the lump-sum amount. Because of this, plan sponsors are less averse to adopting lump-sum provisions.
*Declining interest rates combined with conversion methodology: Lump-sum activity accelerated in 2012 due to a combination of unrelated factors, among them a declining interest rate environment while the conversion methodology allows a look-back period. In short, the lump-sum factors could be based on interest rates from 12 months prior, so this allowed higher interest rates that produced a lower lump-sum amount. This temporary situation provided a window of lower lump-sum amounts. If, and when, interest rates increase, this situation will be eliminated and ultimately reversed.
Whether to take a lump sum rather than an annuity from a pension plan is a decision that each participant will need to make for himself or herself. Here are the top four things a participant should consider:
Decision Variables for Participants
1. Health status of both of the participant and his or her spouse: At the extreme, a participant who is not in good health should select the lump sum. However, if the spouse is in excellent health, the participant may still want to consider an annuity with significant survivor benefits.
2. Longevity: How old did the participant’s parents live? The spouse’ parents? Longevity risk, the risk of outliving one’s assets, can be hedged by annuities. In selecting a lump sum, the participant effectively is saying he or she will use investment vehicles to hedge this risk. This self-insurance route is “expensive” in that the person will have to lower their consumption to hold back a safety net in case they live a long time. Annuities, on the other hand, work by pooling this longevity risk across a large group of people – either in a pension plan or at an insurance company. The people who die young, in effect, subsidize those people that live a long time. The benefits of this pooling are tremendous. Another factor to consider is the age difference between the participant and his or her spouse. The greater the age difference, the higher the longevity risk.
3. Other assets (both type and amount): This is an important consideration on several fronts:
*As an individual’s wealth increases, the risk of making a bad choice is reduced. A person with $3 million of other investable assets may not have to worry about making the wrong choice between taking a $500,000 lump sum or a $50,000 annuity. On the other hand, an annuity may be a more prudent choice for a person with few assets outside of the pension plan.
*Diversity of retirement income sources. Most people will have Social Security providing an inflation-indexed annuity. Does the participant have any other annuity income sources? How much of his or her basic living expenses would other annuity sources cover? If Social Security provides only a quarter of basic living expenses, an annuity may be a good option to provide a guaranteed income stream to fill this gap. On the other hand, if a person has a pension from a prior employer and his or her spouse also has a pension plan, so that all annuity sources cover their basic living expenses, a lump sum may be more suitable.
4. Gender: Women generally live longer than men. So, an annuity that provides a lifetime income to a woman would cost more because the issuer would expect to pay more assets over her lifetime compared to a man. However, in the name of eliminating sex discrimination this difference between the sexes is ignored when pension plans calculate the lump-sum amount. The result is that women receive a smaller lump sum than the “actuarial equivalent” annuity, and vice versa for men. So, on this point alone, women would be better off selecting the annuity.
What Can Plan Sponsors Do?
Today, plans sponsors view offering lump sums as a benefit, an option that participants can take advantage of, and see it as cost-neutral to their pension plan. During a plan termination process, lump- sum payments are also significantly less than the cost of buying an annuity from an insurance company.
From a communication standpoint, plan sponsors have typically expressed the decision as simply a financial one: Take a lump sum of $500,000 or an annuity of $50,000. When confronted with numbers like this, participants are much more likely to take the $500,000 rather than the $50,000. Many ongoing plans with lump-sum options have 90–95% take-up of lump sums. Are participants better off with this choice? Who knows. Will our society be better off and our retirement systems successful with these results? Uncertain.
Here are three ways plan sponsors can help participants make the decision:
1. More communication: Behavioral finance professionals, experts in the field of how people make financial decisions, would say that how the question is framed is the most important thing. Option A or Option B. Plan sponsors should consider providing additional information to communicate the trade-off between a lump sum or annuity. Emphasize the issues of making financial decisions as one ages and the downside risk of uncertain investment results vs. guaranteed lifetime payments in an annuity. Make the decision more about the retirement experience and needs and less about the financial trade-off today.
2. Add more choice: Right now, the traditional trade-off is better lump sum or annuity—an all-or-nothing choice. Many participants are afraid of putting all of their plan assets in an annuity provided by a single insurance company. Plan sponsors should consider how they could address this concern by.
* Offering 50% lump sum, 50% annuity. This may appeal to people who want some certainty, but also value having control of their assets.
* Offering to diversify the insurance providers. To reduce the counterparty risk of having a single insurance company providing 100% of the benefit, a plan sponsor could select two insurers to both provide 50% of the benefit. This would complicate the annuity placement, but may be considered worthwhile if this counterparty concern is deemed to be significant. Other ways to reduce this risk should also be considered. For example, some lifetime income products are being developed for the 401(k) marketplace where a consortium of insurers—rather than a single company—provides the guarantees.
*Providing the opportunity to buy longevity annuities. These deferred annuities insure against the risk of outliving one’s assets because they kick in and start payments at the age of 85 if the participant lives that long. By using about 10% of his or her assets to buy the annuity, a participant can provide significant longevity protection and still have 90% of the assets to use for other purposes.
3. Inflation indexation: This optional form of benefit payment may be a very attractive feature for a retiree. Plan sponsors may want to consider capping this feature at 4% annually.
Summary
The recent emergence of lump-sum payments from pension plans has raised awareness of how difficult it can be for individual participants to make the best decision. Participants need to do their part to be more educated in exactly what this decision entails for their financial wellbeing. Plan sponsors should look to helping them make this decision, as well as look at other ways to provide options for participants to have a safe, secure retirement income plans.
—–
Dan Cassidy, FSA, EA, MAAA, CFA, is managing director of P-Solve Cassidy, a consulting firm focused on enterprise risk management of retirement plans. He has worked in financial services for more than 20 year. Cassidy was a consulting actuary for Towers Perrin and Mercer before starting Cassidy Retirement Group, which merged with P-Solve. He is the author of A Manager’s Guide to Strategic Retirement Plan Management,” published by Wiley, and a contributing author of Pension Actuary’s Guide to Financial Economics published by the Society of Actuaries, where he serves on the board of directors and is a past general chair of the Education System. Cassidy earned a B.S. degree in mathematics from Tufts University.
