Should the Lump Sum Window Stay Closed?

Offering lump sum windows to pension recipients recently got a green light of sorts. But not everyone is convinced that that’s a wonderful thing, and suggest that lump sums may not be exactly a panacea.

The IRS in Notice 2019-18 said that it no longer plans to amend the required minimum distribution (RMD) regulations to prohibit pension plans from offering retirees lump-sum buyouts. “The regulatory trail of breadcrumbs is a bit more complex than this, but the end result is that pensioner windows are now being tacitly accepted,” says Mike Clark, Principal Financial Group Consulting Actuary, in “Retiree Lump Sum Windows: Best Left Closed?”, a post on Principal’s blog.

Such opportunities for participants who are no longer employed but have not started receiving pension payments are not new, according to Clark; in fact, he says, they “have been wide open for years.” What is new, Clark writes, is offering lump sums to current retirees who are receiving pension payments.

Why offer a lump sum? Cost and the bottom line, Clark indicates, observing that they are “Cost is the primary reason why sponsors offer lump sums to terminated vested participants instead of buying annuities.” He’s not alone in that observation. “Companies who sponsor pension plans generally offer lump-sum buyouts to improve their balance sheets and reduce the total liabilities of their pension plans,” wrote Sen. Ron Wyden (D-OR), Senate Finance Committee Ranking Member, and Sen. Patty Murray (D-WA), Senate Health, Education, Labor and Pension Committee Ranking Member in their March 27 joint letter to Treasury Secretary Steven Mnuchin and IRS Commissioner Charles Rettig.

Offering lump sums also is a way to reduce risk, writes Clark, who says they “are a common method for cost effectively transferring risk out of DB plans.” But while they may reduce risk for plans, lump sum payments may introduce it for retirees. In the process of reducing a sponsor’s risk, Wyden and Murray wrote in their letter, “they also transfer their risk to retirees that the retirees might outlive their savings.”

Lump-sum buyouts may not be a bad deal for retirees, Wyden and Murray admit, noting that “not all lump-sum buyouts are bad for those retirees accepting such offers.” But they’re not always good, either. “Payments to retirees are much more certain” than a lump sum payment to a terminated vested former employee, says Clark. Not only that, Wyden and Murray point out that “the decision about whether to accept such a buyout offer is complex”, adding: “The complex actuarial formulas used to determine the immediate value of the lifetime pension benefit also often leave retirees who accept a lump sum offer with less money than they may have received otherwise.”

Clark further suggests that even for a plan sponsor, opening the retiree lump sum window may not be an ideal option, for two reasons:

1. Costs may increase. Insurers take note when plans make lump-sum payments as well as lifetime income payments. Also, there will be associated administrative costs and complications. All of this, Clark says, “add costs that offset savings.”
2. Ethical questions arise. Lump sum offers add variables for retirees to consider, which, Clark argues, “can be a difficult choice even for savvy participants and their financial advisors.” He adds, “Embarking on a process that introduces opportunities for retirees to make mistakes, or be misled or exploited by others, is a heavy question for plan fiduciaries to weigh.”

Wyden and Murray concur, pointing out in their letter that the Government Accountability Office in 2015 found that disclosures to retirees about lump sum offers “sometimes omitted key information and that retirees often did not fully understand the trade-offs involved in the choice they were given.” The report, they said, resulted in lump sum offers to current retirees be prohibited, and, they add, “these issues have yet to be resolved.”

Wyden and Murray called it “cold comfort” that the administration says it plans to continue to study the matter, and “strongly urge” that the Treasury and the IRS “reconsider retracting the intent to propose regulations under section 401(a)(9)of the Code until such time that better protections are in place for our nation’s retirees.”