Defined benefit lump-sum distribution "window"

[Belgarath]

Suppose a DB plan only offers an annuity form of benefit. However, under some sort of "de-risking" strategy, they decide to offer a lump-sum distribution option for a limited period. This is available to anyone who has not started receiving benefits yet, regardless of when they terminated employment.

You DB'ers probably know this like the back of your hand - for someone less than NRA, when calculating the current lump sum benefit, do they have to take the lump sum at NRA, then discount it back to whatever current age might be using the interest rate that would produce the higher lump sum (plan rates or 417(e), or only do that for the lump sum at NRA, but then discount it back using current rates (and not 417(e) if higher) or something else altogether?

Thanks.

P.S. when valuing the present value of the future expected annuity, for someone who is less than NRA, then is it going to be a blend of the applicable "segment rates" or just the segment rate at the time of NRA? Somehow seems like it may be the former rather than the latter. I appreciate any responses. Also, if it matters, let's assume this would be an ERISA plan.

[My 2 cents]

The methodologies followed by plans offering lump sums to participants as they separate from service would generally be followed in the event of a lump sum window. Unless provided otherwise, the lump sum amount would equal the actuarial present value of the accrued benefit, payable commencing as of NRA.

Step 1: Determine the expected cash flow, taking into account the applicable mortality rates.

Step 2: Discount the portion of the cash flow lying within the first 5 years at the first segment rate, the portion of the cash flow lying beyond the 5th year but not beyond the 20th year using the second segment rate, and the portion of the cash flow lying beyond the 20th year using the third segment rate.

Step 3: If the plan calls for paying the larger of the 417(e) lump sum or the present value of the benefits using the plan's regular equivalence basis, recalculate the lump sum using the regular equivalence basis and pick the larger of the answer from step 2 and step 3.

Don't forget that if you are offering an immediate lump sum prior to retirement eligibility, you must offer an immediate QJSA as well.

I personally cannot imagine a lump sum window that did not involve paying the lump sum now. Also, once the limited period is over, it is not necessary to offer lump sums in the future or immediately payable QJSAs or anything. Special benefits like those, offered as a special limited time offer, are not protected under Section 411. At midnight, the coach can truly turn back into a pumpkin.

[david rigby]

Special benefits like those, offered as a special limited time offer, are not protected under Section 411. At midnight, the coach can truly turn back into a pumpkin.

But, there may be other issues. The plan's actuary is well-qualified to help discuss.

As stated by My2Cents in his footer, "Always check with your actuary first."

[Belgarath]

Thanks for the responses. In your experience, is there any sort of "general rule" as to whether such things are favorable, unfavorable, or theoretically "neutral" to the participant? It seems like perhaps they would be favorable if one assumed that the interest that could be earned on the lump sum is greater than whatever assumptions are used in the plan? Or unfavorable if interest earned is lower?

And life expectancy probably factors in...

It just seems like there a lot of these offers out there all of a sudden, and being of a generally cynical mindset, it got me to wondering if such things are generally a bad choice for participants, or no way to say.

[tymesup]

The participant has the same choices they had before, plus the lump sum, so the participant is better off.

The participant can't take the lump sum and buy the same annuity, so the participant is worse off.

Under the old arrangement, the participant couldn't take the annuity and get the same lump sum, so the participant is better off under the new arrangement.

The participant can evaluate their expected longevity and make a rational choice, so the participant is better off.

It's my money, and I need cash now - JG Wentworth.

[Belgarath]

LOL. Thanks.

[AndyH]

"It just seems like there a lot of these offers out there all of a sudden, and being of a generally cynical mindset, it got me to wondering if such things are generally a bad choice for participants, or no way to say."

Nothing wrong with the additional option if the participant is fully informed, but what they may not be informed about is that the mortality tables used to compute lump sums are expected to change soon, and the result may be an increase of 5-10%, all else being equal. This is why windows are hot now.

But the sponsor in that case might not offer a lump sum in the future (if such a routine option does not exist), except possibly at the time of plan termination because it may be cheaper, or necessary, for them at the time of termination.

So the possibility of a greater lump sum at the time of plan termination is a potential downside to the participant, especially in a plan that is likely to terminate soon (e.g. a frozen plan).

p.s. my comments are within the context of a non-cash balance plan.

[Belgarath]

Thanks Andy. So if a plan doesn't normally offer a lump sum, and is unlikely to terminate in the near future, then it sounds like, "you pays your money and you takes your chances" - could be advantages or disadvantages either way, depending upon lots of factors.

Just out of curiosity, it seems to me like with interest rates and inflation at very low levels, if they rise in the future, the purchasing power of the fixed annuity will erode rather badly. For you actuarial types out there, if you were forced to choose which option (lump sum or fixed annuity lifetime payment) would be a "better" general choice for the majority of people (assuming a normal lifespan) based on your best guess/estimate peering into your crystal ball for the next 25 years, which would you choose? That is, which option would produce more money? Caveats by the dozen are already assumed - this is just friendly conversation!

[My 2 cents]

Thanks Andy. So if a plan doesn't normally offer a lump sum, and is unlikely to terminate in the near future, then it sounds like, "you pays your money and you takes your chances" - could be advantages or disadvantages either way, depending upon lots of factors.

Just out of curiosity, it seems to me like with interest rates and inflation at very low levels, if they rise in the future, the purchasing power of the fixed annuity will erode rather badly. For you actuarial types out there, if you were forced to choose which option (lump sum or fixed annuity lifetime payment) would be a "better" general choice for the majority of people (assuming a normal lifespan) based on your best guess/estimate peering into your crystal ball for the next 25 years, which would you choose? That is, which option would produce more money? Caveats by the dozen are already assumed - this is just friendly conversation!

One big problem is that the participant, on receiving a lump-sum payout of their retirement benefit (probably substantially more money than they ever had at one time) becomes, ipso facto, a money manager (all aspects - investing the money successfully or otherwise and controlling the speed with which the proceeds are spent). Powerball is up to almost $400 million - why not put the lump sum entirely into Powerball tickets?

Actuarial types may have the knowledge and self-control to make it work. How easy is that for non-actuarial types?

So the question should perhaps not be which option ultimately produces more money but rather which will leave the plan participant better off in 10 years or 20 years or 30 years?

[Belgarath]

All good, valid points. But if you don't mind, which would YOU choose, again, assuming normal life span? If you prefer to plead the 5th Amendment, I fully understand! Thanks.

P.S. if I were in such a situation and had a choice, I think I might lean towards the lump sum. Could of course be a huge mistake...

[ak2ary]

There is no right and no wrong answer. In some cases the lump sum will be significantly less valuable actuarially because it is usually the value of the age 65 benefit and may ignore subsidies available at early retirement. But then again, most of the plan that offer windows provide only a QPSA as a death benefit, so that there is a significant forfeiture at death (a total forfeiture for the unmarried)...the lump may be knocked down by the potential for forfeiture, but theres no chance you get zero.

At the end of the day, normally the lump sum and the annuity have the same value using conservative assumptions. I believe most will take the lump sum

• because they are guaranteed to get "something" and that something is usually a LOT of money
• they dont want to end up with "nothing"
• they have concerns about the security of their pensions long term, if Detroit doesnt have to pay...
• they have concerns about the extent of the PBGC guarantee
• AT the end of the day, the lump sum is better if things go bad (short life, money crisis etc) and the annuity is better if things go good (long life, no crises etc)
• People arent worried about what happens when things go good

[Kevin C]

For most participants, I think it should come down to how important the guaranteed monthly income would be in retirement. Their other assets will affect that answer. For someone with little or no retirement savings, the answer could be different than it would be for someone with substantial other assets.

If I were about to retire and had a decent DB benefit, I would likely choose the annuity because, as mentioned above, you can't take a LS and buy a comparable annuity. You also can't take the LS and withdraw the monthly amount you could have had as an annuity and expect the LS to last very long.

[david rigby]

Another factor the participant would use in this analysis is current health status and (perhaps) family history. If all the adults in your family died before age 65, then you might not be optimistic about having a long retirement, which means you will choose the lump sum.

We call that "anti-selection". It's not random, and it's not "average". Thus, every person's analysis will be different.

[My 2 cents]

Another factor the participant would use in this analysis is current health status and (perhaps) family history. If all the adults in your family died before age 65, then you might not be optimistic about having a long retirement, which means you will choose the lump sum.

We call that "anti-selection". It's not random, and it's not "average". Thus, every person's analysis will be different.

But the law prohibits the plan sponsor from trying to defend against anti-selection (other than not permitting participants to elect lump sums).

When those big lump sum windows were offered to retirees a few years ago, significant anti-selection was expected (i.e., the mortality among those who did not take the offer was expected to be unusually low, since those in poor health, who otherwise would have died in the next few years, would have elected the lump sum). I wonder if actual experience has matched that expectation. If not, maybe many of those in poor health were unable to deal with the offer, failed to act and were not cashed out.

[AndyH]

Another factor is whether the person is Male or Female because the lump sum will use a unisex table and unfortunately life itself will not.