Lump Sum Windfall May End
When it comes to taking lump sum retirement benefits from a defined-benefit pension plan, timing is everything. And now may be the perfect time.
Just ask Larry Martin Baker. A year ago, his company calculated the lump sum that he would receive when he retired this year. But when he retired a few months ago at the age of 55, the sum he got was 30% higher.
The reason? Interest rates. When interest rates decline -- as they have for several years -- the value of lump sum pension payments rises.
A defined-benefit pension promises to pay a retired worker a set amount every month for the rest of his or her life. However, an increasing number of plans allow workers a choice -- they can receive benefits in the traditional way through monthly payments, or they can get the money all at once in a lump sum payment.
The lump sums paid by these plans must be sufficient to provide the promised monthly stipend when invested at current interest rates. When market interest rates are low, it takes comparatively more upfront cash to generate the same monthly payment.
With the rate on the 30-year Treasury bond -- the benchmark for traditional pension calculations -- lingering at historically low levels, that creates something of a windfall for retirees such as Baker.
“When interest rates go up, lump sums go down, and vice versa,” said Paul Gewirtz, partner and consulting actuary at Ernst & Young in Cleveland. Baker “had the good fortune to retire when interest rates were extremely low.”
The days of the lump sum windfall may be numbered, though. Some industry leaders maintain that pension interest rates are artificially low today, and thus the formula for calculating pension obligations should be changed.
Examining Calculation
Many members of Congress and the Bush administration agree and are holding hearings aimed at determining how to change pension calculations. If proposals that now are being weighed succeed, pension calculations will use a higher interest rate, which will diminish the size of lump sum payments from these traditional plans.
No one knows precisely how much this could affect lump sum benefits, but many pension experts believe the reductions could be significant.
(The interest rate debate doesn’t affect defined-contribution pension plans, such as 401(k)s, or cash balance plans, which are a hybrid pension. With both of those plans, participants always see their pension balance as a lump sum, unlike traditional defined-benefit pensions, which generally are characterized as a set monthly payment. Lump sum amounts are calculated only at the companies that provide lump sums as an option -- and even then, they’re generally calculated only for workers who request it.)
In the meantime, workers who are nearing retirement may benefit by taking the lump sum and reinvesting the proceeds in a diversified portfolio of stocks and bonds, some industry experts said.
Consider a recently retired worker who is eligible for pension payments of $2,000 a month starting at age 65. Mortality tables say this retiree will live about 20 more years, which would make her lump sum benefit $319,666, based on the June Treasury security rate of 4.37%.
If the retiree, instead of opting for monthly payments for the rest of her life, invests the lump sum payment and earns a 7% average annual return, the nest egg will provide 240 monthly payments of $2,478 instead of the $2,000 a month she was promised.
Alternatively, the retiree could withdraw just $2,000 a month from the lump sum payment -- matching what her monthly pension check would have been. If she were to keep this up for 20 years, the retiree (or the retiree’s heirs) still would have $249,194 saved at the end of that period. If she chose to take her retirement benefits as a monthly payment, the payments would stop at her death. There usually is no residual to leave to heirs.
“It seemed the conventional wisdom was to take the lump sum unless you figured you were going to live another 30 years,” Baker said.
Inherent Risks
Even with the advantage of getting a bigger lump sum payment, the strategy still has a major risk when compared with the option of receiving a monthly pension check for life: outliving the money.
In the example above, if the retiree lives more than the planned-for 20 years, there’s a good chance the nest egg will be gone. However, a monthly pension check keeps coming no matter how long the retiree lives.
“Lump sums feed a fantasy that many people live to regret,” Gewirtz said. “I won’t take a lump sum myself because the risk of running out of money is real.”
Retirees who live longer than average or invest poorly -- or who simply fall victim to bad market conditions -- can end up with considerably less money by choosing the lump sum option over a pension check for life.
“If someone was fairly sophisticated and had a very good investment strategy, he’d be well advised to take the lump sum,” said Mark Ugoretz, president of the ERISA Industry Council in Washington.
“But if you are not a sophisticated investor and you’re not prepared to withstand the vicissitudes of the market -- or you had no other income -- I think you’d want to take the benefits as an annuity.”
