Lump sum windows have proven to be effective risk management tools for pension plan sponsors during the market disruptions of recent years. For those clients lucky enough to have access to a pension, the lump sum buyout trend is likely here to stay. Expected changes to the mortality rates used to calculate pension benefits, coupled with rising interest rates and PBGC premiums, continue to make the lump sum buyout offer attractive for plan sponsors.
The client who is evaluating the buyout has an entirely different set of considerations to weigh—and the available options for reinvesting the pension funds is potentially the most important factor for the client to consider. Equally important, however, is an advisor’s informed advice in helping the client reinvest a lump sum to both avoid unnecessary tax liability and ensure that retirement income security is preserved.
To Accept or Decline the Offer
While there are many factors to be considered in determining whether to choose a lump sum pension payment as opposed to a lifetime of annuity payments, the first step is typically to compare the numbers—for example, the client could determine how much it would cost to purchase a commercial annuity that provides a monthly benefit comparable to the pension annuity payment.
However, the client’s life expectancy and general health are also important in comparing the relative values of the two options. An unhealthy client who is not expected to outlive the life expectancy factor that is used in determining the value of the benefit may wish to take the lump sum, rather than opt for annuity payments over a shortened period of time.
Ultimately, however, the choice may center upon the client’s desire to control the pension funds. With the annuity option, the client generally receives a payment each month for life. In previous years, a desire to receive guaranteed income often weighed in favor of choosing the annuity option. However, recent trends in the pension arena have shown that it is possible for the original payment amount to be reduced in certain circumstances (for example, as in the case of plans that are in “critical and declining” status under the Multiemployer Pension Reform Act of 2014), meaning that the “guarantee” of a pension annuity payment is no longer as valuable as it once was for some clients.
Further, the client may simply feel that even if his or her pension plan is stable, the client can obtain guaranteed monthly income from sources that are more flexible and can be tailored to meet his or her individual needs, making the lump sum a more attractive option.
The IRA Rollover
If a client chooses the lump sum option and simply takes the funds, the plan sponsor is typically required to withhold 20% of the distribution for taxes, and an additional 10% penalty will apply if the client is younger than 59 ½. However, if the client rolls the funds into an IRA (or even an employer-sponsored 401(k)), the transaction is tax-free, and withdrawals will eventually be taxed at the client’s ordinary income tax rate, as is usually the case with these plans.
In order to roll the lump sum payment into an IRA to avoid current taxation, the funds should be transferred directly from the pension into the IRA, using a trustee-to-trustee transfer (meaning that the client never has control over the funds). This can be accomplished by directing the plan sponsor to roll the funds into a currently existing or newly created IRA.
Combining IRA funds with the pension buyout funds increases the earning power of the IRA, can streamline the client’s financial management and subjects the client to the often-familiar IRA rules.
The IRA option allows the client to take larger withdrawals in certain years (however, if the client has not reached age 59 ½, the withdrawal may be subject to penalties) in order to meet large unanticipated expenses or simply to travel—an option not available if the client chooses to continue receiving annuity payments from the pension plan.
Annuity Reinvestment of Lump Sum Funds
With proper management, the lump sum can provide clients with a secure lifetime income stream in exactly the same manner as a monthly pension annuity payment. The primary benefit of choosing the lump sum over the annuity option is flexibility. As most clients know, today’s annuity options are incredibly varied so that the client will be able to accomplish a variety of goals, rather than simply receiving a set monthly payment.
Although a pension annuity theoretically offers a fixed monthly payment for life, in most cases, these payments are never adjusted to account for inflation or to take advantage of rising equity markets. On the other hand, many commercial annuities commonly offer both of these options.
Further, annuities can be used to provide a death benefit to a surviving spouse or other heirs, can be purchased in joint form to ensure survivor benefits and can contain a long-term or critical care feature to provide protection against declining health later in life.
Deciding whether to take a lump sum buyout option is only the first step once the offer is on the table—it is equally important that a client who chooses a lump sum option gains competent advice in how to manage those funds in order to ensure secure income during retirement and avoid unnecessary tax liability.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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See this related story by ThinkAdvisor blogger Andrew Rice: Pension Plan Annuity Elections: Another Retirement Planning Gamble