The lump sum payment versus annuity stream question has long been an issue for those clients fortunate enough to have access to a traditional pension—but the choice is one that clients usually face as they approach retirement, rather than once they have already begun to receive annuity payouts.
The recent IRS change of course on this issue may add complications into the mix and encourage lump sum offers for retired clients who are already in pay status. Because lump sum offers have historically been an attractive way for pension plan sponsors to reduce the financial exposure associated with the plan itself, a new crowd of retired clients may soon be facing the choice of whether to accept a lump sum or continue with annuity payouts—and making sure that choice is informed will be vital to protecting these clients’ future financial security.
IRS Back-and-Forth on Lump Sums for Retirees in Pay Status
IRS plan qualification requirements generally require that pension benefits be paid in full or in the form of a non-increasing annuity once the client reaches his or her required beginning date, with the exception that increases in plan benefits are permitted. Prior to formal IRS guidance on the issue, plan sponsors interpreted this to mean that lump sum offers to participants already receiving annuity payments under the plan were permissible. As lump sum offers are one of two primary de-risking strategies a pension plan can use to reduce liabilities, the offers became popular.
In 2015, the IRS reversed its previous stance and announced its intent to amend the RMD rules to prohibit “cash-out” windows for participants already in pay status—i.e., retired participants. Now, the IRS has once again changed course and announced that, for the time being anyway, it is no longer planning to amend the RMD rules to prohibit lump-sum payments to pension plan participants already receiving annuity payments under the plan.
Although the new guidance, released in Notice 2019-18, does not specifically say that pension plan sponsors may now offer lump sum options to retirees, the option would not directly violate the IRC’s RMD rules—at least until the IRS releases additional guidance to the contrary. For the lump sum option to work, the plan will likely have to be at least 80% funded under current regulations, and the option must be offered in a non-discriminatory way (i.e., not only to highly compensated participants).
Impact of IRS’ Change of Course: What Clients Need to Know
The bottom line is, if cash-out options for participants in pay status become popular once again, many clients will have to make a choice at a time when they have likely not considered the issue in some time—but at a time (during retirement) when the client might actually have more of the information necessary to make an informed choice.
While there are many factors to be considered in determining whether to accept the buyout instead of continuing 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.
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 continuing benefit may wish to take the lump sum, rather than opt for annuity payments over a shortened period of time.
With proper management, the lump sum can provide clients with a secure lifetime income stream much the same 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 varied so that the client will be able to accomplish a variety of goals, including estate planning and providing for long-term care options, rather than simply receiving a set monthly payment.
The choice often comes down to the client’s desire to control the funds—if the client feels that he or she can invest the lump sum in a way that provides financial security, that client is probably more likely to accept the buyout. The advisor’s role can prove critical in these situations, as many clients will need guidance with respect to re-investing those funds.
Although significant questions remain for plan sponsors over the viability of legally offering cash-out windows to participants in pay status, the direct prohibition on these options has, for the moment at least, been removed. Clients who are facing pension buyout offers should be informed of their potential options, and counseled about the importance of taking proactive steps to protect their own financial futures if they choose to accept a lump sum buyout.