Thursday, July 18, 2013

Pensions To Lump-sums

Retirees from large companies who have been drawing retirement checks may face a new option. Their former employer may offer to swap them a lump sum payment now in exchange for all future retirement checks. An interesting offer but one that requires very close scrutiny.

First of all—why is the past employer making such and offer? Pension payments are generally made from defined benefit plans, i.e. plans that guarantee the retiree a prescribed benefit based on retirement age, length of employment service, and salaries earned while working. Note here that the employer is bearing all investment risk—the employer must contribute enough money into the plan such that the contributions plus investment earnings will provide the retirement benefits to the retiree over his/her expected lifetime. National media stories are abounding about corporate retirement plans and their underfunded status(i.e. the plans do not have adequate assets to meet the projected pension obligations). That problem has been compounded because the estimated plan earnings assumption has been very difficult to achieve for many plans because of investment performance over the past decade.

Another change working in favor of the employer is a change in allowable interest rates for lump sum calculations. The basic assumption in a lump sum distribution is that the employer will provide the retiree a lump sum of money that can be invested by the retiree to replicate the pension payment stream over the retiree’s life expectancy. The lower the interest rate assumption, the greater the amount of lump sum dollars that were required. Historically, US Treasury security interest rates were the assumed interest rates for lump sum calculations. Plan administrators can now use corporate bond interest rates in their lump sum calculations; those corporate bond interest rates are higher than the Treasury securities. The net impact—the higher the assumed interest rate, the lower the amount of lump sum dollars needed.

The bottom line—some pension plan administrators are attempting to remove retirees from their plans and the offer may not be in the best interest of the retiree. Should you or someone you know face such a choice, we at Paragon Financial Advisors will be happy to assist you in analyzing this decision.
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