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
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.