What To Consider When Companies Offer Your Clients Lump-Sum Option

Many companies are offering a lump-sum option to employees who have a vested defined-benefit pension.

Companies make this kind of offer for their own benefit, of course, but taking the lump sum can be in the employee's benefit as well.

There are advantages and disadvantages with each option. The choice is very important and complex. You may want to consider the use of an experienced financial planner to help you make it. Here are some factors you should take into consideration.

Reduced benefit: Most defined-benefit plans pay a reduced benefit for employees who leave employment before normal retirement age but on or after the plan's early retirement age (generally 55). Employees who leave before the early retirement date can receive a deferred benefit if they were vested.

ERISA issues: The Employment Retirement Income Security Act is a federal law that regulates defined-benefit plans and other employer-sponsored retirement plans. Defined-benefit plans sponsored by governments and churches are generally exempt from ERISA. However, many non-ERISA plans still follow some or all of ERISA rules because of tax code or state law.

ERISA-covered plans provide some protection for spouses. First, a married participant's benefit must be paid in the form of a qualified joint and survivor annuity unless the employee selects another form of payment and the spouse consents, in writing. Second, these plans must treat the employer's spouse as the beneficiary unless the spouse agrees, in writing, that that the employee may designate a different beneficiary.

It is legal for an employer to offer a lump-sum buyout to former employees who were vested in a defined-benefit plan but have not yet begun receiving pension benefits.

Lump-sum calculations: The amount of the lump sum is computed by determining the present value of the employee's future payments using current interest rates and life expectancy assumptions. The lower the interest rate used, the higher the lump sum. Thus, if interest rates increase in the future, a future buyout would result in a lower lump sum payment.

Financial health of employer: An employee should take into consideration the financial status of their employer. For example, if the pension plan is significantly underfunded, and the employer is facing possible bankruptcy, those factors should influence you toward the lump-sum option. Although the Pension Benefit Guaranty Corporation does provide some insurance, its guarantee applies only to a specified maximum amount.

You should determine whether the amount of your expected pension payment exceeds the maximum amount guaranteed by PBGC. For 2020, the maximum monthly guarantee for a straight-life annuity at age 65 is $5,812. Moreover, the PBGC is facing financial difficulties and is also underfunded.

Another option you can consider, for comparison purposes, is to provide the amount of the lump-sum to a highly rated insurance company for a comparable annuity offer.

Health of employee and beneficiary: Another important issue to consider is the health of the employee and that of the spouse. If you are both in good health and expect to outlive your life expectancies, then accepting the lifetime defined-benefit benefit pension, as opposed to the lump-sum, makes more sense. (Naturally, this assumes your employer will remain solvent.)

IRA rollover option: This option is available only if your spouse concurs. With this option, you will have the responsibility of managing the investment. Naturally, you can use the advice of a financial planner, your mutual fund representatives or your broker. Defined-benefit plan annuities are typically fully taxable in the year received, and they can't be rolled over. DB lump-sum payments are eligible for rollover to an IRA. Required minimum distributions apply.

If you want more information regarding the pros and cons of lumps sums vs. defined-benefit pensions, consult Ed Slott's website at www.irahelp.com. If you decide you need the services of a financial planner with expertise in this area, Slott's company can recommend a financial planner in your area.

Elliot Raphaelson welcomes your questions and comments at raphelliot@

gmail.com.