Buyout or pension? The heavyweight bout of retirement decisions
Which is better: buyouts or pensions? It’s the kind of high-value advice that makes clients appreciate why they pay a financial planner. The right decision can be a retirement game-changer — and so can a wrong one.
In October, General Electric became the latest U.S. company to announce major changes to its defined benefit plan. At the same time, the multinational conglomerate announced it would be freezing benefit accruals for approximately 20,000 active employees. It further said it would be offering lump-sum buyouts to about 100,000 former employees who have not yet begun their pension benefits.
The company's actions are further evidence of the demise of DB plans and of the popularity of buyout programs. Since the IRS has recently, again, approved lump-sum windows, this trend can only be expected to grow. Thus it’s more crucial than ever that advisors have a working knowledge of how DB plans work in order to determine whether an offered lump-sum buyout makes sense for a client.
A lump-sum buyout (also known as a lump-sum window) is a limited opportunity for DB plan participants to elect a lump-sum distribution in exchange for giving up future periodic payments. Most DB plans pay a reduced benefit for participants who leave employment before normal retirement age, but on or after the plan’s early retirement date (typically age 55). Participants who leave before the early retirement date can receive a deferred benefit if they leave with a vested benefit.
The Employee Retirement Income Security Act is a federal law that regulates DB plans and other employer-sponsored retirement plans. DB plans sponsored by governments or churches are generally exempt from ERISA. However, many non-ERISA plans still follow some or all of the ERISA rules, or similar rules because of tax code or state law requirements. ERISA-covered DB plans must provide certain protections for spouses.
First, a married participant’s benefit must be paid in the form of a qualified joint and survivor annuity — unless the participant elects another form of payment and the spouse consents. A QJSA pays a benefit over the participant’s lifetime and, if the spouse outlives the participant, pays the spouse a benefit over the spouse’s remaining lifetime.
Second, ERISA-covered DB plans must automatically treat a married participant’s spouse as his beneficiary – unless the participant designates another beneficiary and the spouse consents.
Offering a lump-sum buyout to former employees who have not yet begun their pension benefits (as GE will do) is, at present, legal. By contrast, the legality of window programs for retirees already in pay status is not as clear. The IRS has flip-flopped twice on whether those programs are valid. In 2012, the IRS issued several private letter rulings concluding that lump-sum buyouts for retirees do not violate the required minimum distribution rules that apply to DB plans. But in 2015, the IRS changed course and said it intended to amend the RMD rules to make such buyouts invalid. That never happened, and in March 2019 the IRS had another change of heart when it issued Notice 2019-18, in which the IRS announced that lump-sum windows for retirees were, at least for the time being, permissible.
Any analysis of whether a client should sign off on a lump-sum buyout offer should include the following factors:
How much would the client receive?
The amount of the lump sum is calculated by determining the present value of the client’s future payments, using interest rate and life expectancy assumptions. The lower the interest rate assumption, the higher the lump sum will be. A lump sum offered in the current environment of very low interest rates is likely to be at its peak. This may be a key reason now to take the buyout. If interest rates increase, a future buyout (if one is offered) will be a lower amount. Even if the client wishes the security of a guaranteed pension, it still may pay to take the optimum buyout now and, with the help of the financial advisor, create his own pension through annuities or other lifetime income plans that offer long-term security.
What’s the financial health of the plan and plan sponsor?
The possibility of a client’s former employer going out of business with an underfunded DB plan is a factor favoring a lump-sum distribution, as existing or future periodic payments would be reduced in that eventuality. Although the Pension Benefit Guaranty Corporation, a quasi-governmental agency, ensures pension benefits, its guarantee applies only up to a maximum amount. (For 2019, the maximum monthly guaranteed benefit, payable as a single life annuity at age 65, is $5,607.95).
Advisors should also make clients aware that the PBGC continues to have its own severe financial difficulties, casting some doubt on its ability to pay any guaranteed benefits in the future. Although the PBGC is essentially an insurer, that insurance won’t help if the PBGC doesn’t have the funds to pay the full cost of the loss. If a pension is desired, a client will likely gain more long-term security by going with a regular insurance company that can provide annuities with better guarantees, –as opposed to relying on the company or the PBGC.
How is the client’s (and beneficiary’s) health?
If a retiree receiving a single life annuity is in good health and expects to outlive her life expectancy, then passing up a lump sum might make sense — again assuming there is confidence that the employer will remain solvent.
The same is true if the client is receiving a joint life annuity and the retiree and her beneficiary are healthy. On the other hand, for someone facing medical issues, taking the buyout offer might be the right decision.
Know the client
An unexpected payment of tens — or even hundreds — of thousands of dollars can be tempting to any client. It is therefore up to the advisor to make sure the client understands what they are giving up and that the lump-sum amount may be less than the total amount of their lifetime pension payments.
Also keep in mind that some clients cannot handle receiving a large check. We have all seen problems in past buyouts where a lump sum meant to last a lifetime was gone within two years through squandering or poor investments. A client lacking financial discipline (especially one without sufficient resources elsewhere) might be better off passing up the buyout offer in lieu of retaining monthly pension payments.
A client inclined to invest responsibly might be a better candidate to accept the buyout. By creating a plan to make sure the funds last, the financial advisor can be a major asset here.
What is the best investment for an IRA rollover?
If a client takes a lump sum, the investment risk and responsibility shift to the client. The advisor has an opportunity to recommend an appropriate IRA investment, given the client’s age, risk tolerance and financial situation. Ideally, the investment would generate enough income to replace the lost pension.
Under the tax code, only eligible rollover distributions are, well, eligible for rollover. Annuity payments do not qualify as eligible rollover distributions. So, DB plan annuity payments are typically fully taxable in the year received and cannot be rolled over. On the other hand, DB lump-sum payments are eligible for rollover to an IRA. IRA withdrawals are flexible enough to take advantage of low tax brackets or convert funds to a Roth IRA, but RMDs are required for traditional IRAs.
When will pension payments end?
DB plan annuity payments end upon the death of the pension beneficiary. By contrast, an IRA into which a lump sum is rolled over can be structured to stretch out benefits over a much longer period.
Can spousal consent be obtained?
Plans offering a lump-sum window program must comply with the QJSA and spousal consent rules discussed earlier. Therefore, a married client must receive consent from his spouse before electing a lump sum. In some cases, the spouse may be reluctant to give up QJSA spousal protection. Here again, the advisor needs to know the client.
Lump-sum rollovers tax rules
Before a DB lump-sum payment can be rolled over, an RMD must be taken if the lump sum is paid in or after the year the client attains age 70 ½. RMDs are taxable and cannot be rolled over.
The IRS has special rules for calculating RMDs in this situation [Treas. Reg. § 1.401(a)(9)-6, A-1(d)]. A DB plan can calculate the portion of the lump sum that is an RMD by using the defined contribution plan RMD rules and treating the lump-sum amount as the client’s account balance as of the previous Dec. 31. Alternatively, the plan can treat one year of annuity payments as the portion of the lump sum that is an RMD.
Except for the RMD portion, the lump sum would be subject to automatic 20% withholding for federal income taxes and possibly an additional amount for state tax withholding. Automatic withholding would not apply if the lump sum is directly rolled over, which is the preferred method.
Until recently, most advisors could concentrate on IRA and defined contribution plan rules and not worry too much about DB plans. But the proliferation of lump-sum buyout programs opens up a whole new window of opportunity for advisors. They need to be ready to take advantage of it.