Lump-sum offers present risks and opportunities

Ford and GM decisions on pensions may mark the beginning of a trend

Jul 8, 2012 @ 12:01 am

By Mary Beth Franklin

Ford Motor Co. and General Motors Co. made headlines over the past two months when they offered nonunion retirees a chance to swap their monthly pensions for a lump-sum payout.

Although only about 130,000 retirees are affected by the auto giants' announcements, financial advisers everywhere should take note: This could be the start of a major trend.

“I think you will see many plan sponsors offering lump-sum pension payouts over the next 12 to 24 months,” said Sean Brennan, a principal and pension plan expert at Mercer LLC, a human resources consulting firm.

He noted that 2012 is the first year in which employers can use a blended corporate interest rate, which is more favorable than the previous figure, which incorporated the lower Treasury rate, to calculate lump-sum payouts.

The higher the interest rate, the smaller the lump sum needed to equal a lifetime stream of annuity payments.

Many private pension plans, which are severely underfunded due to the perfect storm of record-low interest rates and volatile stock markets, are unable to offer lump-sum payouts.

Plans that are less than 80% funded can offer participants only half their pension benefit as a lump sum; the balance can be converted to an immediate annuity. Those that are less than 60% funded cannot offer lump-sum payouts.

But that situation could change as a result of legislation that gives employers more flexibility in meeting their pension-funding obligations. The pension stabilization provision attached to a recently approved highway funding and student loan bill also increases the per-person premium that employers must pay to the Pension Benefit Guaranty Corp.

That gives employers yet another reason to reduce the number of plan participants as soon as possible.


Lump-sum payouts offer several advantages over fixed pension benefits, including income flexibility, tax optimization and estate-planning opportunities, said David Kudla, a principal with Mainstay Capital Management LLC, who has worked with GM employees and retirees for more than 20 years.

Lump sums also eliminate what he calls the PBGC risk, which can reduce the pension benefits of higher-paid employees if their plan is taken over by the government's pension protection agency. The largest pension benefit that the PBGC can pay a 65-year-old retiree whose plan is taken over this year is just under $56,000 a year — less for retirees who collect benefits before 65.

But lump sums aren't right for everyone.

“There are people who are very comfortable with fixed monthly payments, particularly when they see volatility in their 401(k) balance, volatility in their [individual retirement accounts], and their home is worth only two-thirds what it was five years ago,” Mr. Kudla said. “No matter how compelling a lump sum might be, we need to remember our fiduciary duty and respect our clients' tolerance for investment risk.”

Those GM retirees who are more comfortable with a fixed payment should stick with the company pension plan, which will be replaced by a Prudential Financial Inc. group annuity this year, Mr. Kudla said.

“Due to the economies of scale of a multibillion-dollar group annuity, you're going to get better terms than you could get on your own,” he said.

But Mike Scarborough, president of Scarborough Capital Management, thinks that retirees can have their cake and eat it, too.

Using a lump-sum payout to buy a variable annuity offers the potential to offset future inflation and to continue full payments to a surviving spouse, rather than the reduced survivor benefits typical of corporate pensions.

And if the market performs well, there may be something left for heirs after the death of the second spouse, said Mr. Scarborough, a veteran adviser of GM workers and retirees.

He concedes, however, that at current lump-sum-payout rates, clients would need to kick in additional cash to replicate the income stream of the monthly corporate pension.

For example, a retiree with a $35,000-a-year pension could be offered a lump-sum payment of $500,000, enough to buy just $25,000 of annual income at today's 5% payout rate. If the individual added another $200,000 from an IRA to the variable annuity, he or she could match the monthly pension income and lock in the upside potential.


The percentage of frozen pension plans that may try to shave the number of plan participants has more than doubled to 38%, from 16%, among Fortune 200 companies over the past five years, according to Mercer.

Consequently, some clients could face similar lump-sum-payout decision over the next few years. It is a good time for advisers to think about what they should tell them.

Mary Beth Franklin ( welcomes your comments and suggestions for column topics. Twitter: @mbfretirepro


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