Advisers need to brush up on plan participants’ risks when taking lump sum distributions

Veteran financial planners and wealth managers are accustomed to dispensing advice to clients on lump sum payouts. But they may want to brace for more activity in the coming year that includes a couple of interesting twists, both legal and regulatory.

In August, the Labor Department’s ERISA Advisory Council spent considerable time reviewing the question of how best to notify employees regarding the pros and cons of taking a lump sum payout versus preserving the lifetime pension income offered by their defined benefit plan. The attention comes amid a trend for DB plan sponsors to pursue so-called “de-risking strategies” that help plan sponsors avoid having to deal with market volatility and associated instability in plan funding levels, as well as reduce administrative costs.

“De-risking” is a bit of a misnomer because financial risks aren’t eliminated through these strategies, they are transferred. In the case of a lump sum payouts, the risk is shifted to the participants. Alternatively, under certain circumstances, a plan sponsor may choose to transfer the financial risks to an insurance company by purchasing a group annuity contract to replace the pension plan benefits with retail annuities.

The current sustained low-interest environment and recently volatile markets have made DB plan sponsors especially eager to transfer risk. There are, however, restrictions on the ability to undertake de-risking strategies for underfunded plans. Moreover, there are rules that require lump sum payout amounts and insurance annuity risk transfers to meet certain tests to help assure that these options are theoretically equivalent to the lifetime pension income associated with staying in the plan. These rules and the current investment environment have dampened the ability of many plans to de-risk; however,If interest rates and market returns rise and more plans become fully funded, the de-risking trend is likely to accelerate.

(Related read: How to clarify the murky regulations governing IRA rollovers)

It is also worth noting that the IRS announced in July that it would put off using new mortality-rate calculations in defined-plans based on longer lifespans until 2017.That decision provides a special window of opportunity for companies wanting to conduct pension risk transfers, because the new assumptions that people live longer will make these strategies more expensive after the new tables go into effect.

Shifting financial risks from the plan sponsors to participants can create regulatory and litigation risks for plan fiduciaries who are obligated to serve the sole best interests of plan participants and beneficiaries. As such, plan fiduciaries need to exercise special care in making sure the technical rules covering de-risking strategies are applied properly and that participants receive full disclosure of (if not education about) the options available to them and the associated benefits and drawbacks of each.

The need for vigilance in this area is heightened by the fact that some experts believe that unless a participant dies within five or six years after retaining a lifetime pension, the plan pension benefit would be a far better value for the participant. For example, one law professor at the meeting of the ERISA Advisory Council, Johnathan B. Forman of the University of Oklahoma, argued that when plan sponsors shift risk to participants, the participants are rarely fully compensated for giving up the lifetime pension income and potential additional benefits attendant to staying in the plan.

A lump sum amount, he said, must be calculated consistent with certain actuarial assumptions based on the present value of the participant’s expected stream of annuity payments over a lifetime. According to Mr. Forman, using the lump sum to purchase a comparable annuity would leave the participant with an income stream of approximately 85% of the value of the plan annuity.

Thus, as an ERISA fiduciary required to act in the participants’ best interests, Mr. Forman argues that plan sponsors may breach their fiduciary duty if they downplay the real reductions in value in notices to their workers about lump sum payout or group annuity offers.

Advisers providing personalized (i.e., fiduciary) advice directly to participants about whether to accept the risks associated with taking a lump sum distribution must themselves be very well-versed on the options available and the ramifications of each alternative. Their advice should be driven by a sound due-diligence process that is well documented and carefully explained to the participant.

While this article has focused upon the fiduciary ramifications of risk transfer strategies for DB plans, the issues and implications for advice rendered to participants will be roughly the same for defined-benefit and defined-contribution plans if the Labor Department’s proposed fiduciary rule is implemented as expected. Advice regarding whether and how to take a plan distribution would be fiduciary in nature and subject to prohibited-transaction rules and the fiduciary duties of loyalty and care.

In summary, the decision about whether or not to take a lump sum distribution from their retirement plan is one of the most important plan participants will ever make.

Consequently, it is one of the most closely scrutinized areas of responsibility for plan fiduciaries. Getting everything right is critical for all involved.

Blaine F. Aikin is president and chief executive of fi360 Inc.