Think of a 75-year-old. Maybe it’s you, maybe it’s someone in your parents’ or grandparents’ generation. Let’s call the 75-year-old “Pat.” Imagine that Pat is receiving a steady payment of, say, $1,000 per month from a pension plan. These payments will continue until Pat dies. Combined with Social Security and some outside savings, the $1,000/month provides Pat with a comfortable retirement

Now suppose the administrator of the pension plan offers Pat a lump sum payment of $117,000. The $1,000 monthly payments would stop. The $117,000 is all Pat or any family members or heirs will ever receive from the pension plan. What kinds of questions should be asked to help Pat decide whether to take the lump sum?

• Is this a fair offer? Is the company sponsoring the plan trying to pull one over on Pat? Let’s assume not. Lump sum amounts are based on interest rates and mortality tables published by the federal government. This is an honest offer. It has to be decided whether it is a good deal based on Pat’s own circumstances.
• How long will the lump sum last? If drawn down at $1,000 per month, it will last 117 months (almost 10 years) – longer if it is invested and earns interest. Will Pat live longer than 10 years or less than 10 years? Does Pat need to withdraw the full $1,000 per month? Can Pat take out less and make the money last longer? Is Pat interested in leaving an inheritance to anyone?
• Is putting all that money in front of Pat a good idea? Would Pat conserve the money, investing it wisely, or would Pat be likely to blow the money on a large luxury item? What are the tax implications? Would this affect any government benefits Pat is receiving now or in the future?
• Is Pat still mentally sharp? Might Pat be a target for scammers? Would family members and friends suddenly show up looking for a handout, as happens to many lottery winners?

Why would the company sponsoring the pension plan want to make this offer to Pat? Generally, such offers are made as part of a “de-risking” strategy. Companies want to get these pension obligations off the books. The plan is holding a certain amount of money intended to cover Pat’s remaining lifetime benefits. There is a risk that the plan’s assets could lose money or Pat could live longer than expected, forcing the company to put more dollars into the plan for Pat’s benefits. To eliminate that risk, the plan sponsor offers lump sum benefits for a limited window of time (transferring the investment and longevity risk to Pat) or buys an annuity contract so an insurance company pays Pat’s future benefits (transferring the risk to the insurer). In recent years, the lump sum has been the more attractive option for companies because it has been cheaper to settle benefits that way instead of through annuity contracts. Either way, the company is settling the benefits at a current price that is known instead of a future price that is uncertain.

So far, paying these lump sums has been perfectly legal. However, in January, the U.S. Government Accountability Office issued a report titled, “Participants Need Better Information When Offered Lump Sums That Replace Their Lifetime Benefits.” Uh oh. Among the concerns raised by the GAO were the lack of investment savvy by some retirees, the potential for blowing the lump sum immediately rather than preserving it throughout retirement, and a lack of key information in election packets needed for a retiree to make an informed decision.

Possibly in response to the GAO study, the IRS recently came out with Notice 2015-49 announcing that some of these lump sum offers will become illegal if the IRS has anything to say about it. There are still a lot of details to be worked out. Proposed regulations must be written and commented on, then final regulations have to be written. But be warned! Except in limited circumstances, including plan terminations, companies won’t be able to wash their hands of the likes of poor Pat by making lump sum payouts. Such retirees will have to continue receiving monthly checks as they have been.

Stay tuned. We’ll let you know in a few years how this turns out.