Surprise! (Surprise Again!) Three factors pension plan sponsors should consider as the IRS makes (another) surprise move on lump sum payouts.

In a surprise move during the summer of 2015, the Treasury Department and the IRS announced that defined benefit (DB) plan sponsors would be restricted from offering lump sums to retirees receiving annuity payments. The reasoning behind this move seemed clear. Asking retirees to choose between continued annuity income and a lump sum, given the retirees’ general informational disadvantage, seemed to introduce potential conflicts. During that time and under President Obama’s administration, the IRS expressed concern about participants being shortchanged on the value of their vested benefits if they switched from life-long monthly payments to a lump-sum distribution once payouts were underway. This protection also kept the investment and longevity risks of pension plans squarely on the shoulders of plan sponsors. So while the suddenness of the move was unexpected, the rationale was consistent with the protective stance that U.S. regulators have adopted with regard to DB plans.

So it was even more surprising when Notice 2019-18, published in the first quarter of 2019, reversed that 2015 restriction. The move comes under the purview of a different administration and was introduced without much fanfare or explanation. The change comes as the pension landscape undergoes a secular shift, with plan sponsors increasingly exploring risk transfer options in an effort to reduce the size of the DB liabilities on company balance sheets.

What’s Next?

The natural next step for any DB plan sponsor would be to assess how this change impacts the plan’s future risk transfer activity. The 2015 Notice reduced the breadth of risk transfer options—plan sponsors were forced to turn to the insurance market to offload pension liabilities tied to retirees, while lump sum offers were restricted to active employees and terminated vested plan participants. Now that retiree lump sum offers are back on the table, should plan sponsors take advantage of this new flexibility? As is typically the case in the DB world, it depends on a number of plan-specific factors.

From the outset, there are a handful of issues to address from the plan sponsor’s perspective. Let’s consider them:

  1. It’s Only an Offer. Lump sum offers are just that—offers. Retirees aren’t obligated to swap their pension payments for a single distribution. The decision will be highly dependent on individual circumstances, and estimates of the rate of lump sum acceptance across a population of retirees can vary widely.
  2. Do Lump Sums Add Up? Although you can make the case that some pensioners would benefit by taking a lump sum, calculating the magnitude of the financial gain requires microeconomic understanding that few possess. For example, in order to make a reasonable comparison of the value of the lump sum offer to their current annuity, individuals would need to accurately assess their life expectancy, applicable discount rate, projected investment returns, and tax impact. That’s a lot to ask of pensioners who may be in their 70s, 80s, or older. Personal circumstances, lack of financial knowledge, family and health-related pressures, could all lead to poor choices. From this perspective it is easy to see why retiree lump sums carry a stigma.
  3. Counting the Cost. Perhaps the most financially salient consideration from a plan sponsor’s perspective revolves around the costs, both explicit and implicit, tied to lump sum offers relative to the other risk transfer option: purchasing a group annuity contract. The annuity market for pension risk transfer has grown at a brisk pace since 2015, no doubt spurred on (at least in part) by the original action of the Treasury Department and IRS. New players have entered the market and pricing has become increasingly competitive. Insurance companies have also made it known that they prefer to take on retirees already in pay status, pricing deals for this group more aggressively than active and terminated vested participants (for whom lump sums are still an option). Over the last four years, this has led to a decline in potential cost savings of a lump sum offer compared to a group annuity contract.
    An attempt to annuitize remaining retirees after a lump sum offer could also be met with higher pricing by insurance companies, under the assumption of adverse selection. That is, insurance companies will assume that those presenting the least attractive risks to underwrite have enough sense to remain in the annuity pool. Although as we mentioned above, this may not be not the case. Offering a lump sum then buying out the remaining retirees could ultimately cost more than a single group annuity contract covering the entire population.

Don’t be Surprised by another Reversal

Sponsors should keep in mind that this may not be the last word on retiree lump sum regulation and the lump sum window once again open for retirees. The recent move has been widely criticized by retiree advocacy groups and throughout the financial media. (CNN Business reported on the announcement with this headline: “It just became easier for employers to dump retirees’ pensions.”)The original action was partially the result of external pressures such as these, and there is no guarantee that sponsors won’t be asked to make another 180-degree turn in the future, with limited notice.

On the surface it seems as though DB plans were gifted some valuable flexibility for their de-risking playbook in 2019, but sponsors would be prudent to consider the unintended consequences that may result before offering a retiree lump-sum window. It wouldn’t be surprising if it closes again.

As an acknowledged plan fiduciary for 25 years, Highland works with clients to make better and more informed decisions regarding their DB plans. Contact us if you’d like to talk through the implications of the IRS’s reversal on retiree lump sum payouts.

Highland Consulting Associates, Inc. (Highland) is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

Mark Baker

Mark is a key member of Highland’s research and client service teams. He is deeply involved in asset allocation, risk modeling, and performance attribution. Mark also has an active role in client report review, including asset/liability reporting and preparing related scorecards. Mark graduated Summa Cum Laude with a B.A. in Mathematics from Cleveland State University. He is an Associate of the Society of Actuaries.

Disclaimer

The information and material published in this report are confidential and non-transferable. Therefore, recipients may not disclose any information or material derived from this report to third parties, or use information or material from this report, without prior written authorization.

This report is provided for informational purposes only. It is not intended to constitute an offer of securities of any of the issuers that may be described in the report. No part of this report is intended as a recommendation of any firm or any security, unless expressly stated otherwise. Nothing contained in this report should be construed as the provision of tax or legal advice.

Past performance is not indicative of future performance. Any information or opinions provided in this report are as of the date of the report and Highland is under no obligation to update the information or communicate that any updates have been made. Information contained herein may have been provided by third parties.

Highland makes no representations or warranties, express or implied, as to the information's accuracy or completeness. Furthermore, such information may be incomplete or condensed. Highland, its directors, employees, assigns, agents, and successors bear no liability for any errors or omissions in this publication or for any losses arising from the use of or reliance upon this information.

This limitation on liability applies to direct, indirect, consequential, special, punitive, or other damages, as well as damages for loss of profits or business interruption. Investors shall bear all responsibility for investment decisions taken on the basis of the contents of this report.