Advise DB Plan Participants Carefully on Lump Sum Window Opportunities
Defined benefit (“DB”) plan sponsors have several motives to offer plan participants a lump sum payout window. One such motive would be to lower the plan’s financial risk, thereby providing better long-term financial security to those participants who remain in the plan. On the other hand, receiving a lump sum payout as a participant could prove to be good or bad, and come with various risks and consequences.
Suggestions from the GAO
Apprehension that countless employees are not making prudent investment decisions once lump sums are obtained has driven the scrutiny of lump sum windows. A report last year by the Government Accountability Office (“GAO”) discovered that, although sponsors legally have the option of allowing employees to choose various lump sum options, the particiants’ understanding of the financial risks that supplement that choice was questionable.
The GAO advised the U.S. Department of Labor (“DOL”) to enhance oversight by mandating that plan sponsors notify the DOL when a lump sum option is included and implemented in the Plan. The report also urged the IRS to evaluate interest rates and mortality tables which are included in the calculation of lump sums and to reevaluate regulations which govern relative value statements.
Considerations for Participants
Nonetheless, DB plan sponsors should proactively take additional steps to ensure that participants have available information and the proper knowledge before opting for a lump sum payout. Some factors and information which participants should take into consideration when making this choice are as follows:
Investment management. When the lump sum payout option is selected, the participants will be required to personally invest the proceeds prudently and wisely to avert greater financial losses than if they’d opted to leave the funds in the plan. Are they confident they are capable enough to make those decisions and accept that challenge?
Value comparison. How does the present value of the anticipated pension annuity benefit compare to the value of the lump sum? If a participant has the ability to purchase a larger retirement benefit from an annuity provider with a single premium purchased with the lump sum proceeds, the participant may opt to take the lump sum, as opposed to the annuity. If that’s not a viable option, then declining the offer may be a better financial decision.
Health considerations. Depending on the participant’s health and well being and their projected life expectancy, generally it would be more advantageous to remain within the pension plan and not take the lump sum option. On the other hand, because pension benefit calculations are calculated by using average life expectancy, it may be more beneficial for the participant to select the lump sum option.
“Last chance” possibility. A lump sum opportunity may be appealing because of unique employer circumstances indicating that no other lump sum window will be available in the future.
Estate planning. With a DB pension annuity, the benefit ceases to exist when the participant (or possibly a surviving spouse) dies. On the other hand, with a lump sum, any residual assets have the possibility to be willed to heirs.
Tax considerations. If the participant does not choose to rollover the lump sum distribution into a qualified retirement plan, then the distribution may be taxable. In addition, early withdrawal for those participants younger than age 59 ½ may be subject to an additional 10% penalty, unless the distribution is made after separation from service, during or after the calendar year in which the participant reaches age 55.
Provision of Sound Guidance
The aforementioned items are only a few of the many considerations that plan participants should contemplate when a lump sum payout is an option presented within the plan. Plan sponsors have a fiduciary obligation to educate and provide guidance to their participants. Finally, if the GAO’s request for enhanced oversight is approved, the plan will already be equipped to make the correct notification to the DOL.
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