Pension plan sponsors often seek to reduce their liability exposure. An easy, inexpensive, and popular way of doing this is to offer lump sums to those who have earned the pension promise, which means they are “vested.” First up among these vested participants are those who no longer work for the company and aren’t yet receiving payment—rather rudely referred to as “terminated vested.” The lump-sum payment option is popular with this group; in general, more than half of them take it. The plan sponsor is happy, too, because the plan liability shrinks which, in turn, reduces the operating expenses and the pension plan’s impact on company financials.
There’s another vested cohort for whom the lump-sum payment option has been considered, and that’s pensioners already receiving payment. Here, though, it gets a bit dicier for one big reason: In a recent Gallup poll of retirees, the majority of those who receive a work-sponsored pension said they relied on it as a major source of income in their retirement. Assuming they receive a monthly pension check, poor decision-making about a lump-sum option could lead to problems not all that far down the road for them.¹ Now, the lump-sum payment is only an option and in no way forced. Within the context of retirement financial planning, this option might be an action to consider—perhaps a pensioner with deteriorating health or in need of money immediately. It’s also true that more options are usually a good thing when it comes to financial planning.
In a January 2015 Government Accountability Office (GAO) report that studied private pensions and lump-sum options, the GAO argued that the risk of poor information on, or a lack of understanding about, a lump-sum payment could undermine important lifetime benefits, with participants “potentially facing a reduction in their retirement assets when they accept a lump-sum offer.”² It’s not hard to conjure up any number of bad scenarios, such as one where granny is talked into handing over her monthly checks for a pot of cash.
It didn’t take long for the IRS to issue Notice 2015-49 on July 9, 2015, which prohibited qualified defined benefit plans from paying lump sums to in-pay retirees and beneficiaries (apart from those sponsors already far along with their offering).
While Vanguard generally prefers more choice for investors, we agree with this decision. Sure, there are plenty of spry retirees who may wish they had the option to gain access to their balance, either for an immediate need, poor health, or perceived investment skill. But there’s a regrettably significant chance of misunderstanding or mishandling this option. Investment mistakes at this point in life could be catastrophic. Better to ensure that most pensioners have a steady income for life with this broad IRS ruling.
1Gallup, April 9–12, 2015.
²United States Government Accountability Office, Private pensions: Participants need better information when offered lump sums that replace their lifetime benefits, January 27, 2015.
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