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But not as much as plan sponsors hoped
With the passage of the Pension Protection Act (PPA) in 2006, defined benefit pension plan sponsors looked forward to some relief when calculating lump-sum payouts for retirees. The PPA paved the way for a shift from using the 30-year Treasury bond interest rate to calculate lump-sum distributions to using a composite corporate bond rate. Many U.S. plan sponsors have been phasing in the change slowly and expect it to be complete by 2012.
The change was welcomed by plan sponsors, many of whom are dealing with chronically underfunded plans, because the replacement corporate rate tends to be higher than the Treasury bond rate. “The yields tend to be higher on a corporate bond, so lump-sum annuities calculated under this rate are likely to be lower,” explained Alan Glickstein, senior consultant with Towers Watson in Dallas.
The change is welcome for other reasons. For example, “the corporate rate is more consistent with how plan sponsors carry pension liabilities on their financial statements,” Glickstein said.
However, with interest rates at historically low levels in 2010-11, the expected relief has not been as great as hoped, at least so far. “Switching from treasuries to corporate interest rates would tend to decrease the size of lump sums,” said Jeff Litwin, a pension consultant with Sibson Consulting in New York. “Unfortunately, the five-year corporate bond interest rate went down instead of up.” Still, low interest rates make the change to the new composite corporate rate more economically neutral because the difference between the Treasury rate and the composite corporate rate is not as pronounced as it might be when interest rates inevitably rise.
This mixed blessing is particularly disappointing for plan sponsors with significantly underfunded plans that were looking for some funding relief, as well as plan sponsors looking to terminate a frozen plan. “Some of these plan sponsors were hoping that this five-year transition to the new interest rate would help their plans’ funding status through smaller lump-sum payouts,” Litwin said. This, in turn, could reduce plan liabilities and make plan termination more affordable. “However, because of the interest rate drop, that approach has not become as affordable as they might have hoped,” he explained.
Still, interest rates are unlikely to stay this low forever. And when those rates increase, plan sponsors might find using the composite corporate rate to be a positive development. In fact, Glickstein noted that plans that do not currently offer a broad-based lump-sum distribution option might be interested in doing so now.
Plans that don't offer a broad-based lump-sum
distribution option might be interested
in doing so now.
However, offering lump-sum distributions might not be a panacea. For example, if a plan sponsor is eager to get retiring employees off the pension books by offering a lump sum, a higher interest rate/lower lump-sum scenario might work against that goal. Employees might opt for other payout options that they consider to be more advantageous financially.
In addition, Glickstein noted that plan participants have eschewed lump-sum distributions no matter what their size in the wake of the 2008-09 market plunge. “The lump-sum distribution is a common option, but lately it has been a less popular choice,” he explained. “Because of the financial crisis, people are a little less willing to take a big chunk of money that they then have to figure out how to invest.”
Making Lump Sums More Attractive
If increasing lump-sum distributions is an important goal for a plan sponsor, there are a few steps they can take to make lump sums more enticing to participants. “Many plans update their lump sum annually by locking in the interest rate in a particular month prior to the beginning of the year,” Glickstein said. “Plan sponsors can always be more generous if they want to.” For example:
• The plan sponsor has the option of setting the interest rate used to calculate lump-sum distributions to offer a lump sum that is richer than the required minimum (as long as the plan sponsor makes sure that the plan remains compliant with all regulations).• Simple communication can help by making sure that participants are aware of their options when it comes to taking a distribution, including the lump-sum option. This communication should extend to plan participants who have left the company but are not yet eligible to receive retirement benefits from the plan.
• The plan sponsor has the option of setting the interest rate used to calculate lump-sum distributions to offer a lump sum that is richer than the required minimum (as long as the plan sponsor makes sure that the plan remains compliant with all regulations).
• Simple communication can help by making sure that participants are aware of their options when it comes to taking a distribution, including the lump-sum option. This communication should extend to plan participants who have left the company but are not yet eligible to receive retirement benefits from the plan.
Beyond these moves, Glickstein suggests that there are other options available to plan sponsors that want to reduce plan liabilities. “One of the best ways to shrink the liability of the plan and get those liabilities off of the company's balance sheet is to sell those liabilities to, say, an insurance company,” he advised.
Alternatively, plan sponsors can simply communicate how interest rate movements can impact the size of lump-sum distributions so that participants at least consider taking the lump-sum option before interest rates increase.
Joanne Sammer is a New Jersey-based business and financial writer. Her articles have appeared in a number of publications, including HR Magazine, Business Finance, Consulting, Compliance Week and Treasury & Risk Management.
Pensions: the Lump-Sum Gamble,Wall Street Journal, November 2010
Cashing Out: Help Employees Make Smarter Distribution Decisions, SHRM Online Benefits Discipline, December 2005
SHRM Online Benefits Discipline
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