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No longer an all-or-nothing choice between single payments or lifetime checks
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When retiring, those fortunate enough to be vested in an employer's defined benefit pension plan have often faced the choice of receiving either a single lump-sum payout or a monthly income stream through an annuity. But on Sept. 9, the IRS published a final rule that allows pension plan sponsors to offer an option of split distributions, with both an initial lump sum and continuing annuity payments, thereby giving plan participants more flexibility in deciding how to receive their pension benefits.
The regulations apply to plan years beginning Jan. 1, 2017, but they may be applied earlier.
"The rule is very welcome, and many employers will start allowing for bifurcation" of pension distributions, said Steven J. Friedman, co-chair of law firm Littler's employee benefits practice group in New York City. While some plan sponsors have already allowed participants to split their distributions this way, relying on a proposed rule the IRS issued in 2012, most have been hesitant to do so without final guidance.
Currently, when lump sums are available through a pension plan, the majority of participants choose to take the single payment rather than selecting a lifetime annuity. "The government became concerned that, with people taking lump sums in such large numbers, many retirees could outlive their money," Friedman said. "Allowing plans to offer retirees the choice of making a partial annuity election may get more people interested in annuities, and from a public policy standpoint, that might not be a bad idea because the annuity will be there for their lifetime."
Similarly, "Participants are better served by having the option to receive a portion of their benefit in annuity form rather than having to make an all-or-nothing decision," states an analysis of the final rule by Xerox HR Services. Advises Roger W. Ferguson Jr., president and CEO of financial services firm TIAA, "Rather than attempting to stretch a lump sum … over a retirement that could last several decades, retirees can budget for living expenses and better weather unexpected challenges if they have a reliable source of monthly income." A recent TIAA report notes, "Employers play an important role in helping employees understand and access lifetime income options."
Amending Plans, Implementing Systems
Pension sponsors who choose to offer split distributions "will certainly have to amend their plan documents," Friedman said, "because most of the time today it's an all-or-nothing distribution structure" under the plan.
A challenge for plan sponsors will be implementing systems to ensure that the bifurcation is done properly, he said. "But since most employers with defined benefit plans are larger entities, they're likely to have a competent third party that's administering their pension plan already, and the third-party administrator should be able to add bifurcation to the menu of possible distributions options in a fairly systematic way."
Plan sponsors have different ways of providing annuities, he added. Some will provide the annuity through the plan directly, but more typically, plan sponsors contract with an insurance company to provide an annuity when the plan participant elects one.
With respect to the plans that offer lump sums today, "many plan sponsors would like participants to choose something different than a single payout," Friedman said.
That's because pension distributions are calculated based on prevailing interest rates, with lower rates requiring larger lump-sum payouts. "In the low-interest-rate environment we're in today, the lump sums have gotten to be very expensive for the plan sponsor," he said. If more participants choose to take at least part of their pension through an annuity, "this could lower pension funding burdens a bit—if the partial annuity becomes popular and if interest rates stay low."
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