The Year of the Lump Sum Buy-Out

Posted on : May 02, 2014 | Filled under : News

The Chinese zodiac designates 2014 as the year of the wooden horse. Since wood is combustible, experts say we should be prepared for conflict, tension, and turmoil. One occurrence that may cause some tension and turmoil during the year is King Wealth Planning-Lump Sum buy outdeciding whether or not to accept a defined benefit (DB) pension plan lump sum buy-out offer. These offers are expected to be popular with companies that are trying to reduce the risks associated with their DB pension plans. They may be a source of tension because they require workers and retirees to make decisions that could profoundly affect their comfort in retirement.

Understanding defined benefit pension plans

Many Americans are familiar with defined contribution (DC) plans, such as 401(k) or 403(b) plans. With DC plans, the employer and/or the plan participant may make contributions to the participant’s account. The participant decides how to invest the savings, and the value of the account may change over time depending on how well the underlying investments perform. The amount of retirement income a DC plan account will generate depends on a variety of factors.

DB pension plans are a different animal entirely because they promise a specific monthly benefit in retirement. Typically, benefits are determined by participants’ income and tenure. Traditional DB plans are employer funded, and Federal rules establish the amount that an employer must contribute to its plan. Plan officials decide how to invest the contributions and the employer is responsible for making sure the amount it has put in the plan, plus any investment earnings, will cover the benefits that have been promised.

Reducing DB plan risk becomes a priority

A preference for DC plans rather than DB plans was apparent long before the financial crisis; however, after the crisis, market volatility and persistently low interest rates made DB plans less attractive. At the end of 2007, the 100 largest corporate DB pension plans in the United States were more than fully funded (105.3 percent funded), according to Milliman Consulting. In other words, the companies had more than enough money set aside to pay the benefits they had promised to current and future retirees. By the end of 2012, that funding ratio had fallen to 77.2 percent. According to Milliman, “Pension expense – the charge to company earnings – also registered a record level of $55.8 billion during fiscal year 2012, a $17.3 billion increase over fiscal year 2011, which at that time was the highest on record.”

This unwelcome development was the catalyst that sparked a search for ways to reduce the risks associated with DB pension plans. De-risking efforts have focused on plan design, financing and investment policies, and liability management. One approach to managing liabilities is to offer lump sum buy-outs to current retirees and former employees. Typically, the amount offered is a sum equal to the full present value of earned and vested plan benefits. The only catch from a company’s perspective was the plans’ funding levels needed to improve before companies could afford to take action. This happened in 2013 when plans’ funding levels reached to 95.2 percent in December.

Pension plan de-risking

There is no right or wrong answer when it comes to deciding whether to take a lump sum buy-out. It all depends on your personal circumstances. If an employer makes an offer, you need to weigh the pros and cons before making a decision. On the positive side, a buy-out provides you with a choice. On the negative side, the money will need to be managed well or it may not last through retirement. Some of the things you may want to consider before deciding whether it makes more sense to have a monthly income for life or a sizeable disbursement today, include:

  • Longevity: Life expectancy has been increasing which means having a lifetime of monthly income could be quite valuable, not to mention comforting.
  • Employment status: If you no longer work for the company making the offer, your DB plan benefits are unlikely to increase between now and your retirement date.
  • Growth opportunities: Taking a lump sum, direct rollover into an Individual Retirement Account (IRA), and investing the assets may provide an opportunity to realize additional growth.
  • Retirement income: If you take a lump sum, you are responsible for investing and managing it to provide income in retirement or a legacy for your heirs.
  • Investment risk: If a lump sum is not managed well, you may run out of money during retirement.
  • Medical issues: A lump sum distribution may provide enough money to help with large and unexpected expenses, such as medical or long-term care costs.
  • Possibility of bankruptcy: If the employer declares bankruptcy, the Pension Benefit Guaranty Corporation may take over the pension and monthly benefits may be reduced.
  • Wealth transfer: DB pension plan accounts rarely provide opportunities to transfer wealth to heirs. Taking a lump sum may give you that opportunity.

Before making a decision about whether to take a lump sum buy-out, it’s a good idea to talk with your financial advisor and discuss how the choice may affect your overall financial plan. If you decide to accept a lump sum buy-out, be sure your employer has correct information regarding your age, salary, and dates of employment. If you’re not yet at retirement age, it’s important to rollover the assets into an IRA or they may be subject to tax and penalties.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Traditional IRAs are accounts funded with tax deductible contributions in which any earnings are tax deferred until withdrawn, usually after retirement age. Unless certain criteria are met, IRS penalties and income taxes may apply on any withdrawals taken from Traditional IRAs prior to age 59½. RMDs (required minimum distributions) must generally be taken by the account holder within the year after turning 70½.


The above material was prepared by Peak Advisor Alliance.

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