Take the money and run?

In 2014, many plan sponsors offered vested, terminated participants the option of electing a lump-sum distribution in lieu of waiting until retirement to collect their pension benefit. These offers provide participants the opportunity to manage their retirement assets to suit their individual needs. For sponsors, these offers are excellent pension risk management opportunities that result in lower plan liabilities, better balance sheet control, and lower participant counts that translate into lower PBGC premiums and plan administration costs. The continuing rise in PBGC premiums and the eventual incorporation of new mortality tables into lump-sum calculation regulations in 2017 make these offers attractive for 2015 and likely 2016.

These offers do create some peril for sponsors and their participants. The participants must be given the option of taking their distributions in cash; they cannot be compelled to roll over their lump sum to an individual retirement account or another qualified plan. Sponsors set up these plans to provide for their employees' retirement, not to fund midlife needs. This issue prompted a Government Accountability Office report that recommended more information be given to participants who are allowed to elect a lump-sum benefit. The GAO is concerned that participants don't really understand the deferred monthly income they are giving up in order to get the immediate lump sum. This article explores several lessons we can learn from participant behavior when offered a lump-sum cashout. Understanding the behavior of participants will help sponsors make better decisions on whether to make these offers and how to communicate with their vested, terminated participants.

P-Solve and Nyhart combined forces and aggregated data from 18 cashout windows representing close to 3,500 participants. The good news is that most vested, terminated participants roll over their cashouts. However, many near retirees are taking the money and running!

What do the data show?

Just over half (51%) of the participants elected to take a lump sum. Only 1% took the immediate annuity benefit that also must be included with these offers. All of these annuity takers were over age 50. Sponsors can expect “take rates” of between 40% and 60% on these offers and do not need to worry about the immediate annuity option being elected by young folks.

The good news is that participants with higher lump-sum amounts that elected a distribution tended to roll over their distribution into an IRA or another qualified retirement plan. The bigger the lump sum, the more likely participants are to roll over their money. Interestingly, the likelihood of doing nothing is only slightly higher with larger lump sums than smaller lumps sums, indicating that inertia is an issue regardless of amount. The chart below shows the comparison of those participants who took their distribution in cash vs. a qualified plan rollover by lump-sum amount.

There is a somewhat alarming pattern when we look at the election patterns by the age of the vested, terminated participants. While the older participants are more likely to roll over their lump sums than younger participants, there is still a fairly high percentage — 25% — of near retirees (in their 50s) who take the money. The average distribution of the individuals between ages 50 and 54 who took cash was $22,000. This amount could easily grow beyond $50,000 by age 67, which would provide a nice supplement to the participant's Social Security benefits. We expand on this important concern below.

We analyzed the data and found no difference in election patterns for gender. These cashout amounts must be determined using unisex mortality tables and uniform interest rates. Since women have longer life expectancies than men, they should be more cautious about taking lump sums.

Participants who elect to take a lump-sum distribution have two options: take the amount in cash or roll it over into an IRA or other qualified retirement plan. What's the difference? Taxes. Money that is rolled over is not taxed until retirement and can continue to build up earnings that are tax deferred. If a participant takes the retirement money in cash, that money gets taxed immediately at whatever tax bracket the participant is in plus a 10% excise tax if they have not reached age 59 1/2. If they continue to invest it (rather than buy a boat), those earnings are taxable as well.

The chart below shows the difference in the eventual money available at retirement if the lump sum is taken as cash vs. rolled over. We have assumed a 50-year-old with a lump sum of $22,000 and an annual return on investment of 5%. We have also assumed a 20% tax rate at age 50 and a 10% tax rate at age 67.

What this chart shows is that all else being equal, rolling over the lump sum into a qualified retirement plan vs. taking the distribution in cash produces more retirement income, even for a distribution of $22,000.

Even small lump sums at early ages can grow to something significant in retirement. Those participants who cash out their pension benefit and don't invest it for the future and instead “buy the boat” are giving away part of their retirement security. While some participants might not “buy the boat,” but instead pay down debts, etc. the tax implications to holding on to those dollars in an IRA or qualified plan should sway individuals to at least consider keeping their money in a qualified retirement plan.

These outcomes are partly what prompted a February GAO report that recommended more information be given to participants who are allowed to elect a lump-sum benefit. It is easy to see how additional disclosures could help participants make informed decisions about the ultimate value of their retirement money.

Plan sponsors considering lump-sum cashout windows will want to enhance their participant communications strategy to help participants understand the full effect of their decision to take a lump sum and understand the retirement savings consequences of taking the distribution in cash or rolling it over.

Ultimately it's not the plan sponsor's role to provide financial advice, but providing information that could urge participants to seek out the advice should be considered.

These lump-sum campaigns for vested, terminated participants are generally quite successful. They result in reduced risk for plan sponsors, just as intended. About half of the participants elect a single lump sum, erasing any future obligation for the plan. At the same time, many participants are happy to have been given the option, resulting in good news on both sides. But the results also indicate the GAO's concern is valid. In general, older participants with higher lump-sum values do the “right thing” and opt to roll over their lump sum into an IRA, thus preserving their retirement dollars and deferring taxation. However, 25% of those ages 50 to 59 are taking the cash, oftentimes substantially reducing their chances of financial security in their retirement years. These participants need information to fully understand the advantages and disadvantages of their decision to take the money and run. The question remains: Do these participants properly understand the cost of this choice?

Charlie Cahill is a managing director in P-Solve's Boston office and leads the firm's actuarial practice. Michael Clark is a director in P-Solve's Denver office.