For several reasons, more participants in traditional defined benefit plans will soon be confronting an important choice, and they need your help. Should they take the lifetime pension they were promised, or a lump-sum payout instead?
Boomer participants are going to be retiring in droves now that the leading edge of their ranks-those born in 1946-is age 65. Meanwhile, cuts by tightfisted state and local governments could force public employees into retirement, or worse, unemployment. Although these workers' ability to take a lump sum is often limited, some 79% of them have pensions, according to the Bureau of Labor Statistics' March 2009 National Compensation Survey.
Then there's a new pension law for private-sector (corporate) plans that becomes effective next year. It generally reduces lump-sum payouts, assuming interest rates remain at current levels. "That will make it less expensive for plan sponsors who want to terminate their plans to do so, and many of them are going to terminate their plans in 2012," says James A. van Iwaarden, a consulting actuary and the president of Van Iwaarden Associates in Minneapolis. Typically, the sponsor freezes the plan before terminating it, he adds.
Fortunately for advisors, the wave of terminations is likely to continue for some time. For a plan to be terminated, it must be 100% funded-i.e., its assets must equal the value of the benefits promised the workers-and currently many plans are underfunded, explains Mary Ann Dunleavy, a consulting actuary at Horizon Actuarial Services LLC, in Silver Spring, Md. It's going to take a while for plans that were severely hurt by the market downturn of '08-'09 to get to full-funded status, she says. Which just means the opportunity to provide advice extends beyond 2012.
Capitalizing on these trends means doing two things. First, advisors must become familiar with the impending law change and its impact. Near-retirees can benefit from your expertise in this area now. Second, planners must get to know the issues surrounding the lump-sum-versus-pension decision that more clients, and prospects, will face.
New in 2012 for Corporate Pensions
The change to private pensions owes to a provision tucked inside the Pension Protection Act of 2006, notes Evan Inglis, the chief actuary at Vanguard.
To calculate the minimum lump sum that may be offered to participants who are retiring, separating from service or having their plan terminated out from under them, the sponsor computes the present value of the pension payments the plan is obligated to make to the participant, based on his or her life expectancy.
From our introductory finance classes, we recall that a present value-in this case, the lump-sum payout-is inversely related to the interest rate used in the discounting process. A lower discount rate produces a higher payout; a higher rate yields a smaller one.
Lump sums from corporate pensions are actually computed with a trio of discount rates, one each for the short, intermediate and long term. The short-term rate is used for discounting pension payments due to the participant within five years. This is known as the first segment. An intermediate-term rate discounts pension payments expected to occur in the second segment, years six through 20. Payments after that fall into the third segment and are discounted at the long-term rate.
The sponsor calculates the present value for each segment using its particular discount rate, then adds the present values together to arrive at the lump-sum benefit.
Beginning in 2012, the segment rates, which are published by the Internal Revenue Service, will be based solely on the yields of corporate bonds rated single-"A" or higher. Since 2008, the rates have been a weighted-average blend of corporate yields and the 30-year Treasury yield.