Companies are increasingly offering lump-sum distributions to pension plan participants. But there’s a catch: There’s very little time to make a decision.
In 2012, major corporations started to use the term pension de-risking to describe their need to lessen, if not eliminate, their pension plan liability. While that might make sense to a shareholder, employees will have legitimate concerns about what it means for their pension benefits. We believe the pension de-risking trend will accelerate, and plan participants should be prepared for changes to their retirement income strategy.
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Expect to see an uptick in lump-sum window offers
It was a quiet first half of the year for pension de-risking activity in U.S. corporations. But recently, more companies began making changes to their pension plans in an effort to decrease their liabilities. One particular strategy is growing in popularity: Companies are offering a one-time payout, or lump-sum distribution, to former employees who receive pension benefits. Participants are given a short window of time to decide whether or not they want to accept such an offer — the decision window ranges anywhere from 30 to 90 days. And as this trend continues to grow, it’s becoming more important for plan participants to prepare for the possibility of a lump-sum window offer and understand its implications.
Lump-sum distributions are not without risk
Lump-sum offers are made to individual participants, and if they accept, they leave the pension plan and roll their assets into an IRA. Whether or not to accept the lump-sum is their decision, and they must ask themselves if it’s riskier to stay in the plan or leave it.
High percentages of people who are offered lump-sums accept them, but some participants never actually get their offer fulfilled. Because the Pension Benefit Guaranty Corporation (PBGC) requires companies to pay an annual premium for each participant, businesses are incentivized to reduce the number of people in their pension plan. Companies sometimes set a lump-sum target (say $1 billion), and then fulfill the accepted offers from the smallest to the largest lump-sum amounts. If the target is reached before all of the offers are fulfilled, some participants may not receive the lump sum distribution they wanted and instead remain in the plan.
Lump-sum offers aren’t the only de-risking strategy
There are several other methods that companies are using to de-risk their pension obligations. Some have been around for a while, such as freezing pension plans. A soft freeze closes the pension plan to new employees, and a hard freeze means that existing employees will no longer see their pension grow.
Newer strategies relieve companies from their pension obligations by shifting the responsibility to an outside insurance company in what is called a pension risk transfer. Some people may feel more comfortable with an insurance company being responsible for their pension plan, but others may feel the opposite. Regardless, the PBGC will only approve a pension risk transfer if there is no change to the benefits participants will receive. As with a lump-sum offer, any of these other de-risking events should also prompt a review of the participant’s retirement income strategy.
Companies are making substantial contributions to their pension plans
A well-funded pension plan makes it easier for a company to pursue a de-risking strategy like a lump-sum window offer. In an effort to improve the financial health of their pension plan, at least four major U.S. companies have announced dramatic increases to their pension contributions that are well above their minimum requirements.
Several factors drive these massive contributions, including three anticipated drivers:
- Longer life expectancy: Pension plans will soon be required to use updated mortality tables that reflect longer life spans. And of course, longer life spans mean larger pension benefits.
- Corporate tax reform: If President Trump’s agenda is enacted, corporate tax rates could potentially decline from 35% to as low as 15%. This is a positive for corporations, but since a portion of pension contributions are deductible by the plan sponsor, it’s more favorable to make large contributions now — especially for companies who will need to significantly shore up their pension plan’s funding level in the near future anyway.
- Rising interest rates: Because current interest rates are low, companies can issue bonds at a low cost. This allows companies to use the money they receive from bondholders to make contributions to their pension plan at a lower cost now, rather than face rising interest rates in the future.
There’s also one known headwind that drives massive contributions:
- Pension Benefit Guaranty Corporation (PBGC) insurance premiums: PBGC is an agency that protects retirement security for American workers with pensions. In order to provide this service, the PBGC requires companies to pay an annual premium for each person in their pension plan. This premium is increasing for pension plans that are underfunded, encouraging companies to contribute more money so their premiums don’t significantly increase.
Lump-sum window offers are coming. Although each offer will differ due to the unique situations of the companies and employees involved, a common feature is having a short period of time to react. To avoid making a rushed decision, it’s important to anticipate the next wave of lump-sum offers and discuss the best possible options on an individual basis.
Article by Abram Claude, Columbia Threadneedle Investments