Considering offering a lump-sum option or purchasing an annuity for your pension plan?
If you’re considering adding a lump sum or annuity feature to transfer risk in your defined benefit (DB) plan, it’s important to understand the impact they can have on pension funding, accounting, plan administration and participant retirement security.
The impact of transferring risk from your pension plan
1. Pension funding
Unless a plan has fully transferred all pension risk, the remaining portion of the plan will likely experience an actuarial loss. This is because the lump sum or annuity purchase at today’s rates will likely be greater than the obligation being transferred. Actuarial losses reduce funding ratios (adjusted funding target attainment percent or AFTAP) and increase funding shortfalls.
2. Highly compensated employees
Certain highly compensated employees (HCEs) may have additional benefit payment restrictions. For example, if the value of the employee’s benefit is more than 1% of plan assets and the plan’s HCE ratio is not at least 110%, the HCE may not be permitted to take the full benefit in the form of a single lump sum.
Buy-out annuities and lump sums can trigger immediate recognition of unrecognized losses through a settlement charge. (Settlement charges are not triggered by buy-in annuity purchases.) Many plans can carry large unrecognized losses under certain conditions, such as a low interest rate environment coupled with less-than-expected asset returns. In cases like this, settlement charges can become quite significant.
To reduce settlement charges, consider looking for ways to recognize potential losses prior to purchasing an annuity and/or offering a lump-sum payment.
4. PBGC coverage and premiums
Buy-out annuities and lump-sums remove benefit payments from the ERISA protection applicable to qualified DB plans. As a result, PBGC insurance and related premiums cease at the time risk is transferred to an insurer or participant.
Important note about PBGC premiums
PBGC flat-rate premiums are reduced as plan head count decreases, but actuarial losses may increase the variable rate premium to offset these savings in the short term. Plan sponsors are still required to pay PBGC premiums on the liabilities that are settled through a buy-in annuity.
5. Participant risk
Lump sum payments transfer investment, interest rate and longevity risk directly onto plan participants. Due to participants’ varying levels of financial knowledge, they may be more or less successful in managing a lump sum throughout their retirement years. Financial education can help.
6. Lump-sum offers to retirees
Some sponsors have offered lump-sum windows to retired participants already receiving monthly payments from the plan. Lump sums may be offered legally to participants who have not previously declined a lump-sum payment offer.
Offering lump sums to retirees can pose ethical and fiduciary questions of whether individuals of advanced age are capable of making such a decision. Those who expect shorter life spans are more likely to elect a lump sum, while those expecting to live longer may be more likely to continue monthly payments. This increases the funding or annuity cost of the remaining group. Please consult with your legal team if you are considering offering lump sums to retirees.
We can help
As with all decisions related to your pension offering, it’s important to remember the goals you have for your plan. Work closely with your financial professional and actuary, to make the decision that will best meet your organization’s needs. Need help? Give us a call at 800-952-3343, ext. 22681 or contact your advisor to get started.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
Insurance products and plan administrative services provided through Principal Life Insurance Co., a member of the Principal Financial Group®, Des Moines, Iowa 50392.
Principal, Principal and symbol design and Principal Financial Group are trademarks and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group.